**Exhibit13**

 

**FIVE - YEAR CONSOLIDATED FINANCIAL HIGHLIGHTS**

 

**Selected Operations Data:**

 
|                                                 |   | **Year  Ended December 31,** |       |
|------------------------------------------------------|--------|------------------------------|------------|
| **(Dollars  in thousands, except per share data)**   |   | **2002**                     |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Total interest income                                |   | **$**                        | **42,868** |   | 51,468 |   | 52,917 |   | 47,104 |   | 48,795 |   |
| Total interest expense                               |   | **21,295**                   |       | 30,444 |   | 33,001 |   | 28,911 |   | 31,898 |   |
| Net interest income                                  |   | **21,573**                   |       | 21,024 |   | 19,916 |   | 18,193 |   | 16,897 |   |
| Provision for loan losses                            |   | **2,376**                    |       | 1,150 |   | 180 |   | 240 |   | 310 |   |
| Net interest income after  provision for loan losses |   | **19,197**                   |       | 19,874 |   | 19,736 |   | 17,953 |   | 16,587 |   |
| Fees and service charges                             |   | **1,723**                    |       | 1,563 |   | 1,297 |   | 848 |   | 518 |   |
| Mortgage servicing fees                              |   | **715**                      |       | 470 |   | 341 |   | 335 |   | 337 |   |
| Securities gains (losses),  net                      |   | **422**                      |       | (671 | ) | (23 | ) | 122 |   | 2,799 |   |
| Gain on sales of loans                               |   | **3,077**                    |       | 2,934 |   | 1,216 |   | 1,932 |   | 2,177 |   |
| Earnings (losses) in  limited partnerships           |   | **(659**                     | )          | (1,311 | ) | (121 | ) | 550 |   | (3,725 | ) |
| Other non-interest income                            |   | **597**                      |       | 599 |   | 613 |   | 506 |   | 524 |   |
| Total non-interest income                            |   | **5,875**                    |       | 3,584 |   | 3,323 |   | 4,293 |   | 2,630 |   |
| Other non-interest expense                           |   | **17,849**                   |       | 15,749 |   | 12,559 |   | 11,895 |   | 13,160 |   |
| Total non-interest expense                           |   | **17,849**                   |       | 15,749 |   | 12,559 |   | 11,895 |   | 13,160 |   |
| Income tax expense                                   |   | **2,099**                    |       | 2,634 |   | 3,798 |   | 3,960 |   | 1,999 |   |
| Income before minority  interest                     |   | **5,124**                    |       | 5,075 |   | 6,702 |   | 6,391 |   | 4,058 |   |
| Minority interest                                    |   | **(142**                     | )          | (383 | ) | 0 |   | 0 |   | 0 |   |
| Net income                                           |   | **$**                        | **5,266**  |   | 5,458 |   | 6,702 |   | 6,391 |   | 4,058 |   |
| Per common share and  common share equivalents:      |   |                         |       |   |   |   |   |   |   |   |   |
| Basic                                                |   | **$**                        | **1.40**   |   | 1.45 |   | 1.75 |   | 1.47 |   | 0.82 |   |
| Diluted                                              |   | **1.32**                     |       | 1.37 |   | 1.69 |   | 1.41 |   | 0.77 |   |

 

**SelectedFinancial Condition Data:**

 
|                                                                         |   | **December 31,** |        |
|------------------------------------------------------------------------------|--------|------------------|-------------|
| **(Dollars in thousands, except per  share data)**                           |   | **2002**         |        | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Total assets                                                                 |   | **$**            | **737,523** |   | 721,114 |   | 716,016 |   | 699,186 |   | 694,658 |   |
| Securities available for  sale                                               |   | **121,397**      |        | 119,895 |   | 139,206 |   | 173,477 |   | 181,625 |   |
| Loans held for sale                                                          |   | **15,127**       |        | 68,018 |   | 7,861 |   | 4,083 |   | 13,095 |   |
| Loans receivable, net                                                        |   | **533,906**      |        | 471,668 |   | 518,765 |   | 447,896 |   | 447,455 |   |
| Deposits                                                                     |   | **432,951**      |        | 421,843 |   | 421,691 |   | 400,382 |   | 433,869 |   |
| Federal Home Loan Bank  advances                                             |   | **218,300**      |        | 217,800 |   | 221,900 |   | 229,400 |   | 185,400 |   |
| Stockholders’ equity                                                    |   | **76,065**       |        | 72,161 |   | 66,626 |   | 64,561 |   | 68,445 |   |
|                                                                         |   |             |        |   |   |   |   |   |   |   |   |
| Book value per share                                                         |   | **17.28**        |        | 16.41 |   | 15.17 |   | 13.57 |   | 12.93 |   |
| Tangible book value per  share                                               |   | **15.68**        |        | 15.39 |   | 14.09 |   | 12.48 |   | 11.87 |   |
|                                                                         |   |             |        |   |   |   |   |   |   |   |   |
| Number of full service  offices                                              |   | **13**           |        | 12 |   | 11 |   | 10 |   | 10 |   |
| Number of mortgage  origination offices                                      |   | **0**            |        | 1 |   | 1 |   | 1 |   | 1 |   |
|                                                                         |   |             |        |   |   |   |   |   |   |   |   |
| Key Ratios(1)                                                                |   |             |        |   |   |   |   |   |   |   |   |
| Stockholders’ equity to  total assets at year end                       |   | **10.31**        | %           | 10.01 | % | 9.31 | % | 9.23 | % | 9.85 | % |
| Average stockholders’  equity to average assets                         |   | **10.66**        |        | 9.91 |   | 9.56 |   | 10.13 |   | 10.63 |   |
| Return on stockholders’  equity (ratio of net income to average equity) |   | **6.94**         |        | 7.57 |   | 9.81 |   | 9.18 |   | 5.38 |   |
| Return on assets (ratio of  net income to average assets)                    |   | **0.74**         |        | 0.75 |   | 0.94 |   | 0.93 |   | 0.57 |   |
| Dividend payout ratio                                                        |   | **57.63**        |        | 39.71 |   | 27.22 |   | 24.11 |   | 36.62 |   |
|                                                                              |        |                  |             |  |  |  |  |  |  |  |  |  |

 

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(1)               Average balances were calculated based uponamortized cost without the market value impact of SFAS No. 115.

 

 

 

7

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**MANAGEMENT’S DISCUSSION AND ANALYSIS**

 

 

**FINANCIAL REVIEW**

The financial review presents management’s discussion and analysis ofthe consolidated financial condition and results of operations of HMNFinancial, Inc. and its subsidiaries (HMN). This review should be read inconjunction with the consolidated financial statements and other financial databeginning on page 24.

 

**General**

HMN’s net income is significantly dependent on its net interest income,which is the difference between interest earned on its loans and investments(interest income), and the interest paid on interest-bearing liabilities suchas deposits and Federal Home Loan Bank (FHLB) advances (interest expense). Netinterest income is determined by (i) the difference between the yield earned oninterest-earning assets and rates paid on interest-bearing liabilities(interest rate spread) and (ii) the relative amounts of interest-earning assetsand interest-bearing liabilities. HMN’s interest rate spread is affected byregulatory, economic and competitive factors that influence interest rates,loan demand and deposit flows. Net interest margin is calculated by dividingnet interest income by the average interest-earning assets and is normallyexpressed as a percentage. Net interest income and net interest margin areaffected by changes in interest rates, the volume and the mix ofinterest-earning assets and interest-bearing liabilities, and the level ofnon-performing assets. HMN’s net income is also affected by the generation ofnon-interest income, which primarily consists of gains or losses from the saleof securities, gains from the sale of loans, service charges, fees, earnings orlosses in limited partnership investments and other income. In addition, netincome is also affected by the level of operating expenses, provisions made forloan losses and amortization and valuation adjustments required on mortgageservicing assets.

 

The operations of financialinstitutions, including the Bank, are significantly affected by prevailingeconomic conditions, competition and the monetary and fiscal policies ofgovernmental agencies. Lending activities are influenced by the demand for andsupply of single family and commercial properties, competition among lenders,the level of interest rates and the availability of funds. Deposit flows andcosts of deposits are influenced by prevailing market rates of interestprimarily on competing investments, account maturities and the levels of personalincome and savings in the market area of the Bank. The interest rates chargedby the FHLB on advances to the Bank also have a significant impact on theBank’s overall cost of funds.

 

**Critical Accounting Policies**

Critical accounting policies are those policies that managementbelieves are the most important to the portrayal of the company’s financialcondition and operating results that require difficult, subjective, or complexjudgment. These judgments are often the result of the need to make estimates aboutthe effect of matters that are inherently uncertain and therefore actualresults could differ significantly from the estimates used. Managementconsiders the following items to be the critical accounting policies of HMN.

 

***Allowance for Loan Losses and RelatedProvision***

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 that include loanimpairment, changes in the size of the portfolios, general economic conditions,loan portfolio composition, and historical experience. The allowance for loanlosses is established for known problem loans, as well as for loans which arenot currently known to require specific allowances. Loans are charged off tothe extent they are deemed to be uncollectible. The adequacy of the allowancefor loan losses is dependent upon management’s estimates of variables affectingvaluation, appraisals of collateral, evaluations of performance and status, andthe amounts and timing of future cash flows expected to be received on impairedloans. Such estimates, appraisals, evaluations and cash flows may be subject tofrequent adjustments due to changing economic prospects of borrowers orproperties. The estimates are reviewed periodically and adjustments, if any,are recorded in the provision for loan losses in the periods in which theadjustments become known. Although management believes that the allowance forloan losses is maintained at an amount considered adequate to provide forprobable loan losses inherent in the portfolio as of the balance sheet dates,future adjustments to the provision for loan losses may be necessary ifconditions differ substantially from those in the assumptions used to determinethe allowance for loan losses.

 

***Mortgage Servicing Rights***

Mortgage servicing rights are capitalized and amortized in proportionto, and over the period of, estimated net servicing income. HMN periodicallyevaluates its capitalized mortgage servicing rights for impairment. Loan typeand note rate are the predominant risk characteristics of the underlying loansused to stratify capitalized mortgage servicing rights for purposes ofmeasuring impairment. The

 

8

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valuation of the mortgage servicing rights is based on the estimatedprepayment speeds and default rates of the stratified portfolio. Changes in themix of loans, interest rates, prepayment speeds, or default rates from theestimates used in the valuation of the mortgage servicing rights may have amaterial effect on the amortization and valuation of mortgage servicing rights.Although management believes that the assumptions used and the valuesdetermined are reasonable, future adjustments may be necessary if economicconditions differ substantially from the economic conditions in the assumptionsused to determine the value of the servicing rights. Refer to the “Mortgageservicing rights, net” line item in the market risk table on page 22 for anindication of how the value of mortgage servicing rights may change in relationto changes in interest rates.

 

***Investment in Limited Partnerships***

HMN has investments in limited partnerships which invest in mortgageservicing assets, the common stock of other financial institutions, and low tomoderate income housing projects which generate tax credits for HMN. HMNgenerally accounts for the earnings or losses from the limited partnerships onthe equity method. The valuation of the limited partnership that invested inmortgage servicing rights is determined using similar estimates and assumptionsas outlined in the mortgage servicing rights paragraph above. Refer to the“Investments in limited partnerships” line item in the market risk table onpage 22 for an indication of how the value of investments in limitedpartnerships may change in relation to changes in interest rates.

 

***Income Taxes***

Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to temporary differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax basis. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin income in the period that includes the enactment date. These calculationsare based on many complex factors including estimates of the timing of reversalsof temporary differences, the interpretation of federal and state income taxlaws, and a determination of the differences between the tax and the financialreporting basis of assets and liabilities. Actual results could differsignificantly from the estimates and interpretations used in determining thecurrent and deferred income tax liabilities.

 

**Results of Operations**

Net income for the year ended December 31, 2002 was $5.3 million,compared to $5.5 million for 2001 and $6.7 million for 2000. Basic earnings pershare were $1.40 for the year ended December 31, 2002, compared to $1.45 for2001 and $1.75 per share for 2000. Diluted earnings per share were $1.32 forthe year ended December 31, 2002, compared to $1.37 for 2001 and $1.69 for2000.

 

In comparing the year endedDecember 31, 2002 to the year ended December 31, 2001, net interest incomeincreased by $549,000 due primarily to interest rates declining to a greaterdegree on FHLB advances and deposits than on interest earning assets. Theprovision 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.

 

In comparing the year endedDecember 31, 2001 to the year ended December 31, 2000, net interest incomeincreased by $1.1 million primarily due to an increase in the averageoutstanding balance of loans held for sale and lower interest rates being paidon FHLB advances and deposits. The provision for loan losses increased $970,000primarily due to increases in the commercial and consumer loan portfolios whichgenerally require a larger provision due to the greater inherent credit risk ofthese loans. Non-interest income increased by $261,000 primarily due toincreased fees and service charges. The $1.7 million increase in gainsrecognized on the sale of loans was entirely offset by a decrease of $1.2million in earnings from limited partnerships, and an increase in losses on itssecurities portfolio of $648,000. Non-interest expense increased by $3.2 millionprimarily due to increased compensation, occupancy and other operating costs.

 

Return on average assets was0.74%, 0.75% and 0.94%, for 2002, 2001 and 2000, respectively. Return onaverage equity was 6.94%, 7.57% and 9.81% for 2002, 2001 and 2000, respectively.

 

***Net Interest Income***

The following table presents the total dollar amount of interest incomefrom average interest-earning assets and the resultant yields, as well as theinterest expense on average interest-bearing liabilities, expressed both in dollarsand rates. Non-accruing loans have been included in the table as loans carryinga zero yield.

 

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|                                                                    |   | **Year  Ended December 31,**      |        |                        |
|-------------------------------------------------------------------------|--------|-----------------------------------|-------------|-----------------------------|
|                                                                    |   | **2002**                          |        | **2001**                    |   | **2000** |   |
| **(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                                 |   | **$**                             | **63,022**  | ** **                  | **1,704** | ** ** | **2.70** | **%** | $ | 71,230 |   | 3,867 |   | 5.43 | % | $ | 93,565 |   | 6,695 |   | 7.15 | % |   |
| Other marketable  securities(1)                                         |   | **60,973**                        | ** **  | **2,420**                   | ** ** | **3.97** | ** ** | 38,106 |   | 2,248 |   | 5.90 |   | 73,947 |   | 4,659 |   | 6.30 |   |   |
| Loans held for sale                                                     |   | **22,485**                        | ** **  | **1,587**                   | ** ** | **7.06** | ** ** | 54,009 |   | 3,764 |   | 6.97 |   | 4,521 |   | 394 |   | 8.72 |   |   |
| Loans receivable, net(2)                                                |   | **479,158**                       | ** **  | **36,426**                  | ** ** | **7.60** | ** ** | 503,063 |   | 40,806 |   | 8.11 |   | 498,359 |   | 40,116 |   | 8.05 |   |   |
| Federal Home Loan Bank stock                                            |   | **12,086**                        | ** **  | **349**                     | ** ** | **2.89** | ** ** | 12,245 |   | 537 |   | 4.38 |   | 12,024 |   | 832 |   | 6.92 |   |   |
| Other interest-earning  assets including cash equivalents               |   | **37,831**                        | ** **  | **382**                     | ** ** | **1.01** | ** ** | 16,715 |   | 246 |   | 1.47 |   | 7,831 |   | 221 |   | 2.83 |   |   |
| Total interest-earning  assets                                          |   | **$**                             | **675,555** | ** **                  | **42,868** | ** ** | **6.35** | ** ** | $ | 695,368 |   | 51,468 |   | 7.40 |   | $ | 690,247 |   | 52,917 |   | 7.67 |   |   |
| **Interest-bearing  liabilities**:                                      |   |                              |        |                        |   |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest checking                                                    |   | **$**                             | **19,095**  | ** **                  | **0** | ** ** | **0.00** | **%** | $ | 13,055 |   | 0 |   | 0.00 | % | $ | 8,834 |   | 0 |   | 0.00 | % |   |
| NOW accounts                                                            |   | **39,625**                        | ** **  | **226**                     | ** ** | **0.57** | ** ** | 33,457 |   | 380 |   | 1.13 |   | 27,001 |   | 311 |   | 1.15 |   |   |
| Passbooks                                                               |   | **35,847**                        | ** **  | **241**                     | ** ** | **0.67** | ** ** | 32,707 |   | 455 |   | 1.39 |   | 33,922 |   | 683 |   | 2.02 |   |   |
| Money market accounts                                                   |   | **47,593**                        | ** **  | **796**                     | ** ** | **1.67** | ** ** | 39,924 |   | 1,271 |   | 3.18 |   | 32,071 |   | 1,237 |   | 3.86 |   |   |
| Certificate accounts                                                    |   | **270,482**                       | ** **  | **9,686**                   | ** ** | **3.58** | ** ** | 299,336 |   | 16,472 |   | 5.50 |   | 304,540 |   | 16,901 |   | 5.55 |   |   |
| Federal Home Loan Bank  advances                                        |   | **215,623**                       | ** **  | **10,346**                  | ** ** | **4.80** | ** ** | 221,891 |   | 11,866 |   | 5.35 |   | 232,484 |   | 13,864 |   | 5.96 |   |   |
| Other borrowed money                                                    |   | **0**                             | ** **  | **0**                       | ** ** | **0.00** | ** ** | 0 |   | 0 |   | 0.00 |   | 57 |   | 5 |   | 8.04 |   |   |
| Total interest-bearing  liabilities                                     |   | **$**                             | **628,265** | ** **                  | **21,295** | ** ** | **3.39** | ** ** | $ | 640,370 |   | 30,444 |   | 4.75 |   | $ | 638,909 |   | 33,001 |   | 5.17 |   |   |
| Net interest income                                                     |   |                              |        | **21,573**                  |   |   | ** ** |   |   | 21,024 |   |   |   |   |   | 19,916 |   |   |   |   |
| Net interest rate spread                                                |   |                              |        |                        |   | **2.96** | **%** |   |   |   |   | 2.65 | % |   |   |   |   | 2.50 | % |   |
| Net earning assets                                                      |   | **$**                             | **47,290**  |                        |   |   |   | ** ** | $ | 54,998 |   |   |   |   |   | $ | 51,338 |   |   |   |   |   |   |
| Net interest margin                                                     |   |                              |        |                        |   | **3.19** | **%** |   |   |   |   | 3.02 | % |   |   |   |   | 2.89 | % |   |
| Average interest-earning  assets to average interest-bearingliabilities |   |                              |        | **107.53**                  | **%** |   |   |   |   | 108.59 | % |   |   |   |   | 108.04 | % |   |   |   |

 

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(1)               Tax exempt income was not significant;therefore, the yield was not presented on a tax equivalent basis. The taxexempt income was $315,093 for 2002, $70,702 for 2001 and $35,521 for 2000.

 

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

 

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Net interest income for theyear ended December 31, 2002 was $21.6 million, an increase of $549,000, or2.6%, from $21.0 million during 2001. Interest income was $42.9 million for theyear ended December 31, 2002, a decrease of $8.6 million, or 16.7%, from $51.5million for the same period in 2001. Interest income declined by $3.7 milliondue to a reduction in interest rates on investments and $2.4 million due to areduction in interest rates on loans. During 2001 and 2002 the Federal Reservedecreased the Federal Funds interest rate twelve times and interest rates ontreasury instruments with maturities of two years and longer generallydecreased. The Wall Street Journal prime rate decreased from approximately9.50% at the beginning of 2001 to 4.75% at the end of 2001 and decreasedanother 50 basis points in the fourth quarter of 2002. These decreases resultedin a lower rate environment in 2002 when compared to 2001. As a result, loanswith rates that were indexed to prime, such as commercial loans and consumerlines of credit, earned less interest income and funds generated from fixedrate loans that prepaid during the year were reinvested in loans at lowerrates. Interest income decreased by $2.5 million due to a decrease in theaverage outstanding interest earning assets. Interest expense was $21.3 millionfor the year ended December 31, 2002, a decrease of $9.1 million, or 30.1%,from the $30.4 million for 2001. Interest expense declined by $6.6 million dueto a decrease in the general interest rates paid on deposits and by $1.2million due to decreased rates paid on FHLB advances. Interest expense alsodecreased by $1.4 million due to a decline in the average outstanding balanceof deposits and Federal Home Loan Bank advances.

 

Net interest income for theyear ended December 31, 2001 was $21.0 million, an increase of $1.1 million, or5.6%, from $19.9 million for the year ended in 2000. Interest income for 2001was $51.5 million, a decrease of $1.4 million, or 2.7%, compared to $52.9million for 2000. Interest income decreased by $3.5 million due to a decreasein the average outstanding balance of securities available for sale during 2001and it decreased by $1.7 million due to a decrease in the weighted averageinterest rate earned on the securities portfolio. These decreases werepartially offset by an increase in interest income of $3.4 million on loansheld for sale. During 2001 the Federal Reserve decreased the Federal Fundsinterest rate eleven times and interest rates on treasury instruments withmaturities of two years and longer generally decreased. The Wall Street Journalprime rate decreased from approximately 9.50% at the beginning of 2001 to 4.75%at the end of 2001. As a result, loans with rates that were indexed to prime,such as commercial loans and consumer lines of credit, earned less interestincome than loans that were indexed to treasury instruments.

 

Net interest margin was3.19%, 3.02% and 2.89% for the years ended December 31, 2002, 2001 and 2000,respectively. Average net earning assets were $47.3 million, $55.0 million and$51.3 million for the years ended December 31, 2002, 2001 and 2000,respectively. HMN has actively purchased its own common stock in the openmarket which reduced net interest earning assets. During 2002, 2001 and 2000HMN paid $1.5 million, $1.6 million and $5.1 million, respectively, to purchaseits common stock in the open market. The decrease in net interest earningassets in 2002 is primarily the result of stock repurchases, dividends, andfixed asset additions exceeding net income. The increase in net interestearning assets in 2001 is the result of net income exceeding stock repurchasesand fixed asset additions. The common stock purchases were the principal reasonfor the decline in net interest earning assets during 2000.

 

The following schedulepresents the dollar amount of changes in interest income and interest expensefor major components of interest-earning assets and interest-bearingliabilities. It quantifies the changes in interest income and interest expenserelated to changes in the average outstanding balances (volume) and thosechanges caused by fluctuating interest rates. For each category ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (i.e., changes involume multiplied by old rate) and (ii) changes in rate (i.e., changes in ratemultiplied by old volume).

 

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|                                    |   | **Year  Ended December 31,**     |       |
|-----------------------------------------|--------|----------------------------------|------------|
|                                    |   | **2002 vs. 2001**                |       |   |   | **2001  vs. 2000** |   |   |   |
|                                    |   | **Increase  (Decrease)  Due to** |       | **Total  Increase  (Decrease)** |   | **Increase  (Decrease)  Due to** |   |   |   |
| **(Dollars  in thousands)**             |   | **Volume(1)**                    |       | **Rate(1)** |   |   | **Volume(1)** |   | **Rate(1)** |   | **Total  Increase  (Decrease)** |   |
| Interest-earning assets:                |   |                             | ** ** |   |   |   |   |   |   |   |   |   |   |
| Securities available for  sale:         |   |                             | ** ** |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed and  related securities |   | **$**                            | **(404**   | **)** | (1,759 | ) | (2,163 | ) | $ | (1,406 | ) | (1,422 | ) | (2,828 | ) |
| Other marketable  securities            |   | **1,634**                        | ** ** | (1,462 | ) | 172 |   | (2,132 | ) | (279 | ) | (2,411 | ) |
| Loans held for sale, net                |   | **(2,224**                       | **)**      | 47 |   | (2,177 | ) | 3,428 |   | (58 | ) | 3,370 |   |
| Loans receivable, net                   |   | **(1,887**                       | **)**      | (2,494 | ) | (4,381 | ) | 451 |   | 239 |   | 690 |   |
| Federal Home Loan Bank  stock           |   | **(7**                           | **)**      | (180 | ) | (187 | ) | 16 |   | (311 | ) | (295 | ) |
| Other, including cash  equivalents      |   | **390**                          | ** ** | (254 | ) | 136 |   | 44 |   | (19 | ) | 25 |   |
| Total interest-earning  assets          |   | **$**                            | **(2,498** | **)** | (6,102 | ) | (8,600 | ) | 401 |   | (1,850 | ) | (1,449 | ) |
| Interest-bearing  liabilities:          |   |                             | ** ** |   |   |   |   |   |   |   |   |   |   |
| NOW accounts                            |   | **$**                            | **79**     | ** ** | (233 | ) | (154 | ) | 72 |   | (3 | ) | 69 |   |
| Passbooks                               |   | **48**                           | ** ** | (261 | ) | (213 | ) | (23 | ) | (205 | ) | (228 | ) |
| Money market accounts                   |   | **277**                          | ** ** | (752 | ) | (475 | ) | 121 |   | (87 | ) | 34 |   |
| Certificates                            |   | **(1,468**                       | **)**      | (5,319 | ) | (6,787 | ) | (287 | ) | (142 | ) | (429 | ) |
| Federal Home Loan Bank  advances        |   | **(328**                         | **)**      | (1,192 | ) | (1,520 | ) | (612 | ) | (1,386 | ) | (1,998 | ) |
| Other borrowed money                    |   | **0**                            | ** ** | 0 |   | 0 |   | (5 | ) | 0 |   | (5 | ) |
| Total interest-bearing  liabilities     |   | **$**                            | **(1,392** | **)** | (7,757 | ) | (9,149 | ) | (734 | ) | (1,823 | ) | (2,557 | ) |
| Net interest income                     |   |                             | ** ** |   |   | $ | 21,573 |   |   |   |   |   | 21,024 |   |
|                                         |        |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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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.

 

The following table setsforth the weighted average yields on HMN’s interest-earning assets, theweighted average interest rates on interest-bearing liabilities and theinterest rate spread between the weighted average yields and rates as of thedate indicated. Non-accruing loans have been included in the table as loanscarrying a zero yield.

 

**At December 31, 2002**

 
| Weighted average yield on:                                      |   |   |    |
|-----------------------------------------------------------------|--------|--------|---------|
| Securities available for  sale:                                 |   |   |    |
| Mortgage-backed and related  securities                         |   | 1.39   | %       |
| Other marketable securities                                     |   | 3.22   |    |
| Loans held for sale                                             |   | 5.92   |    |
| Loans receivable, net                                           |   | 7.41   |    |
| Federal Home Loan Bank  stock                                   |   | 3.00   |    |
| Other interest-earning  assets                                  |   | 0.83   |    |
| Combined weighted average  yield on interest-earning assets     |   | 6.17   |    |
|                                                            |   |   |    |
| Weighted average rate on:                                       |   |   |    |
| NOW accounts                                                    |   | 0.30   |  % |
| Passbooks                                                       |   | 0.35   |    |
| Money market accounts                                           |   | 1.16   |    |
| Certificates                                                    |   | 3.43   |    |
| Federal Home Loan Bank  advances                                |   | 4.59   |    |
| Combined weighted average  rate on interest-bearing liabilities |   | 3.09   |    |
| Interest rate spread                                            |   | 3.08   |    |

 

***Provision For Losses on Loans***

The provision for loan losses and the related allowance is considered acritical accounting policy of HMN. It is determined based on management’sevaluation of the loan portfolio and its evaluation of national and regionaleconomic indicators (including the possibility at each year end that therecould be an increase in general interest rates), such as national and regionalunemployment data, single family loan delinquencies as reported separately bythe Federal National Mortgage Association (FNMA) and the Federal Home Loan BankMortgage Corporation (FHLMC), local single family construction permits,development plans and local economic growth rates, and the current regulatoryand general economic environment. HMN will continue to monitor and modify itsallowance for losses as these conditions dictate. Although HMN maintains itsallowance for losses at a level it considers adequate to provide for estimatedlosses, there can be no assurance that such losses will not exceed theestimated amount or that additional provisions for loan losses will not berequired in future periods.

 

12

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The provision for loanlosses for 2002 was $2.4 million, compared to $1.2 million for 2001 and$180,000 for 2000. The provision for loan losses increased due to thedeterioration of certain loans that were charged off during 2002. The provisionalso increased due to the $115 million in growth that was experienced in thecommercial and consumer loan portfolios which generally require a largerprovision due to the greater inherent credit risk of these loans. The provisionalso increased because of increases in specific loan reserves, as well as aslowing economy which resulted in an increase in nonaccruing loans of $1.1million. Based upon management’s evaluation of the loan portfolio and itsunderstanding of the economic conditions in the areas where it has a concentrationof loans, the provision was deemed adequate for each of the years in the threeyear period ended December 31, 2002. HMN incurred $1.4 million of loancharge-offs during 2002 and it recovered $34,000 of loans previouslycharged-off. HMN incurred $517,000 of loan charge-offs during 2001 and itrecovered $6,000 of loans previously charged-off. HMN incurred $312,000 of loancharge-offs during 2000 and it recovered $3,000 of loans previouslycharged-off. For more information on the allowance for loan losses refer toNotes 1 and 5 of the Notes to Consolidated Financial Statements.

 

***Non-Interest Income***

Non-interest income was $5.9 million for 2002, compared to $3.6 millionfor 2001 and $3.3 million for 2000. The following table presents certaincomponents of non-interest income:

 
|                                       |   | **Year  Ended December 31,** |      | **Percentage  Increase (Decrease)** |   |
|--------------------------------------------|--------|------------------------------|-----------|-------------------------------------|--------|
| **(Dollars in thousands)**                 |   | **2002**                     |      | **2001**                            |   | **2000** |   | **2002/2001** |   | **2001/2000** |   |
| Fees and service charges                   |   | **$**                        | **1,723** |                                | 1,563  |   | 1,297 |   | **10.2** | **%** | 20.5 | % |
| Mortgage servicing fees                    |   | **715**                      |      | 470                                 |   | 341 |   | **52.1** | ** ** | 37.8 |   |
| Securities gains (losses),  net            |   | **422**                      |      | (671                                | )      | (23 | ) | **162.9** | ** ** | (2,817.4 | ) |
| Gain on sales of loans                     |   | **3,077**                    |      | 2,934                               |   | 1,216 |   | **4.9** | ** ** | 141.3 |   |
| Earnings (losses) in  limited partnerships |   | **(659**                     | **)**     | (1,311                              | )      | (121 | ) | **49.7** | ** ** | (983.5 | ) |
| Other non-interest income                  |   | **597**                      |      | 599                                 |   | 613 |   | **(0.3** | **)** | (2.3 | ) |
| Total non-interest income                  |   | **$**                        | **5,875** |                                | 3,584  |   | 3,323 |   | **63.9** | ** ** | 7.9 |   |

 

Fees and service chargesearned for the year ended December 31, 2002 increased by $160,000  from fees and service charges earned in2001, primarily due to increased fees and service charges on an increasednumber of deposit accounts. During 2002 HMN continued to concentrate ondeveloping more retail and commercial checking account relationships whichcreated more opportunities for fee income. The charges for some services werealso increased during 2002. Fees and service charges earned for the year endedDecember 31, 2001 increased by $266,000 from fees and service charges earned in2000, primarily due to increased fees and service charges on deposit accounts.

 

Mortgage servicing feesincreased by $245,000 and $129,000 for the years ended December 31, 2002 andDecember 31, 2001, respectively. The increases were primarily due to theincreased number of single family loans that were serviced for others. Duringthe past two years the lower mortgage interest rates resulted in increased loanoriginations and loan sales at the Bank and the servicing rights on all ofthese loans were retained. Mortgage servicing fees for the year ended December31, 2000 increased $6,000 from the mortgage servicing fees earned in 1999.

 

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, HMN recognized $422,000 ingains on the sale of securities for the year ended December 31, 2002, anincrease of $1.1 million over 2001’s net losses. The increase in securitiesgains is primarily because the Bank recognized impairment losses of $1.0million on its securities portfolio in 2001. These losses resulted in a netloss on the sale of securities of $671,000 for 2001. During a portion of 2000interest rates in general were rising and the opportunity to sell securities ata gain diminished.

 

Over the past three years,in order to reduce its interest rate risk and increase its other non-interestincome, the Bank, which originates all of its 1-4 family loans at its retailfacilities, sold many of its originated or refinanced fixed rate 1-4 familyloans to FNMA. The mortgage banking business operated by Home Federal MortgageServices, LLC (HFMS) also sold the majority of their mortgage origination andloan brokerage activity. The origination and brokerage activity at HFMSdecreased by $604.4 million from 2001 production levels as the operations werebeing phased down throughout the first half of the year and production stoppedcompletely in the third quarter of 2002. The lower interest rate environment in2002 caused loan originations at the Bank to increase by $40.1 million. For theyear ended December 31, 2002, HMN recognized $3.1 million of net gain on thesale of $274.6 million of primarily single family mortgage loans. The Bankaccounted for $2.9 million of the net gain on sale on $184.6 million oforiginated and refinanced loans sold. HFMS accounted for $262,000 of the netgain on sale on $90.0 million of loans sold. For the year ended December 31,2001, HMN recognized $2.9 million of net gain on the sale of $724.2 million ofprimarily single family mortgage loans.

 

13

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The Bank accounted for $2.1million of the net gain on sale on $136.2 million of originated and refinancedloans sold. 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 pair off fees because loans were notdelivered into their forward sales commitments on a timely basis. The pair offfees resulted in a lower gain on sale of loans for HFMS as a percentage ofloans sold. The lower profit margins coupled with the additional costs relatingto processing the increased loan volume resulted in HFMS generating losses for2002 and 2001. Refer to Note 26 of the Notes to Consolidated FinancialStatements for additional information relating to the results of operations forHFMS. For the year ended December 31, 2000, HMN recognized $1.2 million of netgain on the sale of $103.7 million of primarily single family mortgage loans.The Bank accounted for $752,000 of the net gain on the sale of loans and $31.6million of the loans.

 

For the yearsended December 31, 2002, 2001 and 2000, HMN recognized net losses of $659,000,$1.3 million and $121,000, respectively, from its limited partnershipinvestments. A major portion of HMN’s investment in limited partnershipsresides in a partnership that owns mortgage servicing rights. HMN considers thevaluation of mortgageservicing rights, and thus the investment in this limited partnership, to be acritical accounting policy that is subject to significant estimates. Generally,as interest rates rise the value of fixed rate mortgage servicing rightsincreases and as interest rates fall the value of mortgage servicing rightsdeclines due to changes in the anticipated cash flows caused by prepayments onthe loans being serviced. During 2002, 2001 and 2000 significant declines ininterest rates on single family mortgages caused HMN to recognize losses on itsinvestment in the mortgage servicing limited partnership. The limitedpartnership that invests in mortgage servicing rights has a defined life and isscheduled to have an orderly dissolution during the second half of 2003. Formore information on investments in limited partnerships refer to Notes 1 and 9of the Notes to Consolidated Financial Statements. Other non-interest incomeconsists primarily of fees and commissions earned on the sale of financialplanning products and services. For the year ended December 31, 2002 othernon-interest income was $597,000, compared to $599,000 for 2001 and $613,000for 2000. The changes in other non-interest income from 2000 to 2002 areprincipally due to changes in the volume of sales.

 

***Non-Interest Expense***

Non-interest expense for the year ended December 31, 2002 was $17.8million, compared to $15.7 million for the year ended in 2001 and $12.6 millionfor 2000. The following table presents the components of non-interest expense:

 
|                                                                                         |   | **Year  Ended December 31,** |       | **Percentage  Increase (Decrease)** |   |
|----------------------------------------------------------------------------------------------|--------|------------------------------|------------|-------------------------------------|--------|
| **(Dollars in thousands)**                                                                   |   | **2002**                     |       | **2001**                            |   | **2000** |   | **2002/2001** |   | **2001/2000** |   |
| Compensation and benefits                                                                    |   | **$**                        | **8,013**  |                                | 7,915  |   | 6,391 |   | 1.2 | % | 23.8 | % |
| Occupancy                                                                                    |   | **3,110**                    |       | 2,239                               |   | 1,891 |   | 38.9 |   | 18.4 |   |
| Federal deposit insurance  premiums                                                          |   | **74**                       |       | 80                                  |   | 83 |   | (7.5 | ) | (3.6 | ) |
| Advertising                                                                                  |   | **522**                      |       | 426                                 |   | 303 |   | 22.5 |   | 40.6 |   |
| Data processing                                                                              |   | **1,107**                    |       | 964                                 |   | 790 |   | 14.8 |   | 22.0 |   |
| Amortization of mortgage  servicing rights, net of valuation adjustments and servicing costs |   | **1,166**                    |       | 758                                 |   | 334 |   | 53.8 |   | 126.9 |   |
| Other                                                                                        |   | **3,857**                    |       | 3,367                               |   | 2,767 |   | 14.6 |   | 21.7 |   |
| Total non-interest expense                                                                   |   | **$**                        | **17,849** |                                | 15,749 |   | 12,559 |   | 13.3 |   | 25.4 |   |

 

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 facilities maintainedduring 2002 and a full year of expenses associated with facility changes thatoccurred in 2001. Amortization of mortgage servicing rights increased by$407,000 because of increased amortization on loans that prepaid during theyear and because the number of loans being serviced increased. Because of thelower interest rates in 2002 many loans that were being serviced by the Bankwere refinanced. When a serviced loan was paid off, the remaining value of theright to service that loan was recorded as additional amortization expense inthe month in which the loan was repaid. Compensation and benefits expense increased by $99,000 in 2002,despite the decrease in compensation expense at the mortgage banking operation,as the Bank hired more employees to staff the additional retail facilities thatwere opened during the year. Data processing expenses increased by $143,000 dueto the increased number of customers and the costs of various services offeredto customers. 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 Standrads (SFAS) No. 142.

 

14

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See Notes 1 and 11 of the Notes to Consolidated Financial Statementsfor additional information relating to goodwill amortization.

 

The $3.2 million increase innon-interest expense from 2000 to 2001 was primarily due to a $1.5 millionincrease in compensation and benefit expense, which primarily resulted fromcommissions paid on the increased single family residential loan volume as wellas additional staff to process the increased volume. Occupancy expenseincreased by $348,000 due to additional facilities maintained during 2001including the new corporate headquarters in Rochester and a full year ofdepreciation on facilities opened or remodeled during 2000. Data processingincreased by $174,000 due to the increased costs of various services offered tocustomers including Internet banking services. Advertising expenses increased$123,000 as a result of a more developed marketing plan, and other expensesincreased by $600,000 primarily due to increases in fees for professionalservices and other operating costs. Amortization of mortgage servicing rightsincreased $424,000 from 2000 to 2001 because of the increased amortization onloans that prepaid during the year.

 

***Income Taxes***

HMN considers the calculation of current and deferred income taxes tobe a critical accounting policy 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 2002, 2001 and 2000 HMN recorded income tax expense of $2.1million, $2.6 million, and $3.8 million, respectively. The change in income taxexpense between the years is primarily the result of changes in taxable incomebetween the years and certain state tax planning strategies that wereimplemented during 2002. Refer to Notes 1 and 16 of the Notes to ConsolidatedFinancial Statements for additional information relating to income taxes.

 

**Financial Condition**

***Loans Receivable, Net***

The following table sets forth the information on HMN’s loan portfolioin dollar amounts and in percentages (before deductions for loans in process,deferred fees and discounts and allowances for losses) as of the datesindicated.

 
|                        |   | **December  31,** |        |
|-----------------------------|--------|-------------------|-------------|
|                        |   | **2002**          |        | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| **(Dollars  in thousands)** |   | **Amount**        |        | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| **Real Estate  Loans:**     |   |              |        |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family          |   | **$**             | **151,566** | ** ** | **27.72** | **%** | 215,448 |   | 44.73 | % | $ | 312,888 |   | 59.43 | % | $ | 344,674 |   | 70.95 | % | $ | 365,496 |   | 79.31 | % |
| Multi-family                |   | **15,766**        | ** **  | **2.88** | ** ** | 14,369 |   | 2.98 |   | 12,090 |   | 2.30 |   | 8,489 |   | 1.75 |   | 4,719 |   | 1.02 |   |
| Commercial                  |   | **130,559**       | ** **  | **23.88** | ** ** | 70,768 |   | 14.69 |   | 61,654 |   | 11.71 |   | 43,894 |   | 9.04 |   | 28,990 |   | 6.29 |   |
| Construction or development |   | **61,335**        | ** **  | **11.22** | ** ** | 46,977 |   | 9.75 |   | 20,211 |   | 3.84 |   | 16,046 |   | 3.30 |   | 15,155 |   | 3.29 |   |
| Total real estate           |   | **359,226**       | ** **  | **65.70** | ** ** | 347,562 |   | 72.15 |   | 406,843 |   | 77.28 |   | 413,103 |   | 85.04 |   | 414,360 |   | 89.91 |   |
| **Other  Loans:**           |   |              |        |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer Loans:             |   |              |        |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Automobile                  |   | **11,062**        | ** **  | **2.02** | ** ** | 6,624 |   | 1.38 |   | 6,363 |   | 1.21 |   | 4,532 |   | 0.94 |   | 2,897 |   | 0.63 |   |
| Home equity line            |   | **52,106**        | ** **  | **9.53** | ** ** | 35,714 |   | 7.42 |   | 26,907 |   | 5.11 |   | 22,437 |   | 4.62 |   | 19,476 |   | 4.22 |   |
| Home equity                 |   | **23,760**        | ** **  | **4.34** | ** ** | 26,440 |   | 5.49 |   | 28,144 |   | 5.35 |   | 17,349 |   | 3.57 |   | 9,566 |   | 2.08 |   |
| Mobile home                 |   | **4,534**         | ** **  | **0.83** | ** ** | 5,456 |   | 1.13 |   | 4,921 |   | 0.93 |   | 791 |   | 0.16 |   | 58 |   | 0.01 |   |
| Other                       |   | **4,959**         | ** **  | **0.91** | ** ** | 4,897 |   | 1.02 |   | 4,561 |   | 0.87 |   | 3,127 |   | 0.64 |   | 2,803 |   | 0.61 |   |
| Total consumer loans        |   | **96,421**        | ** **  | **17.63** | ** ** | 79,131 |   | 16.44 |   | 70,896 |   | 13.47 |   | 48,236 |   | 9.93 |   | 34,800 |   | 7.55 |   |
| Commercial business loans   |   | **91,119**        | ** **  | **16.67** | ** ** | 54,940 |   | 11.41 |   | 48,760 |   | 9.25 |   | 24,435 |   | 5.03 |   | 11,695 |   | 2.54 |   |
| Total other loans           |   | **187,540**       | ** **  | **34.30** | ** ** | 134,071 |   | 27.85 |   | 119,656 |   | 22.72 |   | 72,671 |   | 14.96 |   | 46,495 |   | 10.09 |   |
| Total loans                 |   | **546,766**       | ** **  | **100.00** | **%** | 481,633 |   | 100.00 | % | 526,499 |   | 100.00 | % | 485,774 |   | 100.00 | % | 460,855 |   | 100.00 | % |
| Less:                       |   |              |        |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans in process            |   | **6,826**         |        |   | ** ** | 4,692 |   |   |   | 2,953 |   |   |   | 2,771 |   |   |   | 7,997 |   |   |   |
| Unamortized discounts       |   | **142**           |        |   | ** ** | 278 |   |   |   | 289 |   |   |   | 297 |   |   |   | 414 |   |   |   |
| Net deferred loan fees      |   | **1,068**         |        |   | ** ** | 1,212 |   |   |   | 1,348 |   |   |   | 1,537 |   |   |   | 1,948 |   |   |   |
| Allowance for losses        |   | **4,824**         |        |   | ** ** | 3,783 |   |   |   | 3,144 |   |   |   | 3,273 |   |   |   | 3,041 |   |   |   |
| Total loans receivable, net |   | **$**             | **533,906** |   |   | ** ** | $ | 471,668 |   |   |   | $ | 518,765 |   |   |   | $ | 477,896 |   |   |   | $ | 447,455 |   |   |   |
|                             |        |                   |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

15

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HMN established a commerciallending department in 1998 in order to facilitate a change in the mix of assetson its balance sheet. The purpose of changing the mix was to reduce interestrate risk and enhance performance by increasing its investment in shorter termand generally higher yielding commercial real estate and commercial businessloans and reduce its investment in longer term one-to-four family real estateloans. HMN intends to continue to originate more commercial real estate,commercial business and consumer loans while maintaining the level ofone-to-four family loans held in portfolio.

 

The one-to-four family realestate loans were $151.6 million at December 31, 2002, a decrease of $63.8million, or 29.6%, compared to $215.4 million at December 31, 2001. During 2002loan prepayments increased as a result of the low interest rate environment andmany loans that were in the loan portfolio at December 31, 2001 were refinancedand sold to FNMA. The increased prepayments and the related loan sales were theprincipal cause of the decline in the one-to-four family loan portfolio.

 

The one-to-four family realestate loans were $215.4 million at December 31, 2001, a decrease of $97.5million, or 31.1%, compared to $312.9 million at December 31, 2000. During 2001loan prepayments increased as a result of the low interest rate environment andmany loans that were in the loan portfolio at December 31, 2000 were refinancedand sold to FNMA. The increased prepayments and the related loan sales were theprincipal cause of the decline in the one-to-four family loan portfolio.

 

The one-to-four family realestate loans were $312.9 million at December 31, 2000, a decrease of $31.8million, or 9.2%, compared to $344.7 million at December 31, 1999. Loanproduction decreased in 2000 as a result of rising interest rates and becauseHMN stopped purchasing one-to-four family loans from a third party originatorduring 2000. HMN originated or purchased $140.3 million in one-to-four familyloans from a third party originator during 2000, a decrease of $82.0 million,or 36.9%, compared to $222.3 million in one-to-four family loans during 1999.The reduced loan volume was the principal cause of the decline in theone-to-four family loan portfolio.

 

Commercial real estate loanswere $130.6 million at December 31, 2002, an increase of $59.8 million,compared to $70.8 million at December 31, 2001. Commercial business loans were$91.1 million at December 31, 2002, an increase of $36.2 million, compared to$54.9 million at December 31, 2001. The continued emphasis on commercial realestate and commercial business loans resulted in the origination or purchase ofcommercial real estate loans totaling $70.7 million in 2002, $18.3 million in2001 and $18.2 million in 2000. Commercial business loans originated orpurchased were $101.0 million in 2002, $48.2 million in 2001 and $42.4 millionin 2000. The increased production was the principal reason for the increase incommercial real estate and commercial business loans in 2002.

 

Commercial real estate loanswere $70.8 million at December 31, 2001, an increase of $9.1 million, comparedto $61.7 million at December 31, 2000. Commercial business loans were $54.9million at December 31, 2001, an increase of $6.1 million, compared to $48.8million at December 31, 2000. The continued emphasis on commercial real estateand commercial business loans resulted in the origination or purchase ofcommercial real estate loans totaling $18.3 million in 2001, compared to $18.2million in 2000. Commercial business loans originated or purchased in 2001 were$48.2 million, compared to $42.4 million in 2000. The increased production wasthe principal reason for the increase in commercial real estate and commercialbusiness loans in 2001.

 

Commercial real estate loanswere $61.7 million at December 31, 2000, an increase of $17.8 million, comparedto $43.9 million at December 31, 1999. Commercial business loans were $48.8million at December 31, 2000, an increase of $24.4 million, compared to $24.4million at December 31, 1999. Increased production was the principal reason forthe increase in commercial real estate and commercial business loans in 2000.

 

Home equity line loans were$52.1 million at December 31, 2002, compared to $35.7 million at December 31,2001 and $26.9 million at December 31, 2000. The open-end home equity lines arewritten with an adjustable rate with terms of up to 20 years, a 10 year drawperiod which requires “interest only” payments and a 10 year repayment periodwhich fully amortizes the outstanding balance. Due to the general decline ininterest rates during 2002 and 2001, many borrowers consolidated their debtinto home equity lines and paid off closed-end home equity loans whenrefinancing their first mortgage. Closed-end home equity loans are written withfixed- or adjustable-rates with terms up to 15 years. Home equity loans were$23.8 million at December 31, 2002, compared to $26.4 million at December 31,2001 and $28.1 million at December 31, 2000.

 

***Allowances for Loan Losses***

The determination of the allowance for loan losses and the relatedprovision is considered to be a critical accounting policy that is subject tosignificant estimates. The current level of the allowance for loan losses is aresult of management’s assessment of the risks within the portfolio based onthe information obtained through the credit evaluation process. HMN utilizes arisk-rating system on non-homogenous commercial real estate and commercialbusiness loans that includes regular credit reviews to identify and quantifythe risk in the commercial portfolio. The allowance for all loans is based onthe Bank’s and the industry’s historical loan loss experience, evaluation ofeconomic conditions, regular reviews of delinquencies and loan portfolioquality, evolving standards imposed by the Office of Thrift Supervision (OTS),and other factors that, in management’s judgment, deserve recognition. Theallowance is allocated to individual loan categories based upon the relativerisk characteristics of the loan portfolios

 

16

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and the actual loss experience. HMN increases its allowance for loanlosses by charging the provision for loan losses against income. The methodologyfor establishing the allowance for loan losses takes into considerationprobable losses that have been identified in connection with specific loans aswell as losses in the loan portfolio for which specific reserves are notrequired. Management conducts quarterly reviews of the loan portfolio andevaluates the need to establish general allowances on the basis of thesereviews.

 

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 $4.8 million, or 0.88%, of total loans at December 31, 2002,compared to $3.8 million, or 0.79%, of total loans at December 31, 2001, $3.1million, or 0.60%, of total loans at December 31, 2000, $3.3 million, or 0.69%,of total loans at December 31, 1999, and $3.0 million, or 0.68%, of total loansat December 31, 1998. The following table reflects the activity in theallowance for loan losses and selected statistics:

 
|                                                                            |   | **December  31,** |       |
|---------------------------------------------------------------------------------|--------|-------------------|------------|
| **(Dollars in thousands)**                                                      |   | **2002**          |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Balance at the beginning of  year                                               |   | **$**             | **3,783**  | ** ** | 3,144 |   | 3,273 |   | 3,041 |   | 2,748 |   |
| Provision for losses                                                            |   | **2,376**         | ** ** | 1,150 |   | 180 |   | 240 |   | 310 |   |
| Charge-offs:                                                                    |   |              | ** ** |   |   |   |   |   |   |   |   |
| One-to-four family                                                              |   | **(44**           | **)**      | 0 |   | 0 |   | (1 | ) | (2 | ) |
| Consumer                                                                        |   | **(310**          | **)**      | (170 | ) | (59 | ) | (9 | ) | (17 | ) |
| Commercial business and  real estate                                            |   | **(1,015**        | **)**      | (347 | ) | (253 | ) | 0 |   | 0 |   |
| Recoveries                                                                      |   | **34**            | ** ** | 6 |   | 3 |   | 2 |   | 2 |   |
| Net charge-offs                                                                 |   | **(1,335**        | **)**      | (511 | ) | (309 | ) | (8 | ) | (17 | ) |
| Balance at end of year                                                          |   | **$**             | **4,824**  | ** ** | 3,783 |   | 3,144 |   | 3,273 |   | 3,041 |   |
| Year end allowance for loan  losses as a percent of year end gross loan balance |   | **0.88**          | **%**      | 0.79 | % | 0.60 | % | 0.69 | % | 0.68 | % |
| Ratio of net loan  charge-offs to average loans outstanding                     |   | **0.26**          | ** ** | 0.10 |   | 0.06 |   | 0.00 |   | 0.00 |   |
| Allowance for loan losses  as a percentage of total assets at year end          |   | **0.65**          | ** ** | 0.52 |   | 0.44 |   | 0.47 |   | 0.44 |   |

 

The following table reflects the allocation of the allowance for loanlosses:

 
|                        |   | **At  December 31,** |      | **Allocations  as a Percentage of Total  Loans Outstanding by Type** |   |
|-----------------------------|--------|----------------------|-----------|----------------------------------------------------------------------|--------|
| **(Dollars in thousands)**  |   | **2002**             |      | **2001**                                                             |   | **2000** |   | **1999** |   | **1998** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Real estate loans:          |   |                 |      |                                                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family          |   | **$**                | **97**    |                                                                 | 215    |   | 302 |   | 527 |   | 544 | ** ** | **22.72** | **%** | 44.73 |   | 59.43 |   | 70.95 |   | 79.31 |   |
| Multi-family                |   | **204**              |      | 203                                                                  |   | 111 |   | 133 |   | 142 | ** ** | **2.88** |   | 2.98 |   | 2.30 |   | 1.75 |   | 1.02 |   |
| Commercial                  |   | **2,030**            |      | 903                                                                  |   | 802 |   | 533 |   | 797 | ** ** | **23.88** |   | 14.69 |   | 11.71 |   | 9.04 |   | 6.29 |   |
| Construction or development |   | **597**              |      | 560                                                                  |   | 408 |   | 231 |   | 455 | ** ** | **11.22** |   | 9.75 |   | 3.84 |   | 3.30 |   | 3.29 |   |
| Consumer                    |   | **545**              |      | 565                                                                  |   | 414 |   | 674 |   | 546 | ** ** | **17.63** |   | 16.44 |   | 13.47 |   | 9.93 |   | 7.55 |   |
| Commercial business         |   | **1,349**            |      | 1,337                                                                |   | 665 |   | 291 |   | 328 | ** ** | **16.67** |   | 11.41 |   | 9.25 |   | 5.03 |   | 2.54 |   |
| Unallocated                 |   | **2**                |      | 0                                                                    |   | 442 |   | 884 |   | 229 | ** ** | **0.00** |   | 0.00 |   | 0.00 |   | 0.00 |   | 0.00 |   |
| Total                       |   | **$**                | **4,824** |                                                                 | 3,783  |   | 3,144 |   | 3,273 |   | 3,041 | ** ** | **100.00** | **%** | 100.00 |   | 100.00 |   | 100.00 |   | 100.00 |   |

 

The one-to-four family realestate allowance allocation declined in recent years due to a decline in theone-to-four family loan portfolio. The allocation of the allowance for loanlosses increased in 2002 from 2001 for commercial, construction or development,multi-family real estate, consumer and commercial business loans because of theincrease in the respective portfolios. The commercial real estate loanallocation also increased because of increases in specific reserves of$564,000.

 

17

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***Allowance for Real Estate Losses***

Real estate properties acquired or expected to be acquired through loanforeclosures are initially recorded at the lower of the related loan balance, lessany specific allowance for loss, or fair value less estimated selling costs.Valuations are periodically performed by management and an allowance for lossesis established if the carrying value of a property exceeds its fair value lessestimated selling costs. There was no activity in the allowance for real estatelosses during 2002, 2001 or 2000 and the balance of the allowance for realestate losses was zero at December 31, 2002.

 

***Non-performing Assets***

Loans are reviewed at least quarterly and any loan whose collectibilityis doubtful is placed on non-accrual status. Loans are placed on nonaccrualstatus when either principal or interest is 90 days or more past due, unless,in the judgment of management, the loan is well collateralized and in the processof collection. Interest accrued and unpaid at the time a loan is placed onnon-accrual status is charged against interest income. Subsequent payments areeither applied to the outstanding principal balance or recorded as interestincome, depending on the assessment of the ultimate collectibility of the loan.Restructured loans include the Bank’s troubled debt restructurings (whichinvolved forgiving a portion of interest or principal on any loans or makingloans at a rate materially less than the market rate). Foreclosed andrepossessed assets include assets acquired in settlement of loans.

 

Non-performing assets(comprised of non-accrual loans, restructured loans, impaired securities,delinquent accounts receivable, real estate acquired through foreclosure, andrepossessed assets) totaled $4.9 million at December 31, 2002, compared to $3.8million at December 31, 2001, $1.6 million at December 31, 2000, $818,000 atDecember 31, 1999 and $806,000 at December 31, 1998. The $1.1 million increasein non-performing assets in 2002 compared to 2001 relates primarily to a netincrease of $1.0 million in non-accruing commercial business andnon-residential loans.

 

The increase from 2000 to2001 is primarily the result of classifying $1.4 million of impaired securitiesas non-performing assets, increases in specific reserves on commercial businessloans of $382,000, and an increase in non-accrual loans of $1.1 million due toa slowing economy. Non-performing assets had the following activity during2002: charge offs of $1,139,000, sales of $188,000, transfers in of $7,259,000and transfers out due to performance of $4,786,000. Non-performing assets hadthe following activity during 2001: charge-offs of $124,000, transfers in of$3,263,000 and transfers out due to performance of $990,000. Non-performingassets had the following activity during 2000: charge-offs of $8,000, transfersin of $1,128,000 and transfers out due to performance of $326,000.Non-performing assets had the following activity during 1999: sales of $18,000,transfers in of $423,000 and transfers out due to performance of $393,000. Thefollowing table sets forth the amounts and categories of non-performing assetsin HMN’s portfolio.

 
|                                                  |   | **December  31,** |       |
|-------------------------------------------------------|--------|-------------------|------------|
| **(Dollars in thousands)**                            |   | **2002**          |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Non-accruing loans:                                   |   |              | ** ** |   |   |   |   |   |   |   |   |
| Real estate:                                          |   |              | ** ** |   |   |   |   |   |   |   |   |
| One-to-four family                                    |   | **$**             | **695**    | ** ** | 771 |   | 775 |   | 165 |   | 317 |   |
| Commercial real estate                                |   | **1,719**         | ** ** | 187 |   | 0 |   | 0 |   | 73 |   |
| Consumer                                              |   | **495**           | ** ** | 311 |   | 142 |   | 177 |   | 86 |   |
| Commercial business                                   |   | **427**           | ** ** | 890 |   | 95 |   | 0 |   | 0 |   |
| Total                                                 |   | **3,336**         | ** ** | 2,159 |   | 1,012 |   | 342 |   | 476 |   |
| Accruing loans delinquent  90 days or more:           |   |              | ** ** |   |   |   |   |   |   |   |   |
| One-to-four family                                    |   | **171**           | ** ** | 24 |   | 405 |   | 476 |   | 312 |   |
| Consumer                                              |   | **0**             | ** ** | 0 |   | 0 |   | 0 |   | 0 |   |
| Total                                                 |   | **171**           | ** ** | 24 |   | 405 |   | 476 |   | 312 |   |
| Other assets                                          |   | **866**           | ** ** | 1,390 |   | 0 |   | 0 |   | 0 |   |
| Foreclosed and repossessed  assets:                   |   |              | ** ** |   |   |   |   |   |   |   |   |
| Real estate:                                          |   |              | ** ** |   |   |   |   |   |   |   |   |
| One-to-four family                                    |   | **300**           | ** ** | 0 |   | 195 |   | 0 |   | 18 |   |
| Commercial real estate                                |   | **127**           | ** ** | 0 |   | 0 |   | 0 |   | 0 |   |
| Consumer                                              |   | **107**           | ** ** | 155 |   | 0 |   | 0 |   | 0 |   |
| Commercial business                                   |   | **0**             | ** ** | 33 |   | 0 |   | 0 |   | 0 |   |
| Total                                                 |   | **534**           | ** ** | 188 |   | 195 |   | 0 |   | 18 |   |
| Total non-performing assets                           |   | **$**             | **4,907**  | ** ** | 3,761 |   | 1,612 |   | 818 |   | 806 |   |
| Total as a percentage of  total assets                |   | **0.67**          | **%**      | 0.52 | % | 0.23 | % | 0.12 | % | 0.12 | % |
| Total non-performing loans                            |   | **$**             | **3,507**  | ** ** | 2,183 |   | 1,417 |   | 818 |   | 788 |   |
| Total as a percentage of  total loans receivable, net |   | **0.66**          | **%**      | 0.46 | % | 0.27 | % | 0.17 | % | 0.18 | % |
| Allowance for loan losses  to non-performing loans    |   | **134.60**        | **%**      | 173.29 | % | 221.87 | % | 400.29 | % | 385.79 | % |

 

18

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For the year ended December31, 2002, gross interest income which would have been recorded had thenon-accruing loans been current in accordance with their original termsamounted to $678,694. The amounts that were included in interest income on acash basis for such loans during 2002 were $551,542.

 

In addition to thenon-performing assets set forth in the table above, as of December 31, 2002there were no loans with known information about the possible credit problemsof the borrowers or the cash flows of the secured properties that have causedmanagement to have concerns as to the ability of the borrowers to comply withpresent loan repayment terms which may result in the future inclusion of suchitems in the non-performing asset categories. Management has considered theBank’s non-performing and “of concern” assets in establishing its allowance forloan losses.

 

***Mortgage Servicing Rights***

HMN considers the capitalization and valuation of servicing rights tobe a critical accounting policy that is subject to significant estimates.Servicing rights are valued quarterly by an unrelated third party specializingin the valuation of servicing rights and are reviewed by HMN. The assumptionsused to value the mortgage servicing rights are based on loan types, noterates, default rates, and prepayment speeds, among other assumptions. Changesin the mix of loans, interest rates, default rates, or prepayment speeds mayhave a material effect on the amortization and valuation of mortgage servicingrights. Although management believes that the assumptions used and the valuesdetermined are reasonable based upon current circumstances, adjustments may benecessary if future economic conditions differ substantially from the economiccondition in the assumptions used to determine the value of the servicingrights. Refer to Notes 1 and 7 of the Notes to Consolidated FinancialStatements for additional information relating to mortgage servicing rights.

 

***Contractual Obligations andCommercial Commitments***

HMN has certain obligations and commitments to make future paymentsunder contracts. At December 31, 2002, the aggregate contractual obligations(excluding bank deposits) 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                                                 |   | $                                              | 218,300 |   | 64,400 |   | 43,000 |   | 0 |   | 110,900 |   |
| Annual rental commitments  under non-cancelable operating leases |   | 1,729                                          |    | 450 |   | 847 |   | 432 |   | 0 |   |
|                                                             |   | $                                              | 220,029 |   | 64,850 |   | 43,847 |   | 432 |   | 110,900 |   |
|                                                             |   |                                           |    |   |   |   |   |   |   |   |   |
|                                                             |   | **Amount of Commitment-Expiration by  Period** |    |
| Other Commerical  Commitments:                                   |   |                                           |    |   |   |   |   |   |   |   |   |
| Commercial lines of credit                                       |   | $                                              | 21,124  |   | 20,196 |   | 798 |   | 0 |   | 130 |   |
| Commitments to lend                                              |   | 82,811                                         |    | 34,346 |   | 34,464 |   | 46 |   | 13,955 |   |
| Standby letters of credit                                        |   | 1,167                                          |    | 1,042 |   | 125 |   | 0 |   | 0 |   |
|                                                             |   | $                                              | 105,102 |   | 55,584 |   | 35,387 |   | 46 |   | 14,085 |   |

 

***Regulatory Capital Requirements***

As a result of the Federal Deposit Insurance Corporation ImprovementAct of 1991 (FDICIA), banking and thrift regulators are required to take promptregulatory action against institutions which are undercapitalized. FDICIArequires banking and thrift regulators to categorize institutions as “wellcapitalized,” “adequately capitalized,” “undercapitalized,” “significantlyundercapitalized,” or “critically undercapitalized”. A savings institution willbe deemed to be well capitalized if it: (i) has a total risk-based capitalratio of 10% or greater, (ii) has a Tier 1 (core) risk-based capital ratio of6% or greater, (iii) has a leverage (core) ratio of 5% or greater, and (iv) isnot subject to any order or written directive by the OTS to meet and maintain aspecific capital level for any capital measure. The Bank is of the opinion thatit is considered well capitalized at December 31, 2002. Refer to Note 20 of theNotes to Consolidated Financial Statements for a table which reflects theBank’s capital compared to its capital requirements.

 

***Dividends***

The declaration of dividends are subject to, among other things, HMN’sfinancial condition and results of operations, the Bank’s compliance with itsregulatory capital requirements, tax considerations, industry standards,economic conditions, regulatory restrictions, general business practices andother factors. Refer to Note 19 of the Notes to Consolidated Financial Statementsfor information on regulatory limitations on dividends from the Bank to HMN andmore information on dividends.

 

19

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**Liquidity**

HMN manages its liquidity position to ensure that the funding needs ofborrowers and depositors are met timely and in the most cost effective manner.Asset liquidity is the ability to convert assets to cash through the maturityof the asset or the sale of the asset. Liability liquidity results from theability of the Bank to attract depositors from either its retail branches orfrom brokers and to borrow funds from third party sources such as the FHLB.

 

The primary investingactivities are the origination or purchase of loans and the purchase ofsecurities. Principal and interest payments on mortgages and securities alongwith the proceeds from the sale of loans held for sale are the primary sourcesof cash for HMN. Additional cash can be obtained by selling securities from theavailable for sale portfolio or by selling loans. Loans could also besecuritized by FNMA or FHLMC and used as collateral for additional borrowingwith the FHLB.

 

The primary financingactivity is the attraction of retail deposits. The Bank also obtains funds byutilizing brokered certificates of deposit. The Bank has the ability to borrowadditional funds from the FHLB by pledging additional securities or loans.Refer to Note 14 of the Notes to Consolidated Financial Statements for moreinformation on additional advances that could be drawn upon based upon existingcollateral levels with the FHLB. Information on outstanding advance maturitiesand related early call features is also included in Note 14.

 

HMN anticipates that itsliquidity requirements for 2003 will be similar to the cash flows itexperienced in 2002 with the following exceptions: expenditures for premisesand equipment are anticipated to be $2.2 million which is less than the 2002expenditures; net increase in loans receivable is anticipated to be $102million; and the funds provided from deposits and/or FHLB advances will beapproximately $56 million.

 

HMN’s most liquid assets arecash 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.

 

Cash and cash equivalents atDecember 31, 2002 were $27.7 million, an increase of $4.7 million, compared to$23.0 million at December 31, 2001. Net cash provided by operating activitiesduring 2002 was $68.9 million. HMN conducted the following major investingactivities during 2002: proceeds from the sale of securities available for salewere $18.0 million, principal received on payments and maturities of securitiesavailable for sale was $45.4 million, purchases of securities available forsale were $63.2 million, and net increase in loans receivable of $69.3 million.HMN spent $4.3 million for the purchase of equipment and updating its premises,and received $807,000 from the sale of real estate and old branch facilities.Net cash used by investing activities during 2002 was $72.1 million. HMNconducted the following major financing activities during 2002: purchase oftreasury stock of $1.5 million, received $871,000 from exercise of HMN commonstock options, paid $2.6 million in dividends to HMN stockholders, proceedsfrom FHLB advances of $10.0 million and repayments of FHLB advances totaled$9.5 million. Net cash provided by financing activities was $7.9 million.

 

HMN has certificates ofdeposit with outstanding balances of $114.4 million that mature during 2003.Based upon past experience management anticipates that the majority of thedeposits will renew for another term. HMN believes that deposits which do notrenew will be replaced with deposits from a combination of other customers orbrokered deposits. FHLB advances or the sale of securities could also be usedto replace unanticipated outflows of deposits. Management does not anticipatethat it will have a liquidity problem due to maturing deposits.

 

HMN has $64.4million of FHLB advances which mature in 2003 and it has $105.0 million of FHLBadvances with maturities beyond 2003 which have call features that may beexercised by the FHLB during 2003. If the call features are exercised, HMN hasthe option of requesting any advance otherwise available to it pursuant to theCredit Policy of the FHLB. Since HMN has the ability to request another advanceto replace the advance that is being called, management does not anticipatethat it will have a liquidity problem due to advances being called by the FHLBduring 2003.

 

The CreditPolicy of the FHLB may change such that the current collateral pledged tosecure the advances is no longer acceptable or the formulas for determining theexcess pledged collateral may change and the Bank may not have additionalcollateral to pledge to secure the existing advances which could cause the FHLBadvances to become a liquidity problem during 2003.

 

20

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On August 27, 2002, HMN’sBoard of Directors authorized the extension of the stock repurchase program toFebruary 26, 2004. The plan authorized HMN to repurchase up to 350,000 sharesof HMN’s common stock in the open market. At December 31, 2002 there remained300,000 shares approved to be purchased under the plan.

 

***Merger and Acquisitions***

From time to time HMN reviews the possibility of acquiring or mergingwith different companies which would complement the business conducted by HMN.HMN’s Board of Directors has adopted the policy of not disclosing to the publicits intent to acquire or merge until a formal definitive agreement has beensigned by all parties involved with the transaction, except as otherwiserequired by law.

 

***Impact of Inflation and ChangingPrices***

The Consolidated Financial Statements and Notes presented herein havebeen prepared in accordance with generally accepted accounting principles,which require the measurement of financial position and operation results thatare primarily in terms of historical dollars without considering the changes inthe relative purchasing power of money over time due to inflation. The impactof inflation is reflected in the increased cost of operations. Unlike mostindustrial companies, nearly all of the assets and liabilities of HMN aremonetary in nature. As a result, interest rates have a greater impact on HMN’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.

 

**Market Risk**

Market risk is the risk of loss from adverse changes in market pricesand rates. HMN’s market risk arises primarily from interest rate risk inherentin its investing, lending and deposit taking activities. Management activelymonitors and manages its interest rate risk exposure.

 

HMN’s profitability isaffected by fluctuations in interest rates. A sudden and substantial increasein interest rates may adversely impact HMN’s earnings to the extent that the interestrates borne by assets and liabilities do not change at the same speed, to thesame extent, or on the same basis. HMN monitors the projected changes in netinterest income that occur if interest rates were to suddenly change up ordown. The Rate Shock Table located in the Asset/Liability Management section ofthis report discloses HMN’s projected changes in net interest income based uponimmediate interest rate changes called rate shocks.

 

HMN utilizes a model whichuses 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 due todifferent interest rate changes.

 

HMN believes that over thenext twelve months interest rates could conceivably fluctuate in a range of 200basis points up or 100 basis points down from where the rates were at December31, 2002. HMN does not have a trading portfolio. The following table disclosesthe projected changes in market value to HMN’s interest-earning assets andinterest-bearing liabilities based upon incremental 100 basis point changes ininterest rates from interest rates in effect on December 31, 2002.

 

21

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| **Other than trading portfolio**                                         |   |              |   |    |   |     |   |     |   |
|--------------------------------------------------------------------------|--------|-------------------|--------|---------|--------|----------|--------|----------|--------|
| **(Dollars in thousands)**                                               |   | **Market  Value** |   |
| **Basis point change in interest rates**                                 |   | **-100**          |   | **0**   |   | **+100** |   | **+200** |   |
| Cash and cash equivalents                                                |   | $                 | 27,735 |    | 27,729 |     | 27,692 |     | 27,671 |   |
| Securities available for  sale:                                          |   |              |   |    |   |     |   |     |   |
| Fixed-rate CMOs                                                          |   | 6,495             |   | 6,512   |   | 6,446    |   | 6,302    |   |
| Variable-rate CMOs                                                       |   | 43,378            |   | 43,591  |   | 44,343   |   | 45,150   |   |
| Fixed-rate available for  sale mortgage-backed and related securities    |   | 1,599             |   | 1,589   |   | 1,563    |   | 1,522    |   |
| Variable-rate available for  sale mortgage-backed and related securities |   | 204               |   | 203     |   | 201      |   | 199      |   |
| Fixed-rate available for  sale other marketable securities               |   | 70,803            |   | 69,394  |   | 67,627   |   | 66,101   |   |
| Variable-rate available for  sale other marketable securities            |   | 113               |   | 108     |   | 106      |   | 106      |   |
| Federal Home Loan Bank  stock                                            |   | 12,538            |   | 11,881  |   | 11,403   |   | 10,888   |   |
| Fixed-rate loans held for  sale                                          |   | 15,986            |   | 15,111  |   | 15,007   |   | 14,783   |   |
| Loans receivable, net:                                                   |   |              |   |    |   |     |   |     |   |
| Fixed-rate real estate  loans                                            |   | 201,014           |   | 198,766 |   | 195,368  |   | 191,037  |   |
| Variable-rate real estate  loans                                         |   | 153,624           |   | 150,434 |   | 146,549  |   | 143,138  |   |
| Fixed-rate other loans                                                   |   | 90,483            |   | 89,489  |   | 87,776   |   | 86,249   |   |
| Variable-rate other loans                                                |   | 120,898           |   | 119,049 |   | 115,614  |   | 113,977  |   |
| Mortgage servicing rights,  net                                          |   | 1,472             |   | 2,701   |   | 4,093    |   | 4,527    |   |
| Investment in limited  partnerships                                      |   | 766               |   | 863     |   | 1,020    |   | 1,092    |   |
| Total market risk sensitive  assets                                      |   | 747,108           |   | 737,420 |   | 724,808  |   | 712,742  |   |
| Deposits:                                                                |   |              |   |    |   |     |   |     |   |
| NOW accounts                                                             |   | 71,682            |   | 71,682  |   | 71,682   |   | 71,682   |   |
| Passbooks                                                                |   | 41,033            |   | 41,033  |   | 41,033   |   | 41,033   |   |
| Money market accounts                                                    |   | 49,511            |   | 49,511  |   | 49,511   |   | 49,511   |   |
| Certificates                                                             |   | 278,762           |   | 275,265 |   | 271,850  |   | 268,161  |   |
| Federal Home Loan Bank  advances:                                        |   |              |   |    |   |     |   |     |   |
| Fixed-rate advances                                                      |   | 194,900           |   | 187,934 |   | 181,319  |   | 180,105  |   |
| Variable-rate advances                                                   |   | 34,142            |   | 34,175  |   | 34,156   |   | 34,113   |   |
| Total market risk sensitive  liabilities                                 |   | 670,030           |   | 659,600 |   | 649,551  |   | 644,605  |   |
| Off-balance sheet financial  instruments:                                |   |              |   |    |   |     |   |     |   |
| Commitments to extend  credit                                            |   | 2,032             |   | 0       |   | (1,572   | )      | (2,444   | )      |
| Commitments to sell or deliver  loans                                    |   | (1,902            | )      | 0       |   | 2,492    |   | 5,181    |   |
| Net market risk                                                          |   | $                 | 76,948 |    | 77,820 |     | 74,337 |     | 65,400 |   |
| Percentage change from  current market value                             |   | (1.12             | )%     | 0.00    | %      | (4.48    | )%     | (15.96   | )%     |

 

The preceding table wasprepared utilizing the following assumptions (the “Model Assumptions”)regarding prepayment and decay ratios which were determined by management basedupon their review of historical prepayment speeds and future prepaymentprojections. Fixed rate loans were assumed to prepay at annual rates of between9% to 53%, depending on the note rate and the period to maturity. Adjustablerate mortgages (“ARMs”) were assumed to prepay at annual rates of between 12%and 33%, depending on the note rate and the period to maturity. Growing EquityMortgage (GEM) loans were assumed to prepay at annual rates of between 8% and54% 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 10%. Noninterest checkingand NOW accounts were assumed to decay at an annual rate of 9%. Commercial NOWand MMDA accounts were assumed to decay at an annual rate of 20%. FHLB advanceswere projected to be called at the first call date where the projected interestrate on similar remaining term advances exceeded the interest rate on HMN’scallable advance. Refer to Note 14 of the Notes to Consolidated FinancialStatements for more information on call provisions of the 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 in

 

22

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advance of changes in market interest rates, while interest rates onother types 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 constantover the interest changes disclosed in the table. Changes in Interest Spreadcould impact 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 assetswhich are approaching their lifetime interest rate caps could be different fromthe values disclosed 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.

 

***Asset/Liability Management***

HMN’s management reviews the impact that changing interest rates willhave on its net interest income projected for the twelve months followingDecember 31, 2002 to determine if its current level of interest rate risk isacceptable. The following table projects the estimated impact on net interestincome of immediate interest rate changes called rate shocks.

 
| **Rate Shock  in Basis Points** |   | **Net  Interest  Income** |       | **Percentage  Change** |   |
|---------------------------------|--------|---------------------------|------------|------------------------|--------|
| +200                            |   |                      | $          | 26,095,000             |   | 11.50 | % |
| +100                            |   |                      | 25,153,000 |                   | 7.48   | % |
| 0                               |   |                      | 23,403,000 |                   | 0.00   | % |
| -100                            |   |                      | 21,136,000 |                   | (9.69  | )% |
|                                 |        |                           |            |                        |        |  |  |

 

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. HMN has an Asset/Liability Committee which meets at least on amonthly basis to discuss changes made to the interest rate risk position andprojected profitability. The committee makes recommendations for adjustments tothe asset liability position of the Bank to the Board of Directors of the Bank.This committee also reviews the Bank’s portfolio, formulates investmentstrategies and oversees the timing and implementation of transactions to assureattainment of the Board’s objectives in the most effective manner. In addition,the Board reviews on a quarterly basis the Bank’s asset/liability position,including simulations of the effect on the Bank’s capital of various interestrate scenarios.

 

In managing itsasset/liability mix, the Bank, at times, depending on the relationship betweenlong- and short-term interest rates, market conditions and consumer preference,may place more emphasis on managing net interest margin than on better matchingthe interest rate sensitivity of its assets and liabilities in an effort toenhance net interest income. Management believes that the increased netinterest income resulting from a mismatch in the maturity of its asset andliability portfolios can, during periods of declining or stable interest rates,provide high enough returns to justify the increased exposure to sudden andunexpected 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 will portfolio only certain fixed rate loans that meet certain riskcharacteristics. The Bank will retain in its portfolio adjustable rate loanswhich reprice over a one year, three year and five year period. At times,depending on its interest rate sensitivity, the Bank may sell seasoned fixedrate single family loans with shorter contractual maturities than thirty yearsin order to reduce interest rate risk and record a gain on the sale of loans.

 

***Forward-looking Information***

This Annual Report, other reports filed with the Securities andExchange Commission, and HMN’s proxy statement may contain “forward-looking”statements that deal with future results, plans or performance. In addition,HMN’s management 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. HMN’s future results maydiffer materially from historical performance and forward-looking statementsabout HMN’s expected financial results or other plans are subject to a numberof risks and uncertainties. These include but are not limited to possiblelegislative changes and adverse economic, business and competitive developmentssuch as shrinking interest margins; deposit outflows; reduced demand forfinancial services and loan products; changes in accounting policies andguidelines, or monetary and fiscal policies of the federal government; changesin credit and other risks posed by HMN’s loan and investment portfolios;technological, computer-related or operational difficulties; adverse changes insecurities markets; results of litigation or other significant uncertainties.

 

23

----

 

**CONSOLIDATED****BALANCE SHEETS**

 
| **December 31, 2002 and 2001**                                                                    |   | **2002**        |            | **2001**    |        |
|---------------------------------------------------------------------------------------------------|--------|-----------------|-----------------|-------------|-------------|
|                                                                                              |   |            | ** **      |        |        |
| **ASSETS**                                                                                        |   |            | ** **      |        |        |
| Cash and cash equivalents                                                                         |   | **$**           | **27,729,007**  | ** **  | 23,019,553  |   |
| Securities available for  sale:                                                                   |   |            | ** **      |        |        |
| Mortgage-backed and  related securities  (amortized cost $51,677,294 and $65,878,534)             |   | **51,895,832**  | ** **      | 66,229,732  |        |
| Other marketable  securities  (amortized cost $67,282,379 and $53,439,401)                        |   | **69,501,417**  | ** **      | 53,665,502  |        |
|                                                                                              |   | **121,397,249** |            | 119,895,234 |        |
| Loans held for sale                                                                               |   | **15,126,509**  | ** **      | 68,017,570  |        |
| Loans receivable, net                                                                             |   | **533,905,652** | ** **      | 471,667,772 |        |
| Accrued interest  receivable                                                                      |   | **3,050,636**   | ** **      | 3,508,828   |        |
| Real estate, net                                                                                  |   | **426,691**     | ** **      | 0           |        |
| Federal Home Loan Bank  stock, at cost                                                            |   | **11,880,500**  | ** **      | 12,245,000  |        |
| Mortgage servicing rights,  net                                                                   |   | **2,691,031**   | ** **      | 1,903,636   |        |
| Premises and equipment,  net                                                                      |   | **12,875,816**  | ** **      | 10,860,756  |        |
| Investment in limited  partnerships                                                               |   | **862,666**     | ** **      | 1,523,650   |        |
| Goodwill                                                                                          |   | **3,800,938**   | ** **      | 3,800,938   |        |
| Core deposit intangible                                                                           |   | **561,331**     | ** **      | 685,509     |        |
| Prepaid expenses and other  assets                                                                |   | **3,214,792**   | ** **      | 3,985,625   |        |
| Total assets                                                                                      |   | **$**           | **737,522,818** | ** **  | 721,114,071 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                    |   |            | ** **      |        |        |
| Deposits                                                                                          |   | **$**           | **432,951,462** | ** **  | 421,843,369 |   |
| Federal Home Loan Bank  advances                                                                  |   | **218,300,000** | ** **      | 217,800,000 |        |
| Accrued interest payable                                                                          |   | **849,427**     | ** **      | 1,017,456   |        |
| Advance payments by  borrowers for taxes and insurance                                            |   | **707,213**     | ** **      | 1,015,570   |        |
| Accrued expenses and other  liabilities                                                           |   | **7,614,406**   | ** **      | 6,535,734   |        |
| Deferred tax liabilities                                                                          |   | **1,456,600**   | ** **      | 976,900     |        |
| Total liabilities                                                                                 |   | **661,879,108** | ** **      | 649,189,029 |        |
| Commitments and  contingencies                                                                    |   |            | ** **      |        |        |
| Minority interest                                                                                 |   | **(420,846**    | **)**           | (236,309    | )           |
| Stockholders’ equity:                                                                        |   |            | ** **      |        |        |
| Serial preferred stock:  ($.01 par value)  Authorized 500,000 shares; issued and outstanding none |   | **0**           | ** **      | 0           |        |
| Common stock ($.01 par  value):  Authorized 11,000,000; issued shares 9,128,662                   |   | **91,287**      | ** **      | 91,287      |        |
| Additional paid-in capital                                                                        |   | **58,885,279**  | ** **      | 59,168,782  |        |
| Retained earnings, subject  to certain restrictions                                               |   | **79,660,481**  | ** **      | 76,956,978  |        |
| Accumulated other  comprehensive income                                                           |   | **1,575,577**   | ** **      | 367,744     |        |
| Unearned employee stock  ownership plan shares                                                    |   | **(4,931,385**  | **)**           | (5,124,746  | )           |
| Unearned compensation  restricted stock awards                                                    |   | **0**           | ** **      | (7,350      | )           |
| Treasury stock, at cost  4,722,856 and 4,732,521 shares                                           |   | **(59,216,683** | **)**           | (59,291,344 | )           |
| Total stockholders’ equity                                                                   |   | **76,064,556**  | ** **      | 72,161,351  |        |
| Total liabilities and  stockholders’ equity                                                  |   | **$**           | **737,522,818** | ** **  | 721,114,071 |   |

 

*See accompanying notes to consolidatedfinancial statements.*

 

24

----

 

**CONSOLIDATED STATEMENTS OF INCOME**

 
| **Years ended December 31, 2002, 2001  and 2000**                                            |   | **2002**       |           | **2001**   |       | **2000**   |       |
|----------------------------------------------------------------------------------------------|--------|----------------|----------------|------------|------------|------------|------------|
|                                                                                         |   |           | ** **     |       |       |       |       |
| Interest income:                                                                             |   |           | ** **     |       |       |       |       |
| Loans receivable                                                                             |   | **$**          | **38,011,750** | ** ** | 44,569,397 |       | 40,510,151 |   |
| Securities available for  sale:                                                              |   |           | ** **     |       |       |       |       |
| Mortgage-backed and related                                                                  |   | **1,704,248**  | ** **     | 3,867,079  |       | 6,694,550  |       |
| Other marketable                                                                             |   | **2,420,317**  | ** **     | 2,248,383  |       | 4,658,871  |       |
| Cash equivalents                                                                             |   | **382,021**    | ** **     | 246,449    |       | 221,465    |       |
| Other                                                                                        |   | **349,214**    | ** **     | 536,619    |       | 832,392    |       |
| Total interest income                                                                        |   | **42,867,550** | ** **     | 51,467,927 |       | 52,917,429 |       |
| Interest expense:                                                                            |   |           | ** **     |       |       |       |       |
| Deposits                                                                                     |   | **10,949,802** | ** **     | 18,578,348 |       | 19,132,506 |       |
| Federal Home Loan Bank  advances and other borrowed money                                    |   | **10,345,102** | ** **     | 11,865,682 |       | 13,868,974 |       |
| Total interest expense                                                                       |   | **21,294,904** | ** **     | 30,444,030 |       | 33,001,480 |       |
| Net interest income                                                                          |   | **21,572,646** | ** **     | 21,023,897 |       | 19,915,949 |       |
| Provision for loan losses                                                                    |   | **2,376,000**  | ** **     | 1,150,000  |       | 180,000    |       |
| Net interest income after  provision for loan losses                                         |   | **19,196,646** | ** **     | 19,873,897 |       | 19,735,949 |       |
| Non-interest income:                                                                         |   |           | ** **     |       |       |       |       |
| Fees and service charges                                                                     |   | **1,723,117**  | ** **     | 1,563,031  |       | 1,297,014  |       |
| Mortgage servicing fees                                                                      |   | **715,074**    | ** **     | 470,081    |       | 340,935    |       |
| Securities gains (losses),  net                                                              |   | **422,346**    | ** **     | (670,958   | )          | (23,122    | )          |
| Gain on sales of loans                                                                       |   | **3,077,294**  | ** **     | 2,934,317  |       | 1,215,702  |       |
| Earnings (losses) in  limited partnerships                                                   |   | **(659,378**   | **)**          | (1,311,568 | )          | (120,922   | )          |
| Other                                                                                        |   | **596,117**    | ** **     | 598,625    |       | 613,275    |       |
| Total non-interest income                                                                    |   | **5,874,570**  | ** **     | 3,583,528  |       | 3,322,882  |       |
| Non-interest expense:                                                                        |   |           | ** **     |       |       |       |       |
| Compensation and benefits                                                                    |   | **8,012,953**  | ** **     | 7,914,452  |       | 6,391,326  |       |
| Occupancy                                                                                    |   | **3,109,548**  | ** **     | 2,239,152  |       | 1,890,947  |       |
| Federal deposit insurance  premiums                                                          |   | **74,108**     | ** **     | 79,714     |       | 83,233     |       |
| Advertising                                                                                  |   | **521,898**    | ** **     | 426,357    |       | 303,046    |       |
| Data processing                                                                              |   | **1,107,248**  | ** **     | 963,958    |       | 789,995    |       |
| Amortization of mortgage  servicing rights, net of valuation adjustments and servicing costs |   | **1,165,762**  | ** **     | 758,352    |       | 333,692    |       |
| Other                                                                                        |   | **3,857,117**  | ** **     | 3,366,698  |       | 2,766,382  |       |
| Total noninterest expense                                                                    |   | **17,848,634** | ** **     | 15,748,683 |       | 12,558,621 |       |
| Income before income tax  expense                                                            |   | **7,222,582**  | ** **     | 7,708,742  |       | 10,500,210 |       |
| Income tax expense                                                                           |   | **2,099,200**  | ** **     | 2,634,385  |       | 3,797,900  |       |
| Income before minority  interest                                                             |   | **5,123,382**  | ** **     | 5,074,357  |       | 6,702,310  |       |
| Minority interest                                                                            |   | **(142,274**   | **)**          | (383,259   | )          | 0          |       |
| Net income                                                                                   |   | **$**          | **5,265,656**  | ** ** | 5,457,616  |       | 6,702,310  |   |
| Basic earnings per share                                                                     |   | **$**          | **1.40**       | ** ** | 1.45       |       | 1.75       |   |
| Diluted earnings per share                                                                   |   | **$**          | **1.32**       | ** ** | 1.37       |       | 1.69       |   |

 

**CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

 
| Net income                                                                   |   | **$**         | **5,265,656** | ** ** | 5,457,616 |      | 6,702,310 |   |
|------------------------------------------------------------------------------|--------|---------------|---------------|------------|-----------|-----------|-----------|--------|
| Other comprehensive  income, net of tax:                                     |   |          | ** **    |       |      |      |      |
| Unrealized gains (losses)  on hedging valuation                              |   | **(35,795**   | **)**         | 35,795     |      | 0         |      |
| Less: minority interest in  hedging valuation                                |   | **(21,950**   | **)**         | 21,950     |      | 0         |      |
| Net unrealized gains  (losses) on hedging valuation                          |   | **(13,845**   | **)**         | 13,845     |      | 0         |      |
| Unrealized gains on  securities:                                             |   |          | ** **    |       |      |      |      |
| Unrealized holding gains  arising during period                              |   | **1,494,824** | ** **    | 1,988,754  |      | 1,136,524 |      |
| Less: reclassification  adjustment for gains (losses) included in net income |   | **273,146**   | ** **    | (402,150   | )         | (14,214   | )         |
| Net unrealized gains on  securities                                          |   | **1,221,678** | ** **    | 2,390,904  |      | 1,150,738 |      |
| Other comprehensive income                                                   |   | **1,207,833** | ** **    | 2,404,749  |      | 1,150,738 |      |
| Comprehensive income                                                         |   | **$**         | **6,473,489** | ** ** | 7,862,365 |      | 7,853,048 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

25

----

 

**CONSOLIDATED STATEMENTS 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, 1999                   |   | $                 | 91,287     |                             | 59,674,715     |                   | 68,423,008     |                                                 | (3,187,743    | )                                                      | (5,511,851     | )                                                    | (96,508    | )                   | (54,832,040     | )                                     | 64,560,868     |   |
| Net income                                   |   |              |       |                             |           | 6,702,310              |           |                                                 |          |                                                   |           |                                                 |       |                |            | 6,702,310                             |           |
| Other comprehensive income                   |   |              |       |                             |           |                   |           | 1,150,738                                            |          |                                                   |           |                                                 |       |                |            | 1,150,738                             |           |
| Treasury stock purchases                     |   |              |       |                             |           |                   |           |                                                 |          |                                                   |           |                                                 |       | (5,091,726          | )               | (5,091,726                            | )              |
| Tax benefits of restricted  stock awards     |   |              |       | 35,200                           |           |                   |           |                                                 |          |                                                   |           |                                                 |       |                |            | 35,200                                |           |
| Employee stock options  exercised            |   |              |       | (257,101                         | )              |                   |           |                                                 |          |                                                   |           |                                                 |       | 858,235             |            | 601,134                               |           |
| Tax benefit of exercised  stock options      |   |              |       | 76,165                           |           |                   |           |                                                 |          |                                                   |           |                                                 |       |                |            | 76,165                                |           |
| Amortization of restricted  stock awards     |   |              |       |                             |           |                   |           |                                                 |          |                                                   |           | 86,708                                               |       |                |            | 86,708                                |           |
| Earned employee stock  ownership plan shares |   |              |       | 55,197                           |           |                   |           |                                                 |          | 193,784                                                |           |                                                 |       |                |            | 248,981                               |           |
| Dividends paid                               |   |              |       |                             |           | (1,744,730             | )              |                                                 |          |                                                   |           |                                                 |       |                |            | (1,744,730                            | )              |
| 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** | ** ** |

 

*See accompanying notes to consolidated financial statements.*

 

26

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**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| **Years  ended December 31, 2002, 2001 and 2000**                                     |   | **2002**         |           | **2001**     |       | **2000**     |       |
|---------------------------------------------------------------------------------------|--------|------------------|----------------|--------------|------------|--------------|------------|
| Cash flows from operating  activities:                                                |   |             | ** **     |         |       |         |       |
| Net income                                                                            |   | **$**            | **5,265,656**  | ** **   | 5,457,616  |         | 6,702,310  |   |
| Adjustments to reconcile  net income to cash provided (used) by operating activities: |   |             | ** **     |         |       |         |       |
| Provision for loan losses                                                             |   | **2,376,000**    | ** **     | 1,150,000    |       | 180,000      |       |
| Depreciation                                                                          |   | **1,460,636**    | ** **     | 1,037,897    |       | 896,741      |       |
| Amortization of (discounts)  premiums, net                                            |   | **501,945**      | ** **     | 107,719      |       | (73,113      | )          |
| Amortization of deferred  loan fees                                                   |   | **(672,993**     | **)**          | (513,671     | )          | (212,200     | )          |
| Amortization of goodwill                                                              |   | **0**            | ** **     | 180,036      |       | 180,024      |       |
| Amortization of core  deposit intangible                                              |   | **124,178**      | ** **     | 108,854      |       | 232,440      |       |
| Amortization of mortgage  servicing rights and net valuation adjustments              |   | **1,137,018**    | ** **     | 724,513      |       | 302,277      |       |
| Capitalized mortgage  servicing rights                                                |   | **(1,956,845**   | **)**          | (1,458,321   | )          | (367,531     | )          |
| Deferred income taxes                                                                 |   | **158,700**      | ** **     | (821,600     | )          | 353,400      |       |
| Securities losses (gains),  net                                                       |   | **(422,346**     | **)**          | 670,958      |       | 23,122       |       |
| Loss on sale of premises                                                              |   | **85,434**       | ** **     | 0            |       | 0            |       |
| Gain on sales of real  estate                                                         |   | **(1,254**       | **)**          | (17,293      | )          | 0            |       |
| Gain on sales of loans                                                                |   | **(3,077,294**   | **)**          | (2,934,317   | )          | (1,215,702   | )          |
| Proceeds from sales of  loans held for sale                                           |   | **283,485,340**  | ** **     | 753,564,329  |       | 109,204,874  |       |
| Disbursements on loans held  for sale                                                 |   | **(221,645,865** | **)**          | (809,722,094 | )          | (110,703,659 | )          |
| Principal collected on  loans held for sale                                           |   | **120,621**      | ** **     | 179,020      |       | 38,601       |       |
| Amortization of restricted  stock awards                                              |   | **7,350**        | ** **     | 2,450        |       | 86,708       |       |
| Amortization of unearned  ESOP shares                                                 |   | **193,361**      | ** **     | 193,321      |       | 193,784      |       |
| Earned employee stock  ownership shares priced above original cost                    |   | **143,604**      | ** **     | 102,572      |       | 55,197       |       |
| Decrease (increase) in  accrued interest receivable                                   |   | **458,192**      | ** **     | 802,919      |       | (451,293     | )          |
| Increase (decrease) in  accrued interest payable                                      |   | **(168,029**     | **)**          | (558,065     | )          | 142,410      |       |
| Equity losses of limited  partnerships                                                |   | **659,378**      | ** **     | 1,311,568    |       | 120,922      |       |
| Equity losses of minority  interest                                                   |   | **(142,274**     | **)**          | (383,259     | )          | 0            |       |
| Decrease (increase) in  other assets                                                  |   | **126,663**      | ** **     | (1,937,860   | )          | (112,976     | )          |
| Increase in other  liabilities                                                        |   | **629,031**      | ** **     | 2,890,551    |       | 870,222      |       |
| Other, net                                                                            |   | **78,247**       | ** **     | (26,826      | )          | (33,295      | )          |
| Net cash (used) provided by  operating activities                                     |   | **68,924,454**   | ** **     | (49,888,983  | )          | 6,413,263    |       |
| Cash flows from investing  activities:                                                |   |             | ** **     |         |       |         |       |
| Proceeds from sales of  securities available for sale                                 |   | **18,036,553**   | ** **     | 19,135,721   |       | 41,454,275   |       |
| Principal collected on  securities available for sale                                 |   | **25,481,396**   | ** **     | 24,062,724   |       | 9,198,142    |       |
| Proceeds collected on  maturity of securities available for sale                      |   | **19,900,000**   | ** **     | 13,695,000   |       | 14,500,000   |       |
| Purchases of securities  available for sale                                           |   | **(63,173,006**  | **)**          | (34,461,933  | )          | (17,958,537  | )          |
| Proceeds from sales of  loans receivable                                              |   | **0**            | ** **     | 12,156       |       | 204,264      |       |
| Purchase of Federal Home  Loan Bank stock                                             |   | **0**            | ** **     | 0            |       | (775,000     | )          |
| Redemption of Federal Home  Loan Bank stock                                           |   | **364,500**      | ** **     | 0            |       | 0            |       |
| Net decrease (increase) in  loans receivable                                          |   | **(69,313,264**  | **)**          | 44,264,172   |       | (53,310,741  | )          |
| Proceeds from sale of  mortgage servicing rights                                      |   | **33,032**       | ** **     | 0            |       | 0            |       |
| Proceeds from sale of  premises and equipment                                         |   | **655,465**      | ** **     | 0            |       | 0            |       |
| Proceeds from sale of real  estate                                                    |   | **151,453**      | ** **     | 316,797      |       | 0            |       |
| Purchases of premises and  equipment                                                  |   | **(4,281,615**   | **)**          | (2,438,943   | )          | (1,826,017   | )          |
| Net cash provided (used) by  investing activities                                     |   | **(72,145,486**  | **)**          | 64,585,694   |       | (8,513,614   | )          |
| Cash flows from financing  activities:                                                |   |             | ** **     |         |       |         |       |
| Increase in deposits                                                                  |   | **10,925,976**   | ** **     | 334,938      |       | 21,364,898   |       |
| Purchase of treasury stock                                                            |   | **(1,496,111**   | **)**          | (1,584,152   | )          | (5,091,726   | )          |
| Stock options exercised                                                               |   | **871,131**      | ** **     | 646,199      |       | 601,134      |       |
| Dividends to stockholders                                                             |   | **(2,562,153**   | **)**          | (1,881,226   | )          | (1,744,730   | )          |
| Proceeds from Federal Home  Loan Bank advances                                        |   | **10,000,000**   | ** **     | 267,700,000  |       | 167,800,000  |       |
| Repayment of Federal Home  Loan Bank advances                                         |   | **(9,500,000**   | **)**          | (271,800,000 | )          | (175,300,000 | )          |
| Minority interest in  mortgage services                                               |   | **0**            | ** **     | 125,000      |       | 0            |       |
| Increase (decrease) in  advance payments by borrowers for taxes and insurance         |   | **(308,357**     | **)**          | 365,222      |       | (163,744     | )          |
| Net cash (used) provided by  financing activities                                     |   | **7,930,486**    | ** **     | (6,094,019   | )          | 7,465,832    |       |
| Increase in cash and cash  equivalents                                                |   | **4,709,454**    | ** **     | 8,602,692    |       | 5,365,481    |       |
| Cash and cash equivalents,  beginning of year                                         |   | **23,019,553**   | ** **     | 14,416,861   |       | 9,051,380    |       |
| Cash and cash equivalents,  end of year                                               |   | **$**            | **27,729,007** | ** **   | 23,019,553 |         | 14,416,861 |   |
| Supplemental cash flow  disclosures:                                                  |   |             | ** **     |         |       |         |       |
| Cash paid for interest                                                                |   | **$**            | **21,462,933** | ** **   | 31,002,095 |         | 32,859,070 |   |
| Cash paid for income taxes                                                            |   | **1,952,500**    | ** **     | 3,713,121    |       | 3,340,300    |       |
| Supplemental noncash flow  disclosures:                                               |   |             | ** **     |         |       |         |       |
| Loans securitized and  transferred to securities available for sale                   |   | **0**            | ** **     | 0            |       | 11,129,146   |       |
| Loans transferred to loans  held for sale                                             |   | **4,669,139**    | ** **     | 2,172,128    |       | 1,095,640    |       |
| Transfer of loans to real  estate                                                     |   | **628,233**      | ** **     | 86,123       |       | 244,258      |       |
| Transfer of real estate to  loans                                                     |   | **0**            | ** **     | 0            |       | 50,140       |       |

 

*See accompanying notes to consolidated financial statements.*

 

27

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

*December 31, 2002, 2001 and 2000*

** **

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

HMN Financial, Inc. (HMN) is a stock savings bank holding company thatowns 100 percent of Home Federal Savings Bank (the Bank or Home Federal). HomeFederal has a community banking philosophy and operates retail bankingfacilities in Minnesota and Iowa. The Bank has two wholly owned subsidiaries,Osterud Insurance Agency, Inc. (OAI) which offers financial planning productsand services and Home Federal Holding, Inc. (HFH) which is the holding companyfor Home Federal REIT, Inc. (HFREIT) which invests in real estate loansacquired from the Bank. HMN has another wholly owned subsidiary, SecurityFinance Corporation (SFC) which acts as an intermediary for the Bank intransacting like kind property exchanges for Bank customers. The Bank has a 51%owned subsidiary, Home Federal Mortgage Services, LLC (HFMS), which was amortgage banking and mortgage brokerage business located in Brooklyn Park,Minnesota. HFMS’s brokerage and production activity stopped during the thirdquarter of 2002 and the Bank assumed responsibility for certain components ofHFMS. The remaining assets of HFMS, consisting primarily of single familymortgage loans, are in the process of being liquidated.

 

The consolidated financial statementsincluded herein are for HMN, SFC, the Bank and the Bank’s consolidatedentities, OIA, HFH, HFREIT, and HFMS. All significant intercompany accounts andtransactions have been eliminated in consolidation.

*** ***

***Material Estimates***In preparing the financial statements,management is required to make estimates and assumptions that affect thereported amounts of assets and liabilities as of the date of the balance sheetand revenues and expenses for the period. Actual results could differ fromthose estimates.

 

Estimates that areparticularly susceptible to change relate to the determination of the allowancefor losses on loans 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, various regulatoryagencies, as an integral part of their examination process, periodically reviewthe allowance for loan losses. Such agencies may require additions to theallowance based on their judgment about information available to them at thetime 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 Equivalents***For purposes of the statements of cash flows,HMN considers highly liquid investments with original maturities of threemonths or less to be cash equivalents.

 

***Securities***HMN classifies its debt and equity securitiesin one of three categories: trading, available for sale, or held to maturity.Trading securities are bought and held principally for the purpose of sellingthem in the near term. Securities available for sale include securities thatmanagement intends to use as part of its asset/liability strategy or that maybe sold in response to changes in interest rate, changes in prepayment risk, orsimilar factors. Securities held to maturity represent securities which HMN hasthe positive intent and ability to hold to maturity.

 

Securities available forsale are carried at market value. Net unrealized gains and losses, net of taxeffect, are included as a separate component of stockholders’ equity.

 

Securities held to maturityare carried at cost, adjusted for amortization of premiums and discounts, asmanagement has the ability and intent to hold them to maturity.

 

Premiums and discounts areamortized using the level-yield method over the period to maturity. Gains andlosses on the sale of securities are determined using thespecific-identification method and recognized on the trade date. Declines inthe value of securities that are considered other-than-temporary are recordedin noninterest 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 settlement date. Net unrealized losses are recognizedthrough a valuation allowance by charges to income.

 

***Loans Receivable, Net***Loans receivable, net are consideredlong-term investments and, accordingly, are carried at amortized cost. Loanorigination fees received, net of certain loan origination costs, are deferredas an adjustment to the carrying value of the related loans, and are amortizedinto income using the interest 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 loan losses inherent in the 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 thedetermination of the allowance for loan losses, management obtains independentappraisals for significant properties. The allowance for loan losses isestablished for known problem loans as well as for loans which are notcurrently known to require specific allowances. Loans are charged off to theextent they are deemed to be uncollectible. The adequacy of the allowance forloan losses is dependent upon management’s estimates of variables affectingvaluation, appraisals

 

28

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of collateral, evaluations of performance and status, and the amountsand timing of future cash flows expected to be received on impaired loans. Suchestimates, appraisals, evaluations and cash flows may be subject to frequentadjustments due to changing economic prospects of borrowers or properties. Theestimates are reviewed periodically and adjustments, if any, are recorded inthe provision for loan losses in the periods in which the adjustments becomeknown.

 

Interest income isrecognized on an accrual basis except when collectibility is in doubt. Whenloans are placed on a non-accrual basis, generally when the loan is 90 dayspast due, previously accrued but unpaid interest is reversed from income.Interest is subsequently recognized as income to the extent cash is receivedwhen, in management’s judgment, principal is collectible.

 

All impaired loans arevalued at the present value of expected future cash flows discounted at theloan’s initial effective interest rate. The fair value of the collateral of animpaired 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 acreditor will be unable to collect all amounts due according to the contractualterms of the loan agreement. Impaired loans include all loans which aredelinquent as to principal and interest for 120 days or greater and all loansthat are restructured in a troubled debt restructuring involving a modificationof terms. All portfolio loans are reviewed for impairment on an individualbasis.

*** ***

***Mortgage Servicing Rights***Mortgage servicing rights are capitalized andamortized in proportion to, and over the period of, estimated net servicingincome. HMN periodically evaluates its capitalized mortgage servicing rightsfor impairment. Loan type and note rate are predominant risk characteristics ofthe underlying 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 ona straight-line basis over estimated useful lives of 5 to 40 years for officebuildings and improvements and 3 to 12 years for furniture and equipment.

*** ***

***Impairment of Long-Lived Assets andfor Long-Lived Assets to Be Disposed Of***HMN reviews long-lived assets and certainidentifiable intangibles for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable.

 

***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 generally accounts for the earnings or losses from thelimited partnerships 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 additional information relating to stock basedcompensation. Had compensation cost for HMN’s stock-based plan been determinedin accordance with the fair value method recommended by SFAS No. 123, HMN’s netincome and earnings per share would have been adjusted to the pro forma amountsindicated below:

 
|                                                                                                                                                    |   | **2002**      |          | **2001**  |      | **2000**  |      |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------|---------------|-----------|-----------|-----------|-----------|
| Net income:                                                                                                                                             |   |          |          |      |      |      |      |
| As reported                                                                                                                                             |   | **$**         | **5,265,656** |      | 5,457,616 |      | 6,702,310 |   |
| Deduct: Total stock-based  employee compensation expense (benefit) determined under fair value based  method for all awards, net of related tax effects |   | **42,960**    |          | (6,805    | )         | 194,279   |      |
| Pro forma                                                                                                                                               |   | **5,222,696** |          | 5,464,421 |      | 6,508,031 |      |
| Earnings per common share:                                                                                                                              |   |          |          |      |      |      |      |
| As reported:                                                                                                                                            |   |          |          |      |      |      |      |
| Basic                                                                                                                                                   |   | **$**         | **1.40**      |      | 1.45      |      | 1.75      |   |
| Diluted                                                                                                                                                 |   | **1.32**      |          | 1.37      |      | 1.69      |      |
| Pro forma:                                                                                                                                              |   |          |          |      |      |      |      |
| Basic                                                                                                                                                   |   | **1.39**      |          | 1.45      |      | 1.70      |      |
| Diluted                                                                                                                                                 |   | **1.31**      |          | 1.37      |      | 1.64      |      |

 

***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.

 

29

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***Earnings per Share***Basic earnings per share (EPS) excludes dilutionand is computed by dividing income available to common stockholders by theweighted-average number of common shares outstanding for the period. DilutedEPS reflects the potential dilution that could occur if securities or othercontracts to issue common stock were exercised or converted into common stockor resulted in the issuance of common stock that then shared in the earnings ofthe entity. Refer to 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 July 2001, the Financial AccountingStandards Board (FASB) issued SFAS No. 141, *BusinessCombinations,*and SFAS No. 142, *Goodwilland Other Intangible Assets.* SFAS No. 141 requires that the purchase method of accounting be usedfor all business combinations initiated after June 30, 2001 as well as allpurchase method business combinations completed after June 30, 2001. SFAS No.141 also specifies criteria that intangible assets acquired in a purchasemethod business combination must meet to be recognized and reported apart fromgoodwill, noting that any purchase price allocable to an assembled workforcemay not be accounted for separately. SFAS No. 142 requires that goodwill andintangible assets with indefinite useful lives no longer be amortized, butinstead tested for impairment at least annually in accordance with theprovisions of SFAS No. 142.

 

HMN adopted the provisionsof SFAS No. 141 effective July 1, 2001 and adopted SFAS No. 142 effectiveJanuary 1, 2002. Intangible assets acquired in business combinations completedbefore July 1, 2001 were evaluated during the first quarter of 2002 todetermine if the useful lives and residual values of all intangible assetsacquired in purchase business combinations met the new criteria established inSFAS No. 141 for recognition apart from goodwill and to make any necessaryamortization period adjustments. Core deposit intangibles acquired in Decemberof 1997 were assigned a remaining life of six years and are being amortized onan accelerated basis.

 

At December 31, 2001 theBank (a reporting unit) had goodwillof $3,800,938 and during the first quarter of 2002 it was determinedthat the fair value of the Bank was in excess of the book value of the Bank,therefore no impairment loss was necessary for goodwill. On January 1, 2002, inaccordance with SFAS No. 142, goodwill amortization ceased. Goodwillamortization for the year ended 2001 was $180,036 or $45,009 per quarter. Referto Note 11 for related disclosure.

 

In June 2001, FASB issuedSFAS No. 143, *Accounting for AssetRetirement Obligations.*SFAS No. 143 amends FASB Statement No. 19, *Financial Accounting and Reporting by Oil and GasProducing Companies,*and applies to all entities. The Statementaddresses financial accounting and reporting for obligations associated withthe retirement of tangible long-lived assets and the associated assetretirement costs and was effective for financial statements issued for fiscalyears beginning after June 15, 2002. It applies to legal obligations associatedwith the retirement of long-lived assets that result from the acquisition,construction, development and/or the normal operation of long-lived asset,except for certain obligations of lessees. The impact of adopting SFAS No. 143will not be material.

 

In August 2001, the FASBissued SFAS No. 144, *Accounting for theImpairment of Disposal of Long-Lived Assets.*This Statement supersedesFASB Statement No. 121, *Accounting for theImpairment of Long-Lived Assets to Be Disposed Of,*and theaccounting and reporting provisions of APB Opinion No. 30, *Reporting the Results of Operations — Reporting theEffects of Disposal of a Segment of a Business, And Extraordinary, Unusual andInfrequently Occurring Events and Transactions,*for the disposal ofa segment of a business (as previously defined in that Opinion). The Statementalso amends Accounting Research Bulletin (ARB) No. 51, *Consolidated Financial Statements,*toeliminate the exception to consolidation for a subsidiary for which control islikely to be temporary. The Statement is effective for financial statementsissued for fiscal years beginning after December 15, 2001. The impact of adoptingSFAS No. 144 was not material.

 

In April 2002, the FASBissued SFAS No. 145, *Rescission of FASBStatements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections.*The provisions of this Statement related to therescission of Statement 4 are to be applied in fiscal years beginning after May15, 2002. Any gain or loss on extinguishment of debt that was classified as anextraordinary item in prior periods presented that does not meet the criteriain Opinion 30 for classification as an extraordinary item shall bereclassified. The impact of adopting SFAS No. 145 on HMN’s financial conditionand its results of operations will not be material.

 

In June 2002, the FASBissued SFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities.*SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities and nullifies Emerging Issues Task Force Issue No. 94-3, *Liability Recognition of Certain Employee TerminationBenefits and Other Costs to Exit an Activity (including Certain Costs Incurredin a Restructuring).*One of the principal differences between SFASNo. 146 and EITF Issue No. 94-3 pertains to the criteria for recognizing aliability for exit or disposal costs. Under EITF Issue No. 94-3, a liabilityfor such costs was recognized as of the date of an entity’s commitment to anexit plan. Pursuant to SFAS No. 146, a liability is recorded as of the date anobligation is incurred. SFAS No. 146

 

30

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requires that an exit or disposal liability be initially measured atfair value. Provisions of SFAS No. 146 are effective for exit or disposalactivities that are initiated after December 31, 2002. The impact of adoptingSFAS No.146 on HMN’s financial condition and its results of operations will notbe material.

 

In October 2002, the FASBissued SFAS No. 147, *Acquisitions of CertainFinancial Institutions.*Except for transactions between two or moremutual enterprises, this Statement removes financial institutions from thescope of SFAS No. 72 and requires those transactions be accounted for inaccordance with SFAS No. 141 and SFAS No. 142. In addition, this Statementamends FASB Statement No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,*to include inits scope long-term customer-relationship intangible assets of financialinstitutions such as depositor- and borrower-relationship intangible assets andcredit cardholder intangible assets. Consequently, those intangible assets aresubject to the same undiscounted cash flow recoverability test and impairmentloss recognition and measurement provision that SFAS No. 144 requires for otherlong-lived assets that are held and used. The provisions of SFAS No. 147, whichrelate to the application of the purchase method of accounting, are effectivefor acquisitions for which the date of acquisition is on or after October 1,2002. The provisions related to accounting for the impairment or disposal ofcertain long-term customer-relationship intangible assets are effective onOctober 1, 2002. The impact of adopting SFAS No. 147 on HMN’s financialcondition and its results of operations was not material.

 

In November 2002, the FASBissued Interpretation No. 45,*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees Including Indirect Guarantees of Indebtedness of Others*(FIN 45). FIN 45 requires disclosures be madeby a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued. It also requires therecognition of a liability by a guarantor at the inception of certainguarantees that it has issued and that a guarantor recognize, at the inceptionof a guarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee. The initial recognition and initial measurementprovisions of this Interpretation are applicable on a prospective basis toguarantees issued or modified after December 31, 2002. The disclosurerequirements are effective for financial statements of interim or annualperiods ending after December 15, 2002. Refer to Note 24 for the related FIN 45disclosure.

 

In December 2002, the FASBissued SFAS No. 148, *Accounting forStock-Based Compensation–Transition and Disclosure – an amendment of FASBStatement No. 123.*This Statement amends SFAS No. 123,*Accounting for Stock-BasedCompensation,*to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. In addition,this Statement amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both the annual and interim financial statements aboutthe method of accounting for stock-based employee compensation and the effectof the method used on reported results. The amendments to SFAS No. 123 areeffective for fiscal years ending after December 15, 2002 and for condensedinterim financial statements issued after December 15, 2002. HMN has notadopted the voluntary change to the fair value based method of accounting forstock-based employee compensation as of December 31, 2002. Refer to the discussion under “Stock -BasedCompensation” in this footnote and Note 17 for required disclosures relating tostock-based compensation.

 

In January 2003, the FASBissued Interpretation No. 46,*Consolidation of Variable Interest Entities*(FIN 46). FIN 46 addresses consolidation bybusiness enterprises of variable interest entities that have certaincharacteristics. It requires a business enterprise that has a controllinginterest in a variable interest entity (as defined by FIN 46) to include theassets, liabilities, and results of the activities of the variable interestentity in the consolidated financial statements of the business enterprise. FIN46 applies immediately to variable interest entities created after January 31,2003, and to variable interest entities in which an enterprise obtains aninterest after that date. For variable interest acquired before February 1,2003, it applies in the first fiscal year or interim period beginning afterJune 15, 2003. The impact of adopting FIN 46 will not be material as HMN doesnot presently have any variable interest entities.

*** ***

***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**

The gross unrealized losses in hedging valuation for the year endedDecember 31, 2002 was $45,000, the income tax benefit would have been $9,000and therefore, the net loss was $36,000. The gross minority interest in hedgingvaluation for the year ended December 31, 2002 was $22,000. The grossunrealized holding gains on securities for the year ended December 31, 2002were $2,283,000, the income tax expense would have been $788,000 and therefore,the net gain was $1,495,000. The gross reclassification adjustment for 2002 was$422,000, the income tax expense would have been $149,000 and therefore, thenet reclassification adjustment was $273,000. The gross unrealized gains inhedging valuation for the year ended December 31, 2001 was $45,000, the incometax expense would have been $9,000 and therefore, the net gain was $36,000. Thegross minority interest in hedging valuation for the year ended December 31, 2001was $22,000. The net unrealized gain deferred to other comprehensive income was$14,000. There was no hedging valuation in the year ended December 31, 2000.The gross unrealized holding gains on securities for the year ended December31, 2001 were $3,291,000, the income tax expense would have been $1,302,000 andtherefore, the net gain was $1,989,000. The gross reclassification adjustmentfor 2001 was $671,000, the income tax benefit would have been $269,000 andtherefore, the net reclassification adjustment was $402,000. The grossunrealized holding losses for the year ended December 31,

 

31

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2000 were $1,886,000, the income tax benefit would have been $749,000and therefore, the net gain was $1,137,000. The gross reclassificationadjustment for 2000 was $23,000, the income tax benefit would have been $9,000and therefore, the net reclassification adjustment was $14,000.

 

**NOTE 3 Securities Available for Sale**

A summary of securities available for sale at December 31, 2002 and2001 is as follows:

 
|                                    |   | **Amortized  cost** |            | **Gross  unrealized  gains** |          | **Gross  unrealized  losses** |        | **Fair  value** |            |
|-----------------------------------------|--------|---------------------|-----------------|------------------------------|---------------|-------------------------------|-------------|-----------------|-----------------|
| *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** | ** ** |
| *December  31, 2001:*                   |   |                |            |                         |          |                          |        |            |            |
| Mortgage-backed securities:             |   |                |            |                         |          |                          |        |            |            |
| FHLMC                                   |   | $                   | 3,604,282       |                         | 94,185        |                          | 0           |            | 3,698,467       |   |
| FNMA                                    |   | 256,482             |            | 4,730                        |          | 0                             |        | 261,212         |            |
| GNMA                                    |   | 63,051              |            | 1,932                        |          | 0                             |        | 64,983          |            |
| Collateralized mortgage  obligations:   |   |                |            |                         |          |                          |        |            |            |
| FHLMC                                   |   | 22,018,460          |            | 82,623                       |          | 81,587                        |        | 22,019,496      |            |
| FNMA                                    |   | 26,577,974          |            | 144,767                      |          | 50,611                        |        | 26,672,130      |            |
| Other                                   |   | 13,358,285          |            | 155,159                      |          | 0                             |        | 13,513,444      |            |
|                                    |   | 65,878,534          |            | 483,396                      |          | 132,198                       |        | 66,229,732      |            |
| Other marketable  securities:           |   |                |            |                         |          |                          |        |            |            |
| U.S. Government and agency  obligations |   | 35,304,271          |            | 210,087                      |          | 9,456                         |        | 35,504,902      |            |
| Corporate debt                          |   | 9,545,532           |            | 96,109                       |          | 0                             |        | 9,641,641       |            |
| Corporate equity                        |   | 8,589,598           |            | 63,744                       |          | 134,383                       |        | 8,518,959       |            |
|                                    |   | 53,439,401          |            | 369,940                      |          | 143,839                       |        | 53,665,502      |            |
|                                    |   | $                   | 119,317,935     |                         | 853,336       |                          | 276,037     |            | 119,895,234     |   |

 

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. Proceeds from securities available for sale which were soldduring 2000 were $41,454,275, resulting in gross gains of $101,689 and grosslosses of $124,811.

 

The following tableindicates amortized cost and estimated fair value of securities available forsale at December 31, 2002, 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 prepay obligations with or without call or prepaymentpenalties:

 
|                                    |   | **Amortized  cost** |        | **Fair  value** |        |
|-----------------------------------------|--------|---------------------|-------------|-----------------|-------------|
|                                    |   |                |        |            |        |
| Due less than one year                  |   | $                   | 49,442,511  |            | 49,563,093  |   |
| Due after one year through  five years  |   | 64,511,255          |        | 66,760,931      |        |
|                                    |   |                |        |            |        |
| Due after five years  through ten years |   | 196,754             |        | 204,186         |        |
| Due after ten years                     |   | 5,000               |        | 5,293           |        |
| No stated maturity                      |   | 4,804,153           |        | 4,863,746       |        |
| Total                                   |   | $                   | 118,959,673 |            | 121,397,249 |   |

 

The allocation ofmortgage-backed securities and collateralized mortgage obligations in the tableabove is based upon the anticipated future cash flow of the securities usingestimated mortgage prepayment speeds.

 

32

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**NOTE 4 Loans Receivable, Net**

A summary of loansreceivable at December 31 is as follows:

 
|                                              |   | **2002**        |            | **2001**    |        |
|---------------------------------------------------|--------|-----------------|-----------------|-------------|-------------|
| Residential real estate  loans:                   |   |            |            |        |        |
| 1-4 family conventional                           |   | **$**           | **174,232,528** |        | 233,652,113 |   |
| 1-4 family FHA                                    |   | **306,815**     |            | 488,510     |        |
| 1-4 family VA                                     |   | **128,911**     |            | 271,356     |        |
|                                              |   | **174,668,254** |            | 234,411,979 |        |
| 5 or more family                                  |   | **29,903,411**  |            | 21,786,780  |        |
|                                              |   | **204,571,665** |            | 256,198,759 |        |
| Commercial real estate:                           |   |            |            |        |        |
| Lodging                                           |   | **37,188,951**  |            | 23,354,781  |        |
| Retail/office                                     |   | **40,648,853**  |            | 31,776,565  |        |
| Nursing home/health care                          |   | **2,250,556**   |            | 34,229      |        |
| Land developments                                 |   | **22,587,781**  |            | 4,080,658   |        |
| Golf courses                                      |   | **11,282,148**  |            | 3,901,784   |        |
| Restaurant, bar café                         |   | **3,279,726**   |            | 2,300,982   |        |
| Gaming                                            |   | **1,204,980**   |            | 1,970,616   |        |
| Warehouse                                         |   | **6,203,530**   |            | 2,512,748   |        |
| Manufacturing                                     |   | **5,806,968**   |            | 0           |        |
| Other                                             |   | **24,201,130**  |            | 21,430,541  |        |
|                                              |   | **154,654,623** |            | 91,362,904  |        |
| Other loans:                                      |   |            |            |        |        |
| Autos                                             |   | **11,061,725**  |            | 6,623,906   |        |
| Home equity line                                  |   | **52,105,686**  |            | 35,713,842  |        |
| Home equity                                       |   | **23,760,135**  |            | 26,439,557  |        |
| Consumer – secured                           |   | **2,700,204**   |            | 2,497,502   |        |
| Commercial business                               |   | **91,119,446**  |            | 54,940,192  |        |
| Savings                                           |   | **533,695**     |            | 594,330     |        |
| Mobile home                                       |   | **4,534,353**   |            | 5,456,362   |        |
| Consumer – unsecured                         |   | **1,724,858**   |            | 1,805,390   |        |
| Total other loans                                 |   | **187,540,102** |            | 134,071,081 |        |
| Total loans                                       |   | **546,766,390** |            | 481,632,744 |        |
| Less:                                             |   |            |            |        |        |
| Unamortized discounts                             |   | **142,439**     |            | 278,161     |        |
| Net deferred loan fees                            |   | **1,068,297**   |            | 1,211,438   |        |
| Allowance for losses                              |   | **4,824,217**   |            | 3,783,112   |        |
| Loans in process                                  |   | **6,825,785**   |            | 4,692,261   |        |
|                                              |   | **$**           | **533,905,652** |        | 471,667,772 |   |
| Weighted average  contractual interest rate       |   | **6.97**        | %               | 7.64        | %           |
| Commitments to originate,  fund or purchase loans |   | **$**           | **80,999,893**  |        | 29,738,750  |   |
| Commitments to deliver  loans to secondary market |   | **61,711,741**  |            | 89,375,910  |        |
| Loans serviced for others                         |   | **337,490,407** |            | 234,911,618 |        |

 

Included in totalcommitments to originate or purchase loans are fixed rate loans aggregating$44,943,293 and $27,435,250 as of December 31, 2002 and 2001, respectively. Theinterest rates on these commitments ranged from 4.75% to 7.88% at December 31,2002 and from 5.50% to 8.00% at December 31, 2001.

 

At December 31, 2002 and2001, loans on nonaccrual status totaled $3,336,046 and $2,159,228,respectively. Had the loans performed in accordance with their original termsthroughout 2002, HMN would have recorded gross interest income of $678,694 forthese loans. Interest income of $551,542 has been recorded on these loans forthe year ended December 31, 2002.

 

At December 31, 2002 and2001 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, 2002.

 

At December 31, 2002, 2001and 2000, the recorded investment in loans that are considered to be impairedwas $3,507,418, $2,183,483 and $1,416,916, respectively, for which the relatedallowance for credit losses was $904,840, $637,233, and $117,533, respectively.The average investment in impaired loans during 2002, 2001 and 2000 was$3,005,743, $1,385,071 and $869,168, respectively. For the years ended December31, 2002, 2001 and 2000, HMN recognized interest income on impaired loans of$551,542, $125,040 and $68,447, respectively. All of the interest income thatwas recognized during 2002, 2001 and 2000 for impaired loans was recognizedusing the cash basis method of income recognition.

 

The aggregate amount ofloans to executive officers and directors of HMN was $8,861,210, $1,324,983 and$476,815, at December 31, 2002, 2001 and 2000, respectively. During 2002repayments on loans to executive officers and directors were $871,573, newloans to executive officers and directors totaled $8,897,300, sales ofexecutive officer and director loans totaled $484,500, and loans removed fromthe executive officer listing due to change in status of the officer were$5,000. During 2001 repayments on loans to executive officers and directorsaggregated $302,869, loans originated aggregated $862,039, and loans added tothe executive officer and director listing due to a change in status of theofficer or director were $288,998.

 

At December 31, 2002, 2001and 2000, HMN was servicing real estate loans for others with aggregate unpaidprincipal balances of approximately $337,490,407, $234,911,618, and$147,905,114, respectively.

 

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, 2002 and 2001, HMN owned singlefamily and multi-family residential loans located in the following states:

 

33

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|           |   | **2002**        |            | **2001**              |      |
|----------------|--------|-----------------|-----------------|-----------------------|-----------|
|           |   | **Amount**      |            | **Percent  of Total** |      | **Amount** |   | **Percent  of Total** |   |
| Alabama        |   | **$**           | **3,967,366**   | ** **            | **2.0**   | **%** | $ | 6,067,456 |   | 2.4 | % |
| California     |   | **1,653,946**   | ** **      | **0.8**               |      | 2,230,094 |   | 0.9 |   |
| Florida        |   | **4,277,451**   | ** **      | **2.1**               |      | 4,701,262 |   | 1.8 |   |
| Georgia        |   | **16,004,376**  | ** **      | **7.8**               |      | 29,548,729 |   | 11.5 |   |
| Illinois       |   | **5,753,548**   | ** **      | **2.8**               |      | 2,747,398 |   | 1.1 |   |
| Iowa           |   | **13,819,533**  | ** **      | **6.8**               |      | 15,874,165 |   | 6.2 |   |
| Maine          |   | **499,666**     | ** **      | **0.2**               |      | 1,395,209 |   | 0.5 |   |
| Massachusetts  |   | **2,217,054**   | ** **      | **1.1**               |      | 3,545,252 |   | 1.4 |   |
| Minnesota      |   | **135,894,338** | ** **      | **66.4**              |      | 155,020,259 |   | 60.5 |   |
| New Hampshire  |   | **875,090**     | ** **      | **0.4**               |      | 1,218,104 |   | 0.5 |   |
| North Carolina |   | **6,099,133**   | ** **      | **3.0**               |      | 13,181,582 |   | 5.2 |   |
| Ohio           |   | **669,452**     | ** **      | **0.3**               |      | 2,084,060 |   | 0.8 |   |
| South Carolina |   | **4,040,068**   | ** **      | **2.0**               |      | 5,206,465 |   | 2.0 |   |
| Tennessee      |   | **714,396**     | ** **      | **0.4**               |      | 2,169,542 |   | 0.9 |   |
| Wisconsin      |   | **3,324,013**   | ** **      | **1.6**               |      | 8,030,367 |   | 3.1 |   |
| Other states   |   | **4,762,235**   | ** **      | **2.3**               |      | 3,178,815 |   | 1.2 |   |
| Total          |   | **$**           | **204,571,665** | ** **            | **100.0** | **%** | $ | 256,198,759 |   | 100.0 | % |

 

Amountsunder one million dollars are included in “Other states”. AtDecember 31, 2002 and 2001, HMN owned commercial real estate loanslocated in the following states:

 
|       |   | **2002**        |            | **2001**              |      |
|------------|--------|-----------------|-----------------|-----------------------|-----------|
|       |   | **Amount**      |            | **Percent  of Total** |      | **Amount** |   | **Percent  of Total** |   |
| Alabama    |   | **$**           | **3,216,316**   | ** **            | **2.1**   | **%** | $ | 1,778,301 |   | 1.9 | % |
| Arizona    |   | **12,099,641**  | ** **      | **7.8**               |      | 0 |   | 0.0 |   |
| Colorado   |   | **1,719,175**   | ** **      | **1.1**               |      | 1,740,529 |   | 1.9 |   |
| Iowa       |   | **8,237,520**   | ** **      | **5.3**               |      | 5,562,462 |   | 6.1 |   |
| Minnesota  |   | **121,301,045** | ** **      | **78.4**              |      | 73,329,031 |   | 80.2 |   |
| Montana    |   | **2,260,264**   | ** **      | **1.5**               |      | 2,335,601 |   | 2.6 |   |
| Nebraska   |   | **969,127**     | ** **      | **0.6**               |      | 881,739 |   | 1.0 |   |
| New Mexico |   | **0**           | ** **      | **0.0**               |      | 702,422 |   | 0.8 |   |
| Oregon     |   | **1,204,980**   | ** **      | **0.8**               |      | 1,268,194 |   | 1.4 |   |
| Texas      |   | **3,583,300**   | ** **      | **2.3**               |      | 3,689,143 |   | 4.0 |   |
| Wisconsin  |   | **63,255**      | ** **      | **0.1**               |      | 75,482 |   | 0.1 |   |
| Total      |   | **$**           | **154,654,623** | ** **            | **100.0** | **%** | $ | 91,362,904 |   | 100.0 | % |

 

**NOTE 5 Allowance for Loan Losses**

Theallowance for loan losses is summarized as follows:

 
| Balance, December 31, 1999 |   | $              | 3,273,311     |       |
|----------------------------|--------|----------------|---------------|------------|
| Provision for losses       |   | 180,000        |          |
| Charge-offs                |   | (312,455       | )             |
| Recoveries                 |   | 2,890          |          |
| 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** | ** ** |

 

**NOTE 6Accrued Interest Receivable**

Accrued interest receivableat December 31 is summarized as follows:

 
|                           |   | **2002**      |          | **2001**  |      |
|--------------------------------|--------|---------------|---------------|-----------|-----------|
| Securities available for  sale |   | **$**         | **388,705**   |      | 568,014   |   |
| Loans receivable               |   | **2,661,931** |          | 2,940,814 |      |
|                           |   | **$**         | **3,050,636** |      | 3,508,828 |   |

 

**NOTE 7Investment in Mortgage Servicing Rights**

A summary of mortgageservicing activity is as follows:

 
|                                     |   | **2002**       |          | **2001**   |      |
|------------------------------------------|--------|----------------|---------------|------------|-----------|
| Mortgage servicing rights                |   |           | ** **    |       |      |
| Balance, beginning of year               |   | **$**          | **1,922,736** | ** ** | 1,188,928 |   |
| Originations                             |   | **1,956,845**  | ** **    | 1,458,321  |      |
| Sales                                    |   | **(41,532**    | **)**         | 0          |      |
| Amortization                             |   | **(1,137,018** | **)**         | (724,513   | )         |
| Balance, end of year                     |   | **2,701,031**  | ** **    | 1,922,736  |      |
| Valuation reserve                        |   |           | ** **    |       |      |
| Balance, beginning of year               |   | **(19,100**    | **)**         | 0          |      |
| Additions                                |   | **(213,000**   | **)**         | (19,100    | )         |
| Reductions                               |   | **222,100**    | ** **    | 0          |      |
| Balance, end of year                     |   | **(10,000**    | **)**         | (19,100    | )         |
| Mortgage servicing rights,  net          |   | **$**          | **2,691,031** | ** ** | 1,903,636 |   |
| Fair value of mortgage  servicing rights |   | **$**          | **2,691,031** | ** ** | 1,939,000 |   |

 

Mortgage servicing costs,which include professional services related to valuing mortgage servicingrights, were $29,344 and $14,739, respectively, in 2002 and 2001.

 

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 31,2002:

 
|                              |   | **Loan  Principal  Balance** |        | **Weighted  Average  Interest  Rate** |   | **Weighted  Average  Remaining  Term** |   | **Number  of  Loans** |   |
|-----------------------------------|--------|------------------------------|-------------|---------------------------------------|--------|----------------------------------------|--------|-----------------------|--------|
| Original term 30 year fixed  rate |   | $                            | 139,285,000 |                                  | 6.71   | %                                      | 345    |                  | 1,396  |   |
| Original term 15 year fixed  rate |   | 173,872,000                  |        | 6.12                                  |   | 163                                    |   | 2,323                 |   |
| Seven year balloon                |   | 124,000                      |        | 5.75                                  |   | 73                                     |   | 1                     |   |
| Adjustable rate                   |   | 7,318,000                    |        | 5.25                                  |   | 350                                    |   | 62                    |   |
|                                   |        |                              |             |                                       |        |                                        |        |                       |        |  |

 

**NOTE 8 RealEstate**

A summary of real estate atDecember 31 is as follows:

 
|                                           |   | **2002**    |        | **2001** |       |
|------------------------------------------------|--------|-------------|-------------|----------|------------|
|                                           |   |        |        |     |       |
| In-substance foreclosures                      |   | **$**       | **127,000** |     | 0          |   |
|                                           |   |        |        |     |       |
| Real estate in judgment  subject to redemption |   | **89,691**  |        | 0        |       |
|                                           |   |        |        |     |       |
| Real estate acquired  through foreclosure      |   | **210,000** | ** **  | **0**    | ** ** |
|                                           |   | **426,691** |        | **0**    | ** ** |
| Allowance for losses                           |   | **0**       |        | 0        |       |
|                                           |   | **$**       | **426,691** |     | **0**      | ** ** |

 

34

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**NOTE 9Investment in Limited Partnerships**

Investments in limitedpartnerships at December 31 were as follows:

 
| **Primary partnership activity**        |   | **2002**    |        | **2001** |      |
|-----------------------------------------|--------|-------------|-------------|----------|-----------|
| Mortgage servicing rights               |   | **$**       | **349,577** |     | 991,941   |   |
| Common stock of financial  institutions |   | **289,398** |        | 265,955  |      |
| Low to moderate income  housing         |   | **223,691** |        | 265,754  |      |
|                                    |   | **$**       | **862,666** |     | 1,523,650 |   |

 

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 low income housing credits totaling $84,000which were credited to current income tax benefits.

 

During 2001 HMN’s proportionate loss from the mortgage servicingpartnership was $1,266,000, its proportionate share of losses from the commonstock investments in financial institutions was $19,568 and its proportionateloss on low income housing was $26,000. During 2001 HMN received low incomehousing credits totaling $84,000 which were credited to current income taxbenefits. During 2000 HMN’s proportionate earnings from the mortgage servicingpartnership was $35,848, its proportionate share of losses from the commonstock investments in financial institutions was $130,053 and its proportionateloss on low income housing was $26,718. During 2000 HMN received low incomehousing credits totaling $84,000 which were credited to current income taxbenefits.

 

The limited partnership thatinvests in mortgage servicing rights has a defined life and is scheduled tohave an orderly dissolution during the second half of 2003.

 

**NOTE 10 Intangible Assets**

The gross carrying amount of intangible assets and the associatedaccumulated amortization at December 31, 2002 and December 31, 2001 arepresented in the table below. Amortization expense for intangible assets was$1,137,018 and $724,513 for the year ended December 31, 2002 and December 31,2001, respectively.

 
| **December 31, 2002**         |   | **Gross  Carrying  Amount** |          | **Accumulated  Amortization** |           | **Valuation  Adjustment** |        | **Unamortized  Intangible  Assets** |          |
|-------------------------------|--------|-----------------------------|---------------|-------------------------------|----------------|---------------------------|-------------|-------------------------------------|---------------|
| 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** | ** ** |
|                          |   |                        |          |                          |           |                      |        |                                |          |
| **December  31, 2001**        |   |                        |          |                          |           |                      |        |                                |          |
| Amortized intangible  assets: |   |                        |          |                          |           |                      |        |                                |          |
| Mortgage servicing rights     |   | $                           | 2,455,399     |                          | (532,602       | )                         | (19,100     | )                                   | 1,903,636     |   |
| Core deposit intangible       |   | 1,567,000                   |          | (881,491                      | )              | 0                         |        | 685,509                             |          |
| Total                         |   | $                           | 4,022,339     |                          | (1,414,093     | )                         | (19,100     | )                                   | 2,589,145     |   |

 

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

 
|                    |   | **Mortgage  Servicing  Rights** |    | **Core  Deposit  Intangible** |    | **Total** |    |
|-------------------------|--------|---------------------------------|---------|-------------------------------|---------|-----------|---------|
| Year ended December 31, |   |                            |    |                          |    |      |    |
| 2003                    |   | $                               | 735,635 |                          | 113,857 |      | 849,492 |   |
| 2004                    |   | 527,670                         |    | 113,857                       |    | 641,527   |    |
| 2005                    |   | 381,726                         |    | 113,857                       |    | 495,583   |    |
| 2006                    |   | 278,052                         |    | 113,857                       |    | 391,909   |    |
| 2007                    |   | 203,495                         |    | 105,902                       |    | 309,397   |    |
|                         |        |                                 |         |                               |         |           |         |  |

 

Projections of amortizationare based on existing asset balances and the existing interest rate environmentas of December 31, 2002. HMN’s actual experiences may be significantlydifferent depending upon changes in mortgage interest rates and other marketconditions.

 

35

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

Effective January 1, 2002,the amortization of goodwill was discontinued. The table below reconcilesreported earnings for 2002 to “adjusted” earnings, which exclude goodwillamortization.

 
|                               |   |                                |          | **Year ended December 31, 2001** |      | **Year ended December 31, 2000** |    |
|------------------------------------|--------|-------------------------------------|---------------|----------------------------------|-----------|----------------------------------|---------|
|                               |   | **Year  Ended   December 31, 2002** |          | **Reported  Earnings**           |      | **Goodwill  Amortization**       |    | **Adjusted  Earnings** |   | **Reported  Earnings** |   | **Goodwill  Amortization** |   | **Adjusted  Earnings** |   |
| Income before income tax  expense  |   | **$**                               | **7,222,582** |                             | 7,708,742 |                             | 180,036 |   | 7,888,778 |   | 10,500,210 |   | 180,024 |   | 10,680,234 |   |
| Income tax expense                 |   | **2,099,200**                       |          | 2,634,385                        |      | 0                                |    | 2,634,385 |   | 3,797,900 |   | 0 |   | 3,797,900 |   |
| Income before minority  interest   |   | **5,123,382**                       |          | 5,074,357                        |      | 180,036                          |    | 5,254,393 |   | 6,702,310 |   | 180,024 |   | 6,882,334 |   |
| Minority interest                  |   | **(142,274**                        | **)**         | (383,259                         | )         | 0                                |    | (383,259 | ) | 0 |   | 0 |   | 0 |   |
| Net income                         |   | **$**                               | **5,265,656** |                             | 5,457,616 |                             | 180,036 |   | 5,637,652 |   | 6,702,310 |   | 180,024 |   | 6,882,334 |   |
| Earnings per common share          |   | **$**                               | **1.40**      |                             | 1.45      |                             | 0.05    |   | 1.50 |   | 1.75 |   | 0.05 |   | 1.80 |   |
| Diluted earnings per common  share |   | **$**                               | **1.32**      |                             | 1.37      |                             | 0.05    |   | 1.42 |   | 1.69 |   | 0.05 |   | 1.74 |   |
|                                    |        |                                     |               |                                  |           |                                  |         |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 12 Premises and Equipment**

Asummary of premises and equipment at December 31 is as follows:

 
|                               |   | **2002**       |           | **2001**   |       |
|------------------------------------|--------|----------------|----------------|------------|------------|
| Land                               |   | **$**          | **1,399,741**  |       | 1,580,096  |   |
| Office buildings and  improvements |   | **9,712,405**  |           | 8,375,777  |       |
| Furniture and equipment            |   | **9,325,853**  |           | 7,737,924  |       |
|                               |   | **20,437,999** |           | 17,693,797 |       |
| Less accumulated  depreciation     |   | **7,562,183**  |           | 6,833,041  |       |
|                               |   | **$**          | **12,875,816** |       | 10,860,756 |   |

 

**NOTE 13 Deposits**

Depositsand their weighted average interest rates at December 31 are summarized asfollows:

 
|                  |   | **2002**                   |       | **2001**        |            |
|-----------------------|--------|----------------------------|------------|-----------------|-----------------|
|                  |   | **Weighted  average rate** |       | **Amount**      |            | **Percent of  total** |   | **Weighted  average rate** |   | **Amount** |   | **Percent of  total** |   |
| Noninterest checking  |   | **0.00**                   | **%**      | **$**           | **28,173,034**  | ** ** | **6.5** | **%** | 0.00 | % | $ | 18,147,377 |   | 4.3 | % |
| NOW accounts          |   | **0.30**                   | ** ** | **43,508,898**  | ** **      | **10.1** |   | 0.64 |   | 40,226,061 |   | 9.5 |   |
| Passbooks             |   | **0.35**                   | ** ** | **41,032,871**  | ** **      | **9.5** |   | 0.75 |   | 32,738,309 |   | 7.8 |   |
| Money market accounts |   | **1.16**                   | ** ** | **49,510,654**  | ** **      | **11.4** |   | 1.89 |   | 45,001,866 |   | 10.7 |   |
|                  |   |                       |       | **162,225,457** |            | **37.5** |   |   |   | 136,113,613 |   | 32.3 |   |
| Certificates:         |   |                       |       |            |            |   |   |   |   |   |   |   |   |
| 1-1.99%               |   |                       |       | **23,002,684**  | ** **      | **5.3** |   |   |   | 2,784,991 |   | 0.7 |   |
| 2-2.99%               |   |                       |       | **72,161,515**  | ** **      | **16.7** |   |   |   | 34,924,430 |   | 8.3 |   |
| 3-3.99%               |   |                       |       | **75,444,893**  | ** **      | **17.4** |   |   |   | 64,330,025 |   | 15.2 |   |
| 4-4.99%               |   |                       |       | **74,817,691**  | ** **      | **17.3** |   |   |   | 64,096,795 |   | 15.2 |   |
| 5-5.99%               |   |                       |       | **23,719,214**  | ** **      | **5.5** |   |   |   | 35,908,810 |   | 8.5 |   |
| 6-6.99%               |   |                       |       | **1,468,058**   | ** **      | **0.3** |   |   |   | 70,282,159 |   | 16.6 |   |
| 7-7.99%               |   |                       |       | **111,950**     | ** **      | **0.0** |   |   |   | 13,402,546 |   | 3.2 |   |
| Total certificates    |   | **3.42**                   | ** ** | **270,726,005** | ** **      | **62.5** |   | 4.52 |   | 285,729,756 |   | 67.7 |   |
| Total deposits        |   | **2.34**                   | ** ** | **$**           | **432,951,462** | ** ** | **100.0** | **%** | 3.38 |   | $ | 421,843,369 |   | 100.0 | % |

 

At December 31, 2002 and2001, HMN had $61,353,755 and $52,318,424, respectively, of deposit accountswith balances at $100,000 or more. At December 31, 2002 and 2001, HMN had$11,203,358 and $15,000,000 of certificate accounts, respectively, that had beenacquired through a broker.

 

36

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Certificates had the following maturities at December 31:

 
|                           |   | **2002**                 |        | **2001**                  |     |
|--------------------------------|--------|--------------------------|-------------|---------------------------|----------|
| **Remaining term to maturity** |   | **Amount(in thousands)** |        | **Weighted  averagerate** |     | **Amount(in thousands)** |   | **Weighted  averagerate** |   |
| 1-6 months                     |   | **$**                    | **87,070**  | ** **                | **2.70** | **%** | $ | 141,450 |   | 5.13 | % |
| 7-12 months                    |   | **27,310**               | ** **  | **2.92**                  |     | 45,670 |   | 3.50 |   |
| 13-36 months                   |   | **136,382**              | ** **  | **3.88**                  |     | 76,196 |   | 4.44 |   |
| Over 36 months                 |   | **19,964**               | ** **  | **4.10**                  |     | 22,414 |   | 3.02 |   |
|                           |   | **$**                    | **270,726** |                      | **3.42** |   | $ | 285,730 |   | 4.52 |   |

 

At December 31, 2002mortgage loans and mortgage-backed and related securities with an amortizedcost of approximately $78,649,000 were pledged as collateral for certaindeposits and $595,000 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:

 
|         |   | **2002**      |           | **2001**   |       | **2000**   |       |
|--------------|--------|---------------|----------------|------------|------------|------------|------------|
| NOW          |   | **$**         | **181,073**    |       | 315,149    |       | 310,503    |   |
| Passbook     |   | **241,397**   |           | 454,628    |       | 683,613    |       |
| Money market |   | **589,406**   |           | 897,875    |       | 1,237,646  |       |
| Certificates |   | **9,937,926** |           | 16,910,696 |       | 16,900,744 |       |
|         |   | **$**         | **10,949,802** |       | 18,578,348 |       | 19,132,506 |   |

 

**NOTE 14 Federal Home Loan Bank Advances**

Fixedand variable rate Federal Home Loan Bank advances consisted of the following atDecember 31, 2002 and 2001:

 
|                  |   | **2002**        |            | **2001**   |     |
|-----------------------|--------|-----------------|-----------------|------------|----------|
| **Year  of Maturity** |   | **Amount**      |            | **Rate**   |     | **Amount** |   | **Rate** |   |
| 2002                  |   |            |            |       |     | $ | 9,500,000 |   | 4.42 | % |
| 2003                  |   | **$**           | **64,400,000**  | ** ** | **3.20** | **%** | 64,400,000 |   | 3.47 |   |
| 2004                  |   | **33,000,000**  | ** **      | **5.01**   |     | 33,000,000 |   | 5.01 |   |
| 2005                  |   | **10,000,000**  | ** **      | **2.69**   |     | 0 |   | 0.00 |   |
| 2008                  |   | **90,000,000**  | ** **      | **5.40**   |     | 90,000,000 |   | 5.40 |   |
| 2010                  |   | **10,000,000**  | ** **      | **6.48**   |     | 10,000,000 |   | 6.48 |   |
| 2011                  |   | **10,900,000**  | ** **      | **4.81**   |     | 10,900,000 |   | 4.81 |   |
|                  |   | **218,300,000** |            | **4.59**   |     | 217,800,000 |   | 4.75 |   |
| Lines of Credit       |   | **0**           | ** **      | **0.00**   |     | 0 |   | 0.00 |   |
|                  |   | **$**           | **218,300,000** |       | **4.59** |   | $ | 217,800,000 |   | 4.75 |   |

 

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 ofDecember 31, 2002, HMN had advances from the FHLB with the following callfeatures:

 
| **Year of Maturity** |   | **Callable  Quarterly  in Year 2003** |        | **Callable  Quarterly  in Year 2004** |       | **Callable  Quarterly  in Year 2005** |       |
|----------------------|--------|---------------------------------------|-------------|---------------------------------------|------------|---------------------------------------|------------|
| 2004                 |   | $                                     | 15,000,000  |                                  | 0          |                                  | 0          |   |
| 2008                 |   | 90,000,000                            |        | 0                                     |       | 0                                     |       |
| 2010                 |   | 0                                     |        | 0                                     |       | 10,000,000                            |       |
| 2011                 |   | 0                                     |        | 10,900,000                            |       | 0                                     |       |
|                 |   | $                                     | 105,000,000 |                                  | 10,900,000 |                                  | 10,000,000 |   |

 

At December 31, 2002 theadvances from the FHLB were collateralized by the Bank’s FHLB stock andmortgage loans with unamortized principal balances of approximately$301,716,000 and securities with unamortized principal balances ofapproximately $23,000,000. The Bank has the ability to draw additionalborrowings of $12,982,000 based upon the mortgage loans and securities that arecurrently pledged subject to a requirement to purchase FHLB stock.

 

**NOTE 15  OtherBorrowed Money**

HMN had established a $2,500,000 revolving line of credit with a bankthat was not drawn at December 31, 2002 or 2001. The line of credit expires onNovember 15, 2003.

 

37

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**NOTE 16Income Taxes**

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

 
|           |   | **2002**      |          | **2001**  |      | **2000**  |      |
|----------------|--------|---------------|---------------|-----------|-----------|-----------|-----------|
| Current:       |   |          |          |      |      |      |      |
| Federal        |   | **$**         | **2,223,300** |      | 2,773,200 |      | 2,663,500 |   |
| State          |   | **34,600**    |          | 682,785   |      | 781,000   |      |
| Total current  |   | **2,257,900** |          | 3,455,985 |      | 3,444,500 |      |
| Deferred:      |   |          |          |      |      |      |      |
| Federal        |   | **1,400**     |          | (638,000  | )         | 275,700   |      |
| State          |   | **(160,100**  | **)**         | (183,600  | )         | 77,700    |      |
| Total deferred |   | **158,700**   |          | (821,600  | )         | 353,400   |      |
|           |   | **$**         | **2,099,200** |      | 2,634,385 |      | 3,797,900 |   |

 

The reasons for thedifference between “expected” income tax expense utilizing the federalcorporate tax rate of 34% and the actual income tax expense are as follows:

 
|                                                                  |   | **2002**     |          | **2001** |      | **2000** |      |
|-----------------------------------------------------------------------|--------|--------------|---------------|----------|-----------|----------|-----------|
| Federal expected income tax  expense                                  |   | **$**        | **2,455,700** |     | 2,621,000 |     | 3,570,100 |   |
| Items affecting federal  income tax:                                  |   |         |          |     |      |     |      |
| Dividend received deduction                                           |   | **(145,200** | **)**         | (108,200 | )         | (92,400  | )         |
| Non deductible portion of  minority interest loss                     |   | **72,800**   |          | 130,300  |      | 0        |      |
| Reduction of tax rate due  to resolution of tax law                   |   | **0**        |          | 0        |      | (200,400 | )         |
| State income taxes, net of  federal income tax benefit                |   | **21,700**   |          | 329,500  |      | 568,600  |      |
| Reduction of tax rate due  to employee stock ownership plan dividends |   | **(149,100** | **)**         | (313,000 | )         | 0        |      |
| Low income housing credits                                            |   | **(84,000**  | **)**         | (84,000  | )         | (84,000  | )         |
| Other, net                                                            |   | **(72,700**  | **)**         | 58,785   |      | 36,000   |      |
|                                                                  |   | **$**        | **2,099,200** |     | 2,634,385 |     | 3,797,900 |   |

 

The tax effects of temporarydifferences that give rise to the deferred tax assets and deferred taxliabilities are as follows at December 31:
|                                                                              |   | **2002**      |           | **2001**  |      |
|-----------------------------------------------------------------------------------|--------|---------------|----------------|-----------|-----------|
| Deferred tax assets:                                                              |   |          |           |      |      |
| Allowances for loan and  real estate losses                                       |   | **$**         | **1,705,300**  |      | 1,504,500 |   |
| Investment in limited  partnership                                                |   | **164,500**   |           | 118,900   |      |
| Discounts on assets and  liabilities acquired from MFC                            |   | **900**       |           | 22,200    |      |
| Deferred compensation and  pension costs                                          |   | **176,100**   |           | 243,100   |      |
| Mortgage loan servicing  rights                                                   |   | **0**         |           | 3,850     |      |
| Impairment losses on  securities available for sale                               |   | **157,900**   |           | 407,700   |      |
| Mark to market on forward  sales commitments                                      |   | **85,500**    |           | 0         |      |
| Total gross deferred tax  assets                                                  |   | **2,290,200** |           | 2,300,250 |      |
| Valuation allowance                                                               |   | **0**         |           | 0         |      |
| Net deferred tax assets                                                           |   | **2,290,200** |           | 2,300,250 |      |
| Deferred tax liabilities:                                                         |   |          |           |      |      |
| Tax bad debt reserve over  base year                                              |   | **213,500**   |           | 480,000   |      |
| Premium on assets acquired  from MFC                                              |   | **199,200**   |           | 273,600   |      |
| Net unrealized gain on  market value adjustments to securities available for sale |   | **861,600**   |           | 223,000   |      |
| FHLB stock                                                                        |   | **285,000**   |           | 465,600   |      |
| Deferred loan fees and  costs                                                     |   | **400,500**   |           | 437,400   |      |
| Premises and equipment  basis difference                                          |   | **809,800**   |           | 633,350   |      |
| Originated mortgage  servicing rights                                             |   | **954,700**   |           | 726,800   |      |
| Other                                                                             |   | **22,500**    |           | 35,500    |      |
| Unamortized discount on loan  sale                                                |   | **0**         |           | 1,900     |      |
| Total gross deferred tax  liabilities                                             |   | **3,746,800** |           | 3,277,150 |      |
| Net deferred tax  liabilities                                                     |   | **$**         | **(1,456,600** | **)**     | (976,900  | ) |

 

Retained earnings atDecember 31, 2002 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.

 

38

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**NOTE 17 Employee Benefits**

In the past substantially all full-time employees of the Bank wereincluded in a noncontributory retirement plan administered by a trustee andsponsored by the Financial Institutions Retirement Fund (FIRF). On July 23,2002 the Board of Directors of the Bank resolved to freeze the accrual ofbenefits for existing participants and to not admit new enrollments to the FIRFas of September 1, 2002. The actuarial present value of accumulated planbenefits and net assets available for benefits relating to the Bank’s employeesis not available at December 31, 2002 because such information is notaccumulated for each participating institution. As of June 30, 2002, the FIRFvaluation report reflected that the Bank was obligated to make a contributionfor the plan year ending June 30, 2002 totaling $20,575. No contributions wererequired in 2001 or 2000 because the retirement plan benefits had been reducedand the reduced benefits were fully funded. For the years ended December 31,2002, 2001 and 2000 the amounts charged to operating expenses were $5,797,$700, and $5,749, respectively.

 

HMN has a qualified,tax-exempt savings plan with a cash or deferred feature qualifying underSection 401(k) of the Internal Revenue Code (the 401(k) Plan). All employeeswho have attained age 21 are eligible to participate in the Plan. Participantsare permitted to make salary reduction contributions to the 401(k) Plan of upto 12% of the participant’s annual salary. Each participant’s salary reductionis matched by HMN in an amount equal to 25% of the participant’s salaryreduction up to a maximum contribution of 8% of the participant’s annualsalary. Contributions above 8% are not matched by HMN. Generally allparticipant contributions and earnings are fully and immediately vested. HMN’smatching contribution is made monthly but an employee must be employed by HMNon the last day of the plan year in order to vest the current year’s employermatch. Effective January 1, 1997, for new employees HMN’s contributions madeprior to January 1, 2002 are vested on a five year cliff basis in addition tothe requirement of being employed at year end. HMN’s contributions made afterDecember 31, 2001 are vested on a three year cliff basis in addition to therequirement of being employed at year end. HMN’s matching contributions areexpensed when made. HMN’s contributions to the 401(k) Plan were $76,005,$71,200 and $60,700 in 2002, 2001 and 2000, respectively.

 

During 1994 HMN adopted anEmployee Stock Ownership Plan (the ESOP) which met the requirements ofSection(e)(7) of the Internal Revenue Code and Section 407(d)(6) of theEmployee Retirement Income Security Act of 1974, as amended (ERISA) and, as suchthe ESOP was empowered to borrow in order to finance purchases of the commonstock of HMN. The ESOP borrowed $6,085,770 from HMN to purchase 912,866 sharesof common stock in the initial public offering of HMN. In December of 1997 theBank merged with Marshalltown Financial Corporation (MFC). As a result of themerger, in February 1998, the ESOP borrowed $1,476,000 to purchase 76,933shares of HMN common stock to provide the employees from MFC with an ESOPbenefit. The ESOP debt requires quarterly payments of principal plus interestat 7.52%. HMN has committed to make quarterly contributions to the ESOPnecessary to repay the loan including interest. HMN contributed $525,224 forboth 2002 and 2001 and $526,568 for 2000.

 

As the debt is repaid, ESOPshares which were initially pledged as collateral for its debt, are committedto be released from collateral and allocated to active employees, based on theproportion of debt service paid in the year. HMN accounts for its ESOP inaccordance 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 $418,700, $365,921 and$287,073, respectively, for 2002, 2001 and 2000.

 

All employees of the Bankare eligible to participate in the ESOP after they attain age 21 and completeone year of service during which they worked at least 1,000 hours. A summary ofthe ESOP share allocation is as follows for the years ended:

 
|                                                    |   | **2002**    |           | **2001** |      | **2000** |      |
|---------------------------------------------------------|--------|-------------|----------------|----------|-----------|----------|-----------|
| Shares allocated to  participants beginning of the year |   | **$**       | **233,697**    |     | 246,710   |     | 245,294   |   |
| Shares allocated to  participants                       |   | **24,317**  |           | 24,317   |      | 24,382   |      |
| Shares purchased with  dividends from allocated shares  |   | **8,485**   |           | 7,884    |      | 4,012    |      |
| Shares distributed to  participants                     |   | **(21,468** | **)**          | (45,214  | )         | (26,978  | )         |
| Shares allocated to  participants end of year           |   | **245,031** |           | 233,697  |      | 246,710  |      |
| Unreleased shares beginning  of the year                |   | **644,747** |           | 669,064  |      | 693,446  |      |
| Shares released during year                             |   | **(24,317** | **)**          | (24,317  | )         | (24,382  | )         |
| Unreleased shares end of  year                          |   | **620,430** |           | 644,747  |      | 669,064  |      |
| Total ESOP shares end of  year                          |   | **865,461** |           | 878,444  |      | 915,774  |      |
| Fair value of unreleased  shares at December 31         |   | **$**       | **10,435,633** |     | 9,987,131 |     | 8,739,648 |   |

 

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 ofrestricted common stock were awarded to a director. Those shares vest over afive year period beginning in 1998. Compensation and benefit expense related tothe restricted stock was $7,350, $2,450 and $86,708, respectively for 2002,2001 and 2000.

 

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. The optionsvested over a five year period and may be exercised within 10 years of thegrant date. In December 1996, options exercisable for 1,500 shares of commonstock were granted to officers at an exercise price of $12.089. In April 1997,options for 18,000 shares of common stock were granted to a director at anexercise price of $13.007. In April 1999, options for 80,000 shares of commonstock were granted to an officer and directors at an exercise price of $11.50.In April 2000, options for 30,000 shares were granted to directors at anexercise price of $11.25. In April of 2002, options for 15,000 shares weregranted to a director at an exercise price of $16.25.

 

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

 

39

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in HMN and reward them for achieving a high level of corporateperformance and thereby develop a stronger incentive to put forth maximumeffort for the success and growth of HMN. The total number of shares of HMNcommon stock available for distribution under the 2001 Plan in eitherrestricted stock or stock options is 400,000 subject to adjustment for futurestock splits, stock dividends and similar changes to the capitalization of HMN.In April 2002, HMN awarded 212,410 options at $16.13 per share which veststarting in April of 2008 through 2012. The vesting schedule of the optionsawarded in 2002 may accelerate provided HMN attains certain return on equityobjectives.

 

The fair value of theoptions granted under the SOP were $1.85, $2.59, $4.11, $6.08, $5.55 and $4.49for 2002, 2000, 1999, 1998, 1997, and 1995, respectively, and $1.43 for 2002under the 2001 Plan. A summary of stock option activities under both plans aredetailed 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                       |   | 24,937                            |       | 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                                |       |
|                                    |   |                              |       |                     |       |                                  |       |
| *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                                |       |
| Total both plans                        |   | 196,987                           |       | 619,658                  |       | 12.202                                |       |
|                                         |        |                                   |            |                          |            |                                       |            |  |

 

The following table summarizes information about stock optionsoutstanding at December 31, 2002:

 
| **Options  Outstanding** |   | **Options  Exercisable** |       |
|--------------------------|--------|--------------------------|------------|
| **Exercise  price**      |   | **Number  outstanding**  | ** ** | **Weighted  average  remaining contractual  life in years** | ** ** | **Number** | ** ** | **Price** | ** ** |
| $                        | 9.211  |                     | 279,248    |   | 2.4 |   | 279,248 |   | $ | 9.211 |   |
| 13.007                   |   | 18,000                   |       | 4.3 |   | 18,000 |   | 13.007 |   |
| 11.500                   |   | 65,000                   |       | 6.3 |   | 39,000 |   | 11.500 |   |
| 11.250                   |   | 30,000                   |       | 7.4 |   | 12,000 |   | 11.250 |   |
| 16.250                   |   | 15,000                   |       | 9.4 |   | 0 |   | 16.250 |   |
| 16.130                   |   | 212,410                  |       | 9.3 |   | 0 |   | 16.130 |   |
|                     |   | 619,658                  |       |   |   | 348,248 |   |   |   |
|                          |        |                          |            |  |  |  |  |  |  |  |  |

 

HMN uses the intrinsic valuemethod as described in APB Opinion No. 25 and related interpretations toaccount for its stock incentive plans. Accordingly, no compensation cost hasbeen recognized for the option plan. Proceeds from stock options exercised arecredited to common stock and additional paid-in capital. There are no chargesor credits to expense with respect to the granting or exercise of options sincethe options were issued at fair value on the respective grant dates. Hadcompensation cost for HMN’s stock-based plan been determined in accordance withthe fair value method recommended by SFAS No. 123, HMN’s net income andearnings per share would have been adjusted to the pro forma amounts indicatedbelow:

 
|                       |   | **2002**      |          | **2001**  |      | **2000**  |      |
|----------------------------|--------|---------------|---------------|-----------|-----------|-----------|-----------|
| Net income:                |   |          |          |      |      |      |      |
| As reported                |   | **$**         | **5,265,656** |      | 5,457,616 |      | 6,702,310 |   |
| Pro forma                  |   | **5,222,696** |          | 5,464,421 |      | 6,508,031 |      |
| Earnings per common share: |   |          |          |      |      |      |      |
| As reported:               |   |          |          |      |      |      |      |
| Basic                      |   | **$**         | **1.40**      |      | 1.45      |      | 1.75      |   |
| Diluted                    |   | **1.32**      |          | 1.37      |      | 1.69      |      |
| Pro forma:                 |   |          |          |      |      |      |      |
| Basic                      |   | **1.39**      |          | 1.45      |      | 1.70      |      |
| Diluted                    |   | **1.31**      |          | 1.37      |      | 1.64      |      |

 

The preceding disclosed proforma effects of applying SFAS No. 123 to compensation costs, may not be representativeof the effects on reported pro forma net income for future years.

 

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** |   | **1995** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Risk-free interest rate |   | 5.20     | %      | 6.49     | %      | 5.59     | %      | 6.80     | %      | 6.21     | %      | 6.28     | %      |
| Expected life           |   | 9 years  |   | 9 years  |   | 9 years  |   | 10 years |   | 10 years |   | 10 years |   |
| Expected volatility     |   | 13.00    | %      | 15.60    | %      | 30.00    | %      | 18.00    | %      | 18.00    | %      | 20.00    | %      |
| Expected dividends      |   | 4.5      | %      | 3.0      | %      | 2.1      | %      | None     |   | None     |   | None     |   |

 

**NOTE 18 Earnings per Share**

The following table reconciles the weighted average shares outstandingand the income available to common shareholders used for basic and diluted EPS:

 
|                                                                                                      |   | **Year Ended December 31,** |          |
|-----------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------------|
|                                                                                                      |   | **2002**                    |          | **2001** |   | **2000** |   |
| Weighted average number of  common shares outstanding used in basic earnings per common share calculation |   | **3,767,216**               |          | 3,761,115 |   | 3,831,353 |   |
| Net dilutive effect of:                                                                                   |   |                        |          |   |   |   |   |
| Options                                                                                                   |   | **217,576**                 |          | 212,854 |   | 137,568 |   |
| Restricted stock awards                                                                                   |   | **36**                      |          | 509 |   | 1,767 |   |
| Weighted average number of  shares outstanding adjusted for effect of dilutive securities                 |   | **3,984,828**               |          | 3,974,478 |   | 3,970,688 |   |
| Income available to common  shareholders                                                                  |   | **$**                       | **5,265,656** |   | 5,457,616 |   | 6,702,310 |   |
| Basic earnings per common  share                                                                          |   | **$**                       | **1.40**      |   | 1.45 |   | 1.75 |   |
| Diluted earnings per common  share                                                                        |   | **$**                       | **1.32**      |   | 1.37 |   | 1.69 |   |

 

40

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**NOTE 19 Stockholders’ Equity**

Starting in 1995 and continuing throughout 2002, HMN has repurchasedits common stock in the open market. HMN purchased 92,300 shares during 2002,105,200 shares during 2001, and 439,000 shares during 2000 for $1,496,111,$1,584,152 and $5,091,726, respectively. The shares were placed in treasurystock.

 

HMN declared and paiddividends as follows:

 
| **Record date**   |   | **Payable  date**  | ** ** | **Dividend  per share** | ** ** | **Dividend  Payout Ratio** | ** ** |
|-------------------|--------|--------------------|------------|-------------------------|------------|----------------------------|------------|
| February 24, 2000 |   | March 10, 2000     |       | $                       | 0.10       |                       | 27.78      | % |
| May 25, 2000      |   | June 12, 2000      |       | $                       | 0.10       |                       | 27.03      | % |
| August 28, 2000   |   | September 11, 2000 |       | $                       | 0.12       |                       | 25.53      | % |
| November 22, 2000 |   | December 11, 2000  |       | $                       | 0.12       |                       | 27.27      | % |
| 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      | % |

 

On January 28, 2003 HMNdeclared a cash dividend of $0.18 per share payable on March 7, 2003 to holdersof record on February 21, 2003. The annualized dividend payout ratios for 2002,2001 and 2000 were 57.63%, 31.90% and 26.83%, respectively.

 

HMN’s certificate of incorporationauthorizes the issuance of up to 500,000 shares of preferred stock, but to dateno 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  FederalHome Loan Bank Investment and Regulatory Capital Requirements**

The Bank, as a member of the Federal Home Loan Bank System, is requiredto hold a specified number of shares of capital stock, which is carried atcost, in the Federal Home Loan Bank of Des Moines. The Bank has met therequirements as of December 31, 2002.

 

The Bank is subject tovarious regulatory capital requirements administered by the federal bankingagencies. Failure to meet minimum capital requirements can initiate certainmandatory and possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on HMN’s financial statements.Under capital adequacy guidelines and the regulatory framework for promptcorrective action, 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, 2002, thatthe Bank meets all capital adequacy requirements to which it is subject.

 

Management believes thatbased upon the Bank’s capital calculations at December 31, 2002 and otherconditions consistent with the Prompt Corrective Actions Provisions of the OTSregulations, the Bank would be categorized as well capitalized.

 

41

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At December 31, 2002 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                                                     |   | $          | 66,416     |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |   |
| Plus:                                                                              |   |       |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Net unrealized gain on  certain securities available for sale and cash flow hedges |   | (1,543     | )          |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Less:                                                                              |   |       |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Goodwill and other  intangibles                                                    |   | 4,362      |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Excess mortgage servicing  rights                                                  |   | 295        |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Tier I or core capital                                                             |   | 60,216     |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Tier I capital to adjusted  total assets                                           |   |       |       | 8.29                                         | %          | $                   | 29,046     |                                                                      | 4.00       | % | $ | 31,170 |   | 4.29 | % | $ | 36,307 |   | 5.00 | % |
| Tier I capital to  risk-weighted assets                                            |   |       |       | 11.42                                        | %          | $                   | 21,098     |                                                                      | 4.00       | % | $ | 39,118 |   | 7.42 | % | $ | 31,648 |   | 6.00 | % |
| Plus:                                                                              |   |       |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Allowable allowance for  loan losses                                               |   | 3,951      |       |                                         |       |                |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Risk-based capital                                                                 |   | $          | 64,167     |                                         |       |                | $          | 42,197                                                                    |       |   |   | $ | 21,970 |   |   |   | $ | 52,746 |   |   |   |
| Risk-based capital to  risk-weighted assets                                        |   |       |       | 12.17                                        | %          |                |       | 8.00                                                                      | %          |   |   | 4.17 | % |   |   | 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 Sheet Risk**

HMN is a party to financial instruments with off-balance sheet risk inthe normal course of business to meet the financing needs of its customers.These financial instruments include commitments to extend credit. Theseinstruments involve, to varying degrees, elements of credit and interest raterisk in excess of the amounts recognized in the balance sheet. The contractamounts of these instruments reflect the extent 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)**                                                         |   | **2002**            |        | **2001** |   |
| Financial instruments whose  contract amount represents credit risk:        |   |                |        |   |   |
| Commitments to extend  credit                                               |   | **$**               | **215,285** |   | 115,883 |   |
| Commitment of counter party  to purchase loans                              |   | **61,712**          |        | 89,376 |   |
| Financial instruments whose  contract amount represents interest rate risk: |   |                |        |   |   |
| Interest  rate swap                                                         |   | **$ 0**             |        | 15,000 |   |
|                                                                             |        |                     |             |  |  |  |

 

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 counter partyto purchase loans represents commitments to sell loans to FNMA and are enteredinto in the normal course of business by the Bank.

 

Interest rate swaps arederivative instruments that involve the contractual exchange of fixed andfloating rate interest payment obligations based on a notional principalamount. The contractual arrangement is made to enhance management of interestrate risk exposure caused by fluctuations in interest rates. In 2001, HMNentered into an interest rate swap with a notional amount of $15,000,000. Theinterest rate swap was used as a fair value hedge for a certificate of deposit.

 

**NOTE 22 Derivative Instruments and Hedging Activities**

HMN adopted SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities,*in the firstquarter of 2001. In July of 2001, HMN entered into an interest rate swap for$15 million. Under the interest rate swap, HMN paid interest based upon thethree month London Inter-Bank Offer Rate (LIBOR) and received interest paymentsbased upon a fixed rate of 6.0% on a notional value of $15 million in a fair valuehedge with no ineffectiveness. The hedge was

 

42

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offsetting a callable certificate of deposit for $15 million that wasissued by HMN. In July of 2002, the interest rate swap was called and thecorresponding certificate of deposit was also called. As of December 31, 2002,HMN had not entered into any other interest rate swaps.

 

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. Atthe beginning of the second quarter of 2001, certain commitments to sell loansheld for sale were designated as a cash flow hedge of a forecasted transactionand were accounted for in accordance with SFAS No. 133 with no ineffectivenessrecognized in the income statement. In the second quarter of 2002 cash flowhedge accounting was discontinued because HMN ceased delivery of loans under amortgage backed security program. The mortgage banking operations in theBrooklyn Park location were eliminated and some of the activity was moved toother branches within HMN.

 

HMN has commitmentsoutstanding to extend credit to future borrowers or to purchase loans that hadnot closed prior to the end of the quarter which it intends to sell. Thesecommitments are referred to as its mortgage pipeline. As commitments tooriginate or purchase loans enter the mortgage pipeline, generally HMN simultaneouslyenters into commitments to sell the mortgage pipeline into the secondarymarket. The commitments to originate, purchase or sell loans are derivatives.As a result of marking the mortgage pipeline and the related commitments tosell to market for the period ended December 31, 2002, HMN recorded an increaseto other assets of $705,512, and an increase in other liabilities of $705,512.

 

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. Thelower of cost or market and the market value adjustments as of and for the yearended December 31, 2002 include loans that do not qualify for hedge accounting.As a result of marking these loans, HMN recorded a decrease in loans held forsale of $88,689, an increase in other liabilities of $241,946, and a net lossin gains or losses on sale of loans of $330,635. The unrealized gains on loansheld for sale of $241,946 will not be recognized in income until the loans aresold in the first quarter of 2003.

 

**NOTE 23  FairValue of Financial Instruments**

SFAS No. 107, *Disclosures about FairValues of Financial Instruments,*requires disclosure of estimatedfair values of HMN’s financial instruments, including assets, liabilities andoff-balance sheet items for which it is practicable to estimate fair value. Thefair value estimates are made as of December 31, 2002 and 2001 based uponrelevant market information, if available, and upon the characteristics of thefinancial instruments themselves. Because no market exists for a significantportion of HMN’s financial instruments, fair value estimates are based uponjudgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments, and otherfactors. The estimates are subjective in nature and involve uncertainties andmatters of significant judgment and therefore cannot be determined withprecision. Changes in 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 been consideredin any of the estimates.

 

The estimated fair value ofHMN’s financial instruments are shown on the following page. Following thetable, there is an explanation of the methods and assumptions used to estimatethe fair value of each class of financial instruments.

 

43

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|                                      |   | **December  31,**    |       |
|-------------------------------------------|--------|----------------------|------------|
|                                      |   | **2002**             |       | **2001** |   |
| **(in  thousands)**                       |   | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** | **Contract  amount** | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** | **Contract  amount** | ** ** |
| Financial assets:                         |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                 |   | **$**                | **27,729** | ** ** | **27,729** |   |   |   | 23,019 |   | 23,019 |   |   |   |
| Securities available for  sale            |   | **121,397**          | ** ** | **121,397** |   |   |   | 119,895 |   | 119,895 |   |   |   |
| Loans held for sale                       |   | **15,127**           | ** ** | **15,127** |   |   |   | 68,018 |   | 68,018 |   |   |   |
| Loans receivable, net                     |   | **533,906**          | ** ** | **558,625** |   |   |   | 471,668 |   | 494,350 |   |   |   |
| Federal Home Loan Bank  stock             |   | **11,881**           | ** ** | **11,881** |   |   |   | 12,245 |   | 12,245 |   |   |   |
| Accrued interest receivable               |   | **3,051**            | ** ** | **3,051** |   |   |   | 3,509 |   | 3,509 |   |   |   |
| Financial liabilities:                    |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                  |   | **432,951**          | ** ** | **437,490** |   |   |   | 421,843 |   | 426,763 |   |   |   |
| Federal Home Loan Bank  advances          |   | **218,300**          | ** ** | **222,109** |   |   |   | 217,800 |   | 224,880 |   |   |   |
| Accrued interest payable                  |   | **849**              | ** ** | **849** |   |   |   | 1,017 |   | 1,017 |   |   |   |
| Off-balance sheet financial  instruments: |   |                 |       |   |   |   |   |   |   |   |   |   |   |
| Commitments to extend  credit             |   | **706**              | ** ** | **706** | ** ** | **215,285** |   | (313 | ) | (313 | ) | 115,883 |   |
| Commitments to sell loans                 |   | **(947**             | **)**      | **(947** | **)** | **61,712** |   | 1,294 |   | 1,294 |   | 89,376 |   |
| Interest rate swap                        |   | **0**                | ** ** | **0** | ** ** | **0** |   | (182 | ) | (182 | ) | 15,000 |   |
|                                           |        |                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

***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 stock approximatesits 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 ***UnderSFAS No. 107, the fair value of deposits with no stated maturity such aschecking, savings and money market accounts, is equal to the amount payable ondemand. The fair value of certificates of deposit is based on the discountedvalue of contractual cash flows using as discount rates the rates that wereoffered by HMN as of December 31, 2002 and 2001 for deposits with maturitiessimilar to the remaining maturities 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 andOther Borrowed Money ***The fair values of advances and otherborrowed money with fixed maturities are estimated based on discounted cashflow analysis using as discount rates the interest rates charged by the FHLB atDecember 31, 2002 and 2001 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 extendcredit for 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. The fair value ofcommitments to extend credit for 2001 are estimated using quoted market prices.

 

***Commitments to Sell Loans ***The fair values of commitments to sell loansfor 2002 and 2001 are estimated using the quoted market prices for loans withsimilar interest rates and terms to maturity.

 

***Interest Rate Swap ***The fair value of interest rate swaps isestimated based upon the present value of the anticipated cash flows that willbe received from the interest rate swap, taking into account the existingspread between the fixed interest rate and the variable interest rate and theremaining time to the anticipated call date.

 

44

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**NOTE 24 Commitments and Contingencies**

The Bank entered into two guaranty agreements with third parties inorder for Home Federal Mortgage Services, LLC (HFMS) to secure loan purchaseagreements. Under the agreements, the Bank guarantees to satisfy and dischargeall obligations of HFMS arising from transactions entered into between HFMS andthe third parties if HFMS fails to fulfill their obligations. The agreementsare in effect until the obligations of HFMS are fully satisfied and the Bank’sguaranty is limited to a combined maximum of $3 million. No liability has beenrecorded in the consolidated financial statements of HMN for the guarantees andHMN is not aware of any outstanding obligations of HFMS to either of the thirdparties with whom a guarantee exists. There is the possibility that the Bankwould be required to purchase loans that were previously sold to the thirdparties by HFMS 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, 2002 expireover the next two years and totaled approximately $1.2 million at December 31,2002 and at December 31, 2001. The letters of credit were collateralizedprimarily with commercial real estate mortgages. Since the conditions underwhich the Bank is required to fund the standby letters of credit may notmaterialize, the cash requirements are expected to be less than the totaloutstanding commitments.

 

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

The following are the condensed financial statements for the parentcompany only as of December 31, 2002 and 2001 and for the years ended December31, 2002, 2001 and 2000.

 
|                                                     |   | **2002**        |           | **2001**    |       | **2000** |   |
|----------------------------------------------------------|--------|-----------------|----------------|-------------|------------|----------|--------|
| **Condensed  Balance Sheets**                            |   |            |           |        |       |     |   |
| **Assets:**                                              |   |            | ** **     |        |       |     |   |
| Cash and cash equivalents                                |   | **$**           | **447,420**    | ** **  | 2,910,068  |     |   |   |
| Securities available for  sale                           |   | **1,490,500**   | ** **     | 7,433,709   |       |     |   |
| Loans receivable from  subsidiaries                      |   | **4,700,000**   | ** **     | 714,882     |       |     |   |
| Loans receivable, net                                    |   | **1,601,383**   | ** **     | 0           |       |     |   |
| Investment in subsidiaries                               |   | **66,479,331**  | ** **     | 60,390,180  |       |     |   |
| Investment in limited  partnership                       |   | **289,397**     | ** **     | 265,955     |       |     |   |
| Accrued interest receivable                              |   | **21,168**      | ** **     | 119,827     |       |     |   |
| Prepaid expenses and other  assets                       |   | **1,270,981**   | ** **     | 281,369     |       |     |   |
| Deferred tax asset                                       |   | **0**           | ** **     | 220,700     |       |     |   |
| Total assets                                             |   | **$**           | **76,300,180** | ** **  | 72,336,690 |     |   |   |
| Liabilities and  Stockholders’ Equity               |   |            | ** **     |        |       |     |   |
| Other borrowed money                                     |   | **$**           | **0**          | ** **  | 0          |     |   |   |
| Accrued expenses and other  liabilities                  |   | **198,724**     | ** **     | 175,339     |       |     |   |
| Deferred tax liability                                   |   | **36,900**      | ** **     | 0           |       |     |   |
| Total liabilities                                        |   | **235,624**     | ** **     | 175,339     |       |     |   |
| Serial preferred stock                                   |   | **0**           | ** **     | 0           |       |     |   |
| Common stock                                             |   | **91,287**      | ** **     | 91,287      |       |     |   |
| Additional paid-in capital                               |   | **58,885,279**  | ** **     | 59,168,782  |       |     |   |
| Retained earnings                                        |   | **79,660,481**  | ** **     | 76,956,978  |       |     |   |
| Net unrealized loss on  securities available for sale    |   | **1,575,577**   | ** **     | 367,744     |       |     |   |
| Unearned employee stock  option plan shares              |   | **(4,931,385**  | **)**          | (5,124,746  | )          |     |   |
| Unearned compensation  restricted stock awards           |   | **0**           | ** **     | (7,350      | )          |     |   |
| Treasury stock, at cost,  4,722,856 and 4,732,521 shares |   | **(59,216,683** | **)**          | (59,291,344 | )          |     |   |
| Total stockholders’ equity                          |   | **76,064,556**  | ** **     | 72,161,351  |       |     |   |
| Total liabilities and  stockholders’ equity         |   | **$**           | **76,300,180** | ** **  | 72,336,690 |     |   |   |
|                                                     |   |            | ** **     |        |       |     |   |

 

 

45

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| **Condensed  Statements of Income**                                                   |   |           | ** **    |       |      |       |      |
|---------------------------------------------------------------------------------------|--------|----------------|---------------|------------|-----------|------------|-----------|
| Interest income                                                                       |   | **$**          | **365,202**   | ** ** | 651,478   |       | 802,647   |   |
| Interest expense                                                                      |   | **0**          | ** **    | (14,557    | )         | (34,443    | )         |
| Securities gains (losses),  net                                                       |   | **118,238**    | ** **    | (130,344   | )         | 0          |      |
| Equity in earnings of  subsidiaries                                                   |   | **5,095,784**  | ** **    | 5,282,142  |      | 6,592,861  |      |
| Earnings (losses) in  limited partnership                                             |   | **23,441**     | ** **    | (19,568    | )         | (130,053   | )         |
| Other income                                                                          |   | **15,514**     | ** **    | 0          |      | 3,073      |      |
| Compensation and benefits                                                             |   | **(44,250**    | **)**         | (48,601    | )         | (45,219    | )         |
| Occupancy                                                                             |   | **(6,000**     | **)**         | (6,324     | )         | (6,132     | )         |
| Data processing                                                                       |   | **(1,200**     | **)**         | (2,722     | )         | (3,762     | )         |
| Mortgage servicing                                                                    |   | **(1,459**     | **)**         | 0          |      |       |      |
| Other                                                                                 |   | **(523,314**   | **)**         | (458,788   | )         | (499,462   | )         |
| Income before income tax  benefit                                                     |   | **5,041,956**  | ** **    | 5,252,716  |      | 6,679,510  |      |
| Income tax benefit                                                                    |   | **(223,700**   | **)**         | (204,900   | )         | (22,800    | )         |
| Net income                                                                            |   | **$**          | **5,265,656** | ** ** | 5,457,616 |       | 6,702,310 |   |
| **Condensed  Statements of Cash Flows**                                               |   |           | ** **    |       |      |       |      |
| Cash flows from operating  activities:                                                |   |           | ** **    |       |      |       |      |
| Net income                                                                            |   | **$**          | **5,265,656** | ** ** | 5,457,616 |       | 6,702,310 |   |
| Adjustments to reconcile  net income to cash provided (used) by operating activities: |   |           | ** **    |       |      |       |      |
| Equity in earnings of  subsidiaries                                                   |   | **(5,095,784** | **)**         | (5,282,142 | )         | (6,592,861 | )         |
| Equity in (earnings) loss  in limited partnership                                     |   | **(23,441**    | **)**         | 19,568     |      | 130,053    |      |
| Amortization of premiums  (discounts), net                                            |   | **31,028**     | ** **    | 0          |      | 0          |      |
| Securities gains (losses),  net                                                       |   | **(118,238**   | **)**         | 130,344    |      | 0          |      |
| (Decrease) increase in  provision for deferred income taxes                           |   | **257,600**    | ** **    | (171,800   | )         | (11,200    | )         |
| Earned employee stock  ownership shares priced above original cost                    |   | **143,604**    | ** **    | 102,572    |      | 55,197     |      |
| Decrease in restricted  stock awards                                                  |   | **7,350**      | ** **    | 2,450      |      | 86,708     |      |
| Decrease in unearned ESOP  shares                                                     |   | **193,361**    | ** **    | 193,321    |      | 193,784    |      |
| (Increase) decrease in  accrued interest receivable                                   |   | **98,659**     | ** **    | 88,983     |      | (65,756    | )         |
| Increase in accrued  expenses and other liabilities                                   |   | **199,219**    | ** **    | 41,073     |      | 64,586     |      |
| (Increase) decrease in  other assets                                                  |   | **(944,817**   | **)**         | 51,583     |      | 360,244    |      |
| Other, net                                                                            |   | **1**          | ** **    | 0          |      | (1         | )         |
| Net cash provided by  operating activities                                            |   | **14,198**     | ** **    | 633,568    |      | 923,064    |      |
| Cash flows from investing  activities:                                                |   |           | ** **    |       |      |       |      |
| Proceeds from sales of  securities available for sale                                 |   | **6,296,788**  | ** **    | 3,634,968  |      | 0          |      |
| Purchases of securities  available for sale                                           |   | **0**          | ** **    | (2,688,600 | )         | 0          |      |
| Increase in loans  receivable, net                                                    |   | **(1,601,383** | **)**         | 0          |      | 0          |      |
| Decrease of investments in  subsidiaries                                              |   | **0**          | ** **    | 1,096,972  |      | 548,462    |      |
| Net decrease (increase) in  loans receivable from subsidiaries                        |   | **(3,985,118** | **)**         | 3,745,510  |      | 302,239    |      |
| Net cash provided by  investing activities                                            |   | **710,287**    | ** **    | 5,788,850  |      | 850,701    |      |
| Cash flows from financing  activities:                                                |   |           | ** **    |       |      |       |      |
| Purchase of treasury stock                                                            |   | **(1,496,111** | **)**         | (1,584,152 | )         | (5,091,726 | )         |
| Stock options exercised                                                               |   | **871,131**    | ** **    | 646,199    |      | 601,134    |      |
| Dividends to stockholders                                                             |   | **(2,562,153** | **)**         | (1,881,226 | )         | (1,744,730 | )         |
| Increase (decrease) in  other borrowed money                                          |   | **0**          | ** **    | (750,000   | )         | 750,000    |      |
| Proceeds from dividends on  Bank stock                                                |   | **0**          | ** **    | 0          |      | 3,000,000  |      |
| Net cash used by financing  activities                                                |   | **(3,187,133** | **)**         | (3,569,179 | )         | (2,485,322 | )         |
| Increase (decrease) in cash  and cash equivalents                                     |   | **(2,462,648** | **)**         | 2,853,239  |      | (711,557   | )         |
| Cash and cash equivalents,  beginning of year                                         |   | **2,910,068**  | ** **    | 56,829     |      | 768,386    |      |
| Cash and cash equivalents,  end of year                                               |   | **$**          | **447,420**   | ** ** | 2,910,068 |       | 56,829    |   |

 

 

46

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**NOTE 26 Business Segments**

HMN’s wholly owned subsidiary, Home Federal Savings Bank and its 51%owned subsidiary, Home Federal Mortgage Services, LLC (HFMS) have beenidentified as reportable operating segments in accordance with the provisionsof SFAS No. 131. HFMS was deemed to be a segment because it is a separatecorporation which operated independently from the Bank. HFMS has been segmentedfurther into Mortgage Servicing Rights and Mortgage Banking activities. Themortgage servicing segment owned servicing rights on loans which had eitherbeen sold to FNMA or securitized into mortgage backed instruments which wereissued by FNMA. All mortgage servicing rights of HFMS were sold in the fourthquarter of 2002. HFMS had received a servicing fee which was based upon theoutstanding balance of the loan being serviced and paid a subservicer a monthlyfee to service the loan. HFMS’s mortgage banking activity included anorigination function and it also purchases loans from other loan originators.All loans acquired either by origination or by purchase were intended to beresold in the secondary loan market. There have been no loans originated orpurchased at HFMS since the third quarter of 2002.

 

Security FinanceCorporation, Osterud Insurance Agency and HMN, the holding company, did notmeet the quantitative thresholds for determining reportable segments andtherefore are included in the “Other” category.

 

HMN evaluates performanceand allocates resources based on the segment’s net income or loss, return onaverage assets and return on average equity. The segments follow generallyaccepted accounting principles as described in the summary of significantaccounting policies.

 

Each corporation is managedseparately with its own president, who reports directly to either HMN’s chiefoperating decision maker, or the board of directors.

 

The following table setsforth certain information about the reconciliations of reported profit or lossand assets for each of HMN’s reportable segments.

 

47

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|                                                                                         |   |                            |       | **Home  Federal Mortgage Services, LLC** |       |                  |       |                            |       |       |       |             | ** ** |
|----------------------------------------------------------------------------------------------|--------|---------------------------------|------------|-----------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|------------|------------|------------------|------------|
| **(Dollars in thousands)**                                                                   |   | **Home  Federal  Savings Bank** | ** ** | **Mortgage  Servicing  Rights**               | ** ** | **Mortgage  Banking** | ** ** | **Total  Reportable  Segments** | ** ** | **Other**  | ** ** | **Eliminations** | ** ** | **Consolidated  Total** |   |
| **At or for  the year ended December 31, 2002:**                                             |   |                            |       |                                          |       |                  |       |                            |       |       |       |             |       |   |   |
| Interest income external  customers                                                          |   | **$**                           | **41,528** | ** **                                    | **0**      | ** **            | **1,022**  | ** **                      | **42,550** | ** ** | **318**    | ** **       | **0**      | ** ** | **42,868** | ** ** |
| Non-interest income —  external customers                                               |   | **6,162**                       | ** ** | **33**                                        | ** ** | **206**               | ** ** | **6,401**                       | ** ** | **134**    | ** ** | **0**            | ** ** | **6,535** | ** ** |
| Earnings (losses) on  limited partnerships                                                   |   | **(683**                        | **)**      | **0**                                         | ** ** | **0**                 | ** ** | **(683**                        | **)**      | **23**     | ** ** | **0**            | ** ** | **(660** | **)** |
| Intersegment interest  income                                                                |   | **517**                         | ** ** | **0**                                         | ** ** | **0**                 | ** ** | **517**                         | ** ** | **47**     | ** ** | **(564**         | **)**      | **0** | ** ** |
| Intersegment non-interest  income (expense)                                                  |   | **305**                         | ** ** | **0**                                         | ** ** | **0**                 | ** ** | **305**                         | ** ** | **5,168**  | ** ** | **(5,473**       | **)**      | **0** | ** ** |
| Interest expense                                                                             |   | **21,342**                      | ** ** | **0**                                         | ** ** | **517**               | ** ** | **21,859**                      | ** ** | **0**      | ** ** | **(564**         | **)**      | **21,295** | ** ** |
| Amortization of mortgage  servicing rights and net valuation adjustments and servicing costs |   | **1,292**                       | ** ** | **72**                                        | ** ** | **0**                 | ** ** | **1,364**                       | ** ** | **1**      | ** ** | **(199**         | **)**      | **1,166** | ** ** |
| Other non-interest expense                                                                   |   | **15,535**                      | ** ** | **0**                                         | ** ** | **1,108**             | ** ** | **16,643**                      | ** ** | **583**    | ** ** | **(543**         | **)**      | **16,683** | ** ** |
| Income tax expense  (benefit)                                                                |   | **2,367**                       | ** ** | **0**                                         | ** ** | **1**                 | ** ** | **2,368**                       | ** ** | **(269**   | **)**      | **0**            | ** ** | **2,099** | ** ** |
| Minority interest                                                                            |   | **(142**                        | **)**      | **0**                                         | ** ** | **0**                 | ** ** | **(142**                        | **)**      | **0**      | ** ** | **0**            | ** ** | **(142** | **)** |
| Net income (loss)                                                                            |   | **5,165**                       | ** ** | **(39**                                       | **)**      | **(398**              | **)**      | **4,728**                       | ** ** | **5,269**  | ** ** | **(4,731**       | **)**      | **5,266** | ** ** |
| Goodwill                                                                                     |   | **3,801**                       | ** ** | **0**                                         | ** ** | **0**                 | ** ** | **3,801**                       | ** ** | **0**      | ** ** | **0**            | ** ** | **3,801** | ** ** |
| Total assets                                                                                 |   | **732,769**                     | ** ** | **0**                                         | ** ** | **4,440**             | ** ** | **737,209**                     | ** ** | **76,436** | ** ** | **(76,122**      | **)**      | **737,523** | ** ** |
| Net interest margin                                                                          |   | **3.13**                        | **%**      | **NM**                                        |       | **NM**                | ** ** | **NM**                          | ** ** | **NM**     | ** ** | **NM**           | ** ** | **3.19** | **%** |
| Return on average assets                                                                     |   | **0.75**                        | ** ** | **(73.82**                                    | **)%**     | **(2.57**             | **)%**     | **NM**                          | ** ** | **NM**     | ** ** | **NM**           | ** ** | **0.74** | ** ** |
| Return on average realized  common equity                                                    |   | **8.33**                        | ** ** | **(5,035.32**                                 | **)**      | **(160.64**           | **)**      | **NM**                          | ** ** | **NM**     | ** ** | **NM**           | ** ** | **6.94** | ** ** |
| At or for the year ended  December 31, 2001:                                                 |   |                            |       |                                          |       |                  |       |                            |       |       |       |             |       |   |   |
| Interest income — external  customers                                                   |   | $                               | 47,583     |                                          | 0          |                  | 3,457      |                            | 51,040     |       | 428        |             | 0          |   | 51,468 |   |
| Non-interest income —  external customers                                               |   | 3,649                           |       | 52                                            |       | 872                   |       | 4,573                           |       | 323        |       | 0                |       | 4,896 |   |
| Earnings (losses) on  limited partnerships                                                   |   | (1,292                          | )          | 0                                             |       | 0                     |       | (1,292                          | )          | (20        | )          | 0                |       | (1,312 | ) |
| Intersegment interest  income                                                                |   | 2,800                           |       | 0                                             |       | 0                     |       | 2,800                           |       | 225        |       | (3,025           | )          | 0 |   |
| Intersegment non-interest  income (expense)                                                  |   | (246                            | )          | 0                                             |       | 0                     |       | (246                            | )          | 5,282      |       | (5,036           | )          | 0 |   |
| Interest expense                                                                             |   | 30,553                          |       | 0                                             |       | 2,900                 |       | 33,453                          |       | 16         |       | (3,025           | )          | 30,444 |   |
| Amortization of mortgage  servicing rights and net valuation adjustments and servicing costs |   | 640                             |       | 118                                           |       | 0                     |       | 758                             |       | 0          |       | 0                |       | 758 |   |
| Other non-interest expense                                                                   |   | 12,350                          |       | 0                                             |       | 2,215                 |       | 14,565                          |       | 1,002      |       | (576             | )          | 14,991 |   |
| Income tax expense  (benefit)                                                                |   | 2,880                           |       | 0                                             |       | (28                   | )          | 2,852                           |       | (218       | )          | 0                |       | 2,634 |   |
| Minority interest                                                                            |   | (383                            | )          | 0                                             |       | 0                     |       | (383                            | )          | 0          |       | 0                |       | (383 | ) |
| Net income (loss)                                                                            |   | 5,304                           |       | (66                                           | )          | (758                  | )          | 4,480                           |       | 5,438      |       | (4,460           | )          | 5,458 |   |
| Total assets                                                                                 |   | 711,491                         |       | 76                                            |       | 56,751                |       | 768,318                         |       | 72,547     |       | (119,751         | )          | 721,114 |   |
| Net interest margin                                                                          |   | 2.90                            | %          | NM                                            |       | NM                    |       | NM                              |       | NM         |       | NM               |       | 3.02 | % |
| Return on average assets                                                                     |   | 0.90                            |       | (39.43                                        | )%         | (1.37                 | )%         | NM                              |       | NM         |       | NM               |       | 0.75 |   |
| Return on average realized  common equity                                                    |   | 11.39                           |       | (1,122.38                                     | )          | (83.63                | )          | NM                              |       | NM         |       | NM               |       | 7.57 |   |
| At or for the year ended  December 31, 2000:                                                 |   |                            |       |                                          |       |                  |       |                            |       |       |       |             |       |   |   |
| Interest income — external  customers                                                   |   | $                               | 52,001     |                                          | 0          |                  | 313        |                            | 52,314     |       | 603        |             | 0          |   | 52,917 |   |
| Non-interest income —  external customers                                               |   | 2,801                           |       | 60                                            |       | 568                   |       | 3,429                           |       | 15         |       | 0                |       | 3,444 |   |
| Earnings (losses) on  limited partnerships                                                   |   | 9                               |       | 0                                             |       | 0                     |       | 9                               |       | (130       | )          | 0                |       | (121 | ) |
| Intersegment interest  income                                                                |   | 30                              |       | 0                                             |       | 0                     |       | 30                              |       | 282        |       | (312             | )          | 0 |   |
| Intersegment non-interest  income                                                            |   | 387                             |       | 0                                             |       | 0                     |       | 387                             |       | 6,593      |       | (6,980           | )          | 0 |   |
| Interest expense                                                                             |   | 32,997                          |       | 0                                             |       | 243                   |       | 33,240                          |       | 73         |       | (312             | )          | 33,001 |   |
| Amortization of mortgage  servicing rights and net valuation adjustments and servicing costs |   | 260                             |       | 73                                            |       | 0                     |       | 333                             |       | 0          |       | 0                |       | 333 |   |
| Other non-interest expense                                                                   |   | 11,046                          |       | 0                                             |       | 1,004                 |       | 12,050                          |       | 563        |       | (387             | )          | 12,226 |   |
| Income tax expense  (benefit)                                                                |   | 3,954                           |       | (5                                            | )          | (147                  | )          | 3,802                           |       | (4         | )          | 0                |       | 3,798 |   |
| Net income (loss)                                                                            |   | 6,791                           |       | (8                                            | )          | (219                  | )          | 6,564                           |       | 6,731      |       | (6,593           | )          | 6,702 |   |
| Total assets                                                                                 |   | 702,767                         |       | 180                                           |       | 5,599                 |       | 708,576                         |       | 67,379     |       | (59,939          | )          | 716,016 |   |
| Net interest margin                                                                          |   | 2.81                            | %          | NM                                            |       | NM                    |       | NM                              |       | NM         |       | NM               |       | 2.89 | % |
| Return on average assets                                                                     |   | 0.95                            |       | (5.67                                         | )%         | (7.27                 | )%         | NM                              |       | NM         |       | NM               |       | 0.94 |   |
| Return on average realized  common equity                                                    |   | 12.53                           |       | (21.05                                        | )          | (27.00                | )          | NM                              |       | NM         |       | NM               |       | 9.81 |   |

----

NM - Not meaningful

 

48

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**INDEPENDENT AUDITOR‘S REPORT**

 

 

*The Board of Directors*

* *

*HMN Financial, Inc.*

* *

*Rochester, Minnesota:*

 

We have audited the accompanying consolidated balance sheets of HMNFinancial, Inc. and subsidiaries (the Company) as of December 31, 2002 and2001, and the related consolidated statements of income, comprehensive income,stockholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2002. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated 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, 2002 and 2001, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2002, 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*

*January 28, 2003*

 

49

----

 

**SELECTED QUARTERLY FINANCIAL DATA**

 
| **(Dollars in thousands, except per share data)**                        |   | **December 31,  2002** | ** ** | **September 30,  2002** | ** ** | **June 30,  2002** | ** ** |
|--------------------------------------------------------------------------|--------|------------------------|------------|-------------------------|------------|--------------------|------------|
| Selected Operations Data *(3 months ended):*                             |   |                   |       |                    |       |               |       |
| Interest income                                                          |   | **$**                  | **10,583** | ** **              | **10,633** | ** **         | **10,511** | ** ** |
| Interest expense                                                         |   | **5,203**              | ** ** | **5,173**               | ** ** | **5,228**          | ** ** |
| Net interest income                                                      |   | **5,380**              | ** ** | **5,460**               | ** ** | **5,283**          | ** ** |
| Provision for loan losses                                                |   | **575**                | ** ** | **771**                 | ** ** | **310**            | ** ** |
| Net interest income after  provision for loan losses                     |   | **4,805**              | ** ** | **4,689**               | ** ** | **4,973**          | ** ** |
| Noninterest income:                                                      |   |                   |       |                    |       |               |       |
| Fees and service charges                                                 |   | **511**                | ** ** | **418**                 | ** ** | **390**            | ** ** |
| Mortgage servicing fees                                                  |   | **193**                | ** ** | **184**                 | ** ** | **177**            | ** ** |
| Securities gains (losses),  net                                          |   | **0**                  | ** ** | **377**                 | ** ** | **27**             | ** ** |
| Gain on sales of loans                                                   |   | **1,102**              | ** ** | **432**                 | ** ** | **498**            | ** ** |
| Earnings (losses) in  limited partnerships                               |   | **(455**               | **)**      | **(531**                | **)**      | **(52**            | **)**      |
| Other noninterest income                                                 |   | **65**                 | ** ** | **123**                 | ** ** | **151**            | ** ** |
| Total noninterest income                                                 |   | **1,416**              | ** ** | **1,003**               | ** ** | **1,191**          | ** ** |
| Noninterest expense:                                                     |   |                   |       |                    |       |               |       |
| Compensation and benefits                                                |   | **2,006**              | ** ** | **1,987**               | ** ** | **2,069**          | ** ** |
| Occupancy                                                                |   | **899**                | ** ** | **801**                 | ** ** | **726**            | ** ** |
| Federal deposit insurance  premiums                                      |   | **18**                 | ** ** | **18**                  | ** ** | **19**             | ** ** |
| Advertising                                                              |   | **104**                | ** ** | **129**                 | ** ** | **146**            | ** ** |
| Data processing                                                          |   | **283**                | ** ** | **273**                 | ** ** | **287**            | ** ** |
| Amortization of mortgage  servicing rights and net valuation adjustments |   | **281**                | ** ** | **502**                 | ** ** | **171**            | ** ** |
| Other noninterest expense                                                |   | **1,031**              | ** ** | **845**                 | ** ** | **1,108**          | ** ** |
| Total noninterest expense                                                |   | **4,622**              | ** ** | **4,555**               | ** ** | **4,526**          | ** ** |
| Income before income tax  expense                                        |   | **1,599**              | ** ** | **1,137**               | ** ** | **1,638**          | ** ** |
| Income tax expense                                                       |   | **462**                | ** ** | **312**                 | ** ** | **485**            | ** ** |
| Income before minority  interest                                         |   | **$**                  | **1,137**  | ** **              | **825**    | ** **         | **1,153**  | ** ** |
| Minority interest                                                        |   | **$**                  | **(1**     | **)**                   | **(67**    | **)**              | **(115**   | **)** |
| Net income                                                               |   | **$**                  | **1,138**  | ** **              | **892**    | ** **         | **1,268**  | ** ** |
| Basic earnings per share                                                 |   | **$**                  | **0.30**   | ** **              | **0.24**   | ** **         | **0.34**   | ** ** |
| Diluted earnings per share                                               |   | **$**                  | **0.28**   | ** **              | **0.22**   | ** **         | **0.32**   | ** ** |
| Financial Ratios:                                                        |   |                   |       |                    |       |               |       |
| Return on average assets(1)                                              |   | **0.62**               | **%**      | **0.51**                | ** ** | **0.72**           | ** ** |
| Return on average equity(1)                                              |   | **5.81**               | ** ** | **4.58**                | ** ** | **6.75**           | ** ** |
| Average equity to average  assets                                        |   | **10.66**              | ** ** | **10.66**               | ** ** | **10.44**          | ** ** |
| Dividend payout ratio                                                    |   | **81.82**              | ** ** | **56.25**               | ** ** | **36.00**          | ** ** |
| Net interest margin(1)(2)                                                |   | **3.09**               | ** ** | **3.29**                | ** ** | **3.17**           | ** ** |

 

 
| **(Dollars in thousands)**              |   |        |        |        |        |        |        |
|-----------------------------------------|--------|-------------|-------------|-------------|-------------|-------------|-------------|
| Selected Financial  Condition Data:     |   |        |        |        |        |        |        |
| Total assets                            |   | **$**       | **737,523** | ** **  | **719,469** | ** **  | **693,723** | ** ** |
| Securities available for  sale:         |   |        |        |        |        |        |        |
| Mortgage-backed and  related securities |   | **51,896**  | ** **  | **61,882**  | ** **  | **65,565**  | ** **  |
| Other marketable  securities            |   | **69,501**  | ** **  | **46,811**  | ** **  | **67,053**  | ** **  |
| Loans held for sale                     |   | **15,127**  | ** **  | **14,419**  | ** **  | **12,305**  | ** **  |
| Loans receivable, net                   |   | **533,906** | ** **  | **508,036** | ** **  | **470,292** | ** **  |
| Deposits                                |   | **432,951** | ** **  | **422,347** | ** **  | **399,530** | ** **  |
| Federal Home Loan Bank  advances        |   | **218,300** | ** **  | **214,300** | ** **  | **214,300** | ** **  |
| Stockholders’ equity               |   | **76,065**  | ** **  | **75,180**  | ** **  | **73,757**  | ** **  |
|                                         |        |             |             |             |             |             |             |  |

 

----

(1)Annualized

(2) Net interest income divided by averageinterest-earning assets.

 

50

----

 
| **(Dollars in thousands, except per share data)**                        |   | **March 31,  2002** |   | **December  31,  2001** | ** ** | **September  30,  2001** | ** ** | **June 30,  2001** | ** ** | **March 31,  2001** | ** ** |
|--------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|------------|--------------------------|------------|--------------------|------------|---------------------|------------|
| Selected Operations Data *(3 months ended):*                             |   |                |   |                    |       |                     |       |               |       |                |       |
| Interest income                                                          |   | **11,141**          |   | 12,207                  |       | 12,576                   |       | 13,142             |       | 13,543              |       |
| Interest expense                                                         |   | **5,691**           |   | 6,636                   |       | 7,487                    |       | 7,928              |       | 8,393               |       |
| Net interest income                                                      |   | **5,450**           |   | 5,571                   |       | 5,089                    |       | 5,214              |       | 5,150               |       |
| Provision for loan losses                                                |   | **720**             |   | 400                     |       | 300                      |       | 300                |       | 150                 |       |
| Net interest income after  provision for loan losses                     |   | **4,730**           |   | 5,171                   |       | 4,789                    |       | 4,914              |       | 5,000               |       |
| Noninterest income:                                                      |   |                |   |                    |       |                     |       |               |       |                |       |
| Fees and service charges                                                 |   | **404**             |   | 432                     |       | 417                      |       | 363                |       | 351                 |       |
| Mortgage servicing fees                                                  |   | **160**             |   | 142                     |       | 114                      |       | 107                |       | 107                 |       |
| Securities gains (losses),  net                                          |   | **19**              |   | (410                    | )          | 71                       |       | (610               | )          | 278                 |       |
| Gain on sales of loans                                                   |   | **1,044**           |   | 219                     |       | 592                      |       | 1,272              |       | 851                 |       |
| Earnings (losses) in  limited partnerships                               |   | **379**             |   | (788                    | )          | 105                      |       | (325               | )          | (304                | )          |
| Other noninterest income                                                 |   | **258**             |   | 149                     |       | 120                      |       | 200                |       | 130                 |       |
| Total noninterest income                                                 |   | **2,264**           |   | (256                    | )          | 1,419                    |       | 1,007              |       | 1,413               |       |
| Noninterest expense:                                                     |   |                |   |                    |       |                     |       |               |       |                |       |
| Compensation and benefits                                                |   | **1,951**           |   | 2,035                   |       | 1,924                    |       | 2,042              |       | 1,913               |       |
| Occupancy                                                                |   | **683**             |   | 631                     |       | 528                      |       | 515                |       | 565                 |       |
| Federal deposit insurance  premiums                                      |   | **20**              |   | 19                      |       | 20                       |       | 20                 |       | 21                  |       |
| Advertising                                                              |   | **143**             |   | 132                     |       | 95                       |       | 114                |       | 85                  |       |
| Data processing                                                          |   | **264**             |   | 254                     |       | 239                      |       | 241                |       | 230                 |       |
| Amortization of mortgage  servicing rights and net valuation adjustments |   | **211**             |   | 251                     |       | 158                      |       | 209                |       | 140                 |       |
| Other noninterest expense                                                |   | **873**             |   | 1,096                   |       | 813                      |       | 616                |       | 842                 |       |
| Total noninterest expense                                                |   | **4,145**           |   | 4,418                   |       | 3,777                    |       | 3,757              |       | 3,796               |       |
| Income before income tax  expense                                        |   | **2,849**           |   | 497                     |       | 2,431                    |       | 2,164              |       | 2,617               |       |
| Income tax expense                                                       |   | **840**             |   | 278                     |       | 571                      |       | 787                |       | 998                 |       |
| Income before minority  interest                                         |   | **2,009**           |   | 219                     |       | 1,860                    |       | 1,377              |       | 1,619               |       |
| Minority interest                                                        |   | **41**              |   | (353                    | )          | (163                     | )          | 105                |       | 28                  |       |
| Net income                                                               |   | **1,968**           |   | 572                     |       | 2,023                    |       | 1,272              |       | 1,591               |       |
| Basic earnings per share                                                 |   | **0.53**            |   | 0.15                    |       | 0.53                     |       | 0.34               |       | 0.43                |       |
| Diluted earnings per share                                               |   | **0.50**            |   | 0.14                    |       | 0.50                     |       | 0.32               |       | 0.40                |       |
| Financial Ratios:                                                        |   |                |   |                    |       |                     |       |               |       |                |       |
| Return on average assets(1)                                              |   | **1.11**            |   | 0.31                    |       | 1.12                     |       | 0.70               |       | 0.88                |       |
| Return on average equity(1)                                              |   | **10.92**           |   | 3.08                    |       | 11.06                    |       | 7.11               |       | 9.18                |       |
| Average equity to average  assets                                        |   | **10.21**           |   | 9.91                    |       | 9.84                     |       | 9.69               |       | 9.56                |       |
| Dividend payout ratio                                                    |   | **100.00**          |   | 28.00                   |       | 43.75                    |       | 30.00              |       | 29.27               |       |
| Net interest margin(1)(2)                                                |   | **3.23**            |   | 3.20                    |       | 2.93                     |       | 2.98               |       | 2.97                |       |

 

 
| **(Dollars in thousands)**              |   |        |   |    |   |    |   |    |   |    |   |
|-----------------------------------------|--------|-------------|--------|---------|--------|---------|--------|---------|--------|---------|--------|
| Selected Financial  Condition Data:     |   |        |   |    |   |    |   |    |   |    |   |
| Total assets                            |   | **718,781** |   | 721,114 |   | 721,427 |   | 731,345 |   | 730,490 |   |
| Securities available for  sale:         |   |        |   |    |   |    |   |    |   |    |   |
| Mortgage-backed and  related securities |   | **65,533**  |   | 69,230  |   | 68,585  |   | 72,453  |   | 73,132  |   |
| Other marketable  securities            |   | **73,849**  |   | 53,666  |   | 27,324  |   | 40,856  |   | 42,361  |   |
| Loans held for sale                     |   | **25,854**  |   | 68,018  |   | 66,650  |   | 46,608  |   | 45,231  |   |
| Loans receivable, net                   |   | **448,976** |   | 471,668 |   | 499,543 |   | 503,476 |   | 519,307 |   |
| Deposits                                |   | **414,024** |   | 421,843 |   | 429,414 |   | 412,439 |   | 421,456 |   |
| Federal Home Loan Bank  advances        |   | **217,800** |   | 217,800 |   | 209,800 |   | 239,800 |   | 231,800 |   |
| Stockholders’ equity               |   | **73,283**  |   | 72,161  |   | 72,300  |   | 71,142  |   | 69,198  |   |

 

51

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**OTHER FINANCIAL DATA**

 

The following table sets forth the maximummonth-end balance and average balance of FHLB advances.

 
|                                          |   | **Year  Ended December 31,** |        |
|-----------------------------------------------|--------|------------------------------|-------------|
| **(Dollars in thousands)**                    |   | **2002**                     |        | **2001** |   | **2000** |   |
| Maximum Balance:                              |   |                         |        |   |   |   |   |
| Federal Home Loan Bank  advances              |   | **$**                        | **218,300** |   | 240,900 |   | 244,900 |   |
| Federal Home Loan Bank  short-term borrowings |   | **64,400**                   |        | 38,000 |   | 67,000 |   |
| Average Balance:                              |   |                         |        |   |   |   |   |
| Federal Home Loan Bank  advances              |   | **215,673**                  |        | 221,890 |   | 232,862 |   |
| Federal Home Loan Bank  short-term borrowings |   | **36,290**                   |        | 20,470 |   | 50,708 |   |
|                                               |        |                              |             |  |  |  |  |  |

 

The following table sets forth certaininformation as to the Bank’s FHLB advances.

 
|                                             |   | **December  31,** |       |
|--------------------------------------------------|--------|-------------------|------------|
|                                             |   | **2002**          |       | **2001** |   | **2000** |   |
| **(Dollars in thousands)**                       |   | **Amount**        |       | **Weighted  Average  Rate** |   | **Amount** |   | **Weighted  Average  Rate** |   | **Amount** |   | **Weighted  Average  Rate** |   |
| Federal Home Loan Bank  short-term borrowings    |   | **$**             | **64,400** | ** ** | **3.20** | **%** | 9,500 |   | 4.42 | % | 38,000 |   | 6.79 | % |
| Other Federal Home Loan  Bank long-term advances |   | **153,900**       | ** ** | **5.17** |   | 208,300 |   | 4.76 |   | 183,900 |   | 5.85 |   |
| Total                                            |   | **218,300**       | ** ** | **4.59** |   | 217,800 |   | 4.75 |   | 221,900 |   | 6.01 |   |
|                                                  |        |                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

Refer to Note 14 of the Notes to Consolidated Financial Statements formore information on the Bank’s FHLB advances.

 

**COMMON STOCK INFORMATION**

 

The common stock of HMN Financial, Inc. is listed on the Nasdaq StockMarket under the symbol: HMNF. The common stock outstanding is 9,128,662 sharesof which 4,722,856 shares are in treasury stock at December 31, 2002.  As of December 31, 2002 there were 712stockholders of record and 832 estimated beneficial stockholders. The followingtable represents the stock price information for HMN Financial, Inc. asfurnished by Nasdaq for each quarter starting in December 31, 2002 andregressing back to March 31, 1997.

 
|   |   | **Dec. 31,  2002** |       | **Sept. 30,  2002** | ** ** | **June 28,  2002** | ** ** | **March 29,  2002** | ** ** | **Dec. 31,  2001** | ** ** | **Sept. 28,  2001** | ** ** | **June 29,  2001** | ** ** | **March 30,  2001** | ** ** |
|--------|--------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| HIGH   |   | **$**              | **18.14**  | ** **          | **19.31**  | ** **         | **20.25**  | ** **          | **16.17**  |               | 15.85      |                | 17.10      |               | 17.15      |                | 15.06      |   |
| LOW    |   | **15.78**          | ** ** | **16.50**           | ** ** | **15.90**          | ** ** | **15.24**           |       | 13.27              |       | 14.35               |       | 13.50              |       | 13.00               |       |
| CLOSE  |   | **16.82**          | ** ** | **17.46**           | ** ** | **19.06**          | ** ** | **16.05**           |       | 15.49              |       | 15.10               |       | 17.10              |       | 14.75               |       |
|        |        |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |  |

 
|   |   | **Dec. 29,  2000** |   | **Sept. 29,  2000** | ** ** | **June 30,  2000** | ** ** | **March 31,  2000** | ** ** | **Dec. 31,  1999** | ** ** | **Sept. 30,  1999** | ** ** | **June 30,  1999** | ** ** | **March 31,  1999** | ** ** |
|--------|--------|--------------------|--------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| HIGH   |   | $                  | 13.25  |                | 13.88      |               | 11.75      |                | 12.13      |               | 12.75      |                | 13.50      |               | 13.13      |                | 13.50      |   |
| LOW    |   | 12.31              |   | 10.88               |       | 10.13              |       | 9.63                |       | 10.88              |       | 11.88               |       | 10.50              |       | 11.38               |       |
| CLOSE  |   | 13.06              |   | 12.44               |       | 11.00              |       | 10.13               |       | 11.25              |       | 12.25               |       | 11.63              |       | 11.38               |       |
|        |        |                    |        |                     |            |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |  |

 
|   |   | **Dec. 31,  1998** |   | **Sept. 30,  1998** | ** ** | **June 30,  1998** | ** ** | **March 31,  1998** | ** ** | **Dec. 31,  1997** | ** ** | **Sept. 30,  1997** | ** ** | **June 30,  1997** | ** ** | **March 31,  1997** | ** ** |
|--------|--------|--------------------|--------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| HIGH   |   | $                  | 14.75  |                | 16.06      |               | 20.67      |                | 21.33      |               | 21.67      |                | 17.33      |               | 16.25      |                | 16.50      |   |
| LOW    |   | 10.38              |   | 13.25               |       | 15.50              |       | 17.50               |       | 16.17              |       | 14.58               |       | 12.42              |       | 12.00               |       |
| CLOSE  |   | 11.75              |   | 14.50               |       | 15.88              |       | 20.00               |       | 21.67              |       | 16.50               |       | 15.33              |       | 13.36               |       |
|        |        |                    |        |                     |            |                    |            |                     |            |                    |            |                     |            |                    |            |                     |            |  |

 

52

----

 

**CORPORATE AND SHAREHOLDER IN FORMATION**

 

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

1016 Civic Center Drive NW

Rochester, MN 55901

(507) 535-1200

 

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

The annual meeting of shareholders will be held on Tuesday, April 22,2003 at 10:00 a.m. (Central Time) at the Radisson Plaza Hotel, 150 South BroadwayAve., Rochester, Minnesota.

 

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

Faegre & Benson LLP

2200 Wells Fargo Center

90 South Seventh St.

Minneapolis, MN 55402-3901

 

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

KPMG LLP

4200 Wells Fargo Center

90 South Seventh St.

Minneapolis, MN 55402-3900

 

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

Additional information and HMN’s Form 10-K, filed with the Securitiesand Exchange Commission is available without charge upon request from:

HMN Financial, Inc.

Attn: Investor Relations

1016 Civic Center Drive NW

Rochester, MN 55901

 

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

Inquiries regarding change of address, transfer requirements, and lostcertificates should be directed to the transfer agent.

Wells Fargo Bank Minnesota, N.A.

Shareowner Services

161 North Concord Exchange

South St. Paul, MN 55075

www.wellsfargo.com/

shareownerservices

(800) 468-9716

 

**D****IRECTORS**

 

TIMOTHY R. GEISLER

*HMN and Home Federal Savings Bank*

*Chairman of the Board*

*Unit Manager Foundation Accounting*

*Mayo Foundation*

 

MICHAEL MCNEIL

*HMN President and Home Federal*

*Savings Bank President and CEO*

 

TIMOTHY P. JOHNSON

*HMN and Home Federal Savings Bank*

*Executive Vice President,*

*Chief Financial Officer, and Treasurer*

 

ROGER P. WEISE

*Retired Chairman, President and Chief*

*Executive Officer*

*HMN and Home Federal Savings Bank*

 

DUANE D. BENSON

*Executive Director*

*Minnesota Business Partnership*

 

ALLAN R. DEBOER

*Retired Chief Executive Officer*

*RCS of Rochester*

 

MAHLON C. SCHNEIDER

*Senior Vice President External Affairs and*

*General Counsel*

*Hormel Foods Corporation*

 

SUSAN K. KOLLING

*Senior Vice President*

*Branch Manager*

 

MICHAEL J. FOGARTY

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

 

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

 

MICHAEL MCNEIL

*President*

 

TIMOTHY P. JOHNSON

*Executive Vice President,*

*Chief Financial Officer*

*and Treasurer*

 

DWAIN C. JORGENSEN

*Senior Vice President*

 

JON J. EBERLE

*Vice President and Controller*

 

**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

(641) 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

 

Galleria Mall

111 South Broadway, Suite 200

Rochester, MN 55901

(507) 529-6520

 

3900 55th St. NW

Rochester, MN 55901

(507) 535-3460

 

**Spring Valley**

715 North Broadway

Spring Valley, MN 55975

(507) 346-7345

 

**Toledo**

1301 S. County Road

Toledo, IA 52342

(641) 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

 

53

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