**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-K**

 
| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934 [ No Fee Required]** |
|------------|--------------------------------------------------------------------------------------------------------------|

 

**For thefiscal year ended December 31, 2003**

 

**OR**

 
| **o** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  [No Fee Required]** |
|-------|------------------------------------------------------------------------------------------------------------------|

 

**For the transition period from           to            .**

 

**Commissionfile number 0-24100.**

 

**HMN FINANCIAL, INC.**

(Exact Name of Registrantas Specified in its Charter)

 

| **Delaware**                                                         |   | **41-1777397**                        |
|----------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or  organization)     |   | (I.R.S. Employer  Identification No.) |
|                                                                 |   |                                  |
| **1016 Civic Center Drive NorthwestPO Box 6057Rochester, Minnesota** |   | **55901**                             |
| (Address of principal  executive offices)                            |   | (Zip Code)                            |
|                                                                 |   |                                  |
| Registrant’s telephone  number, including area code:            |   | **(507) 535-1200**                    |

 

Securities Registered Pursuant to Section 12(b) of the Act:   **None**

 

Securities Registered Pursuant to Section 12(g) of the Act:   **CommonStock, par value $.01 per share  (Titleof Class)**

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding twelve months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchrequirements for the past 90 days.   YESý NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein,and will not be contained, to the best or registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. ý

 

Indicate by checkmark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act.)  YES o NO ý

 

The aggregate market value of the voting stock held by non-affiliatesof the registrant as of June 30, 2003 (the last business day of theregistrant’s most recently completed second fiscal quarter), was approximately$64.7 million computed by reference to the average high and low prices of$19.40 on such date as reported on Nasdaq National Market.   (The exclusion from such amount of themarket value of the shares owned by any person shall not be deemed an admissionby the Registrant that such person is an affiliate of the Registrant.)

 

As of March 2, 2004, the Registrant had issued and outstanding4,535,280 shares of the Registrant’s Common Stock.

 

Our Internet website is http://www.hmnf.com and you may access, free ofcharge, our annual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to such reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, asamended, as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the Securities and Exchange Commission.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

Parts of the Registrant’s Annual Report for the year ended December 31,2003, are incorporated by reference in Parts I, II and IV of this Form 10-K.Parts of the Registrant’s Proxy Statement dated March 12, 2004, areincorporated by reference in Part III of this Form 10-K.

 

 

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**TABLE OF CONTENTS**

 
| PART I            |                                                                                        |
|-------------------|---------------------------------------------------------------------------------------------|
|              |                                                                                        |   |
| Item 1.           | Business                                                                                    |   |
|              | General                                                                                     |   |
|              | Market Area                                                                                 |   |
|              | Lending  Activities                                                                         |   |
|              | Origination,  Purchases and Sales of Mortgage-Backed and Related Securities                 |   |
|              | Classified Assets  and Delinquencies                                                        |   |
|              | Investment  Activities                                                                      |   |
|              | Sources of  Funds                                                                           |   |
|              | Other  Information                                                                          |   |
|              | Service Corporations  of the Bank                                                           |   |
|              | Competition                                                                                 |   |
|              | Other Corporations  Owned by HMN                                                            |   |
|              | Employees                                                                                   |   |
|              | Regulation and Supervision                                                                  |   |
|              | Forward-looking Information                                                                 |   |
| Item 2.           | Properties                                                                                  |   |
| Item 3.           | Legal Proceedings                                                                           |   |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                        |   |
|              |                                                                                        |   |
| PART II           |                                                                                        |
|              |                                                                                        |   |
| Item  5.          | Market  for the Registrant’s Common Equity and Related Stockholder Matters             |   |
| Item 6.           | Selected Financial  Data                                                                    |   |
| Item  7.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
| Item  7A.         | Quantitative  and Qualitative Disclosure About Market Risk                                  |   |
| Item  8.          | Financial  Statements and Supplementary Data                                                |   |
| Item  9.          | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure       |   |
| Item 9A.          | Controls and  Procedures                                                                    |   |
|              |                                                                                        |   |
| PART III          |                                                                                        |
|              |                                                                                        |   |
| Item  10.         | Directors  and Executive Officers of the Registrant                                         |   |
| Item 11.          | Executive  Compensation                                                                     |   |
| Item  12.         | Security  Ownership of Certain Beneficial Owners and Management                             |   |
| Item  13.         | Certain  Relationships and Related Transactions                                             |   |
| Item  14.         | Principal  Accountant Fees and Services                                                     |   |
|              |                                                                                        |   |
| PART IV           |                                                                                        |
|              |                                                                                        |   |
| Item  15.         | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                            |   |
| Signatures        |                                                                                        |
| Index to Exhibits |                                                                                        |

 

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**PARTI**

 

**ITEM1.     BUSINESS**

 

**General**

HMN Financial, Inc. (HMN or the Company) is a stocksavings bank holding company that owns 100 percent of Home Federal Savings Bank(the Bank).  The Bank has a communitybanking philosophy and operates retail banking and loan production facilitiesin Minnesota and Iowa.  The Bank alsoprovides highly personalized financial services to a select group ofindividuals and businesses through Eagle Crest Capital Bank, a division of HomeFederal Savings Bank, in Edina and Rochester, Minnesota.  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 anotherwholly owned subsidiary, Security Finance Corporation (SFC) which acts as anintermediary for the Bank in transacting like-kind property exchanges for Bankcustomers.  The Bank has a 51% ownedsubsidiary, Home Federal Mortgage Services, LLC (HFMS), which was a mortgagebanking and mortgage brokerage business located in Brooklyn Park,Minnesota.  HFMS’s brokerage andproduction activity stopped during the third quarter of 2002, its assets wereliquidated in 2003 and it is in the process of being dissolved.  The Bank has an 80% owned subsidiary,Federal Title Services, LLC (FTS), which performs mortgage title services forBank customers.

 

As acommunity-oriented financial institution, HMN seeks to serve the financialneeds of communities in its market area. HMN’s business involves attracting deposits from the general public andbusinesses and using such deposits to originate or purchase one-to-four familyresidential, commercial real estate, and multi-family mortgage loans inaddition to consumer, construction, and commercial business loans.  HMN also invests in mortgage-backed andrelated securities, investment securities (consisting primarily of U.S.government agency obligations) and other permissible investments.  The executive offices of HMN are located at1016 Civic Center Drive Northwest, Rochester, Minnesota 55901.  Its telephone number at that address is(507) 535-1200.

 

**MarketArea**

 

The Company servesthe southern Minnesota counties of Fillmore, Freeborn, Houston, Mower, Olmstedand Winona and portions of Steele, Dodge, Goodhue and Wabasha through itscorporate office located in Rochester, Minnesota and its nine branch officeslocated in Albert Lea, Austin, LaCrescent, Rochester, Spring Valley and Winona,Minnesota. The portion of HMN’s southern Minnesota market area consisting ofRochester and the contiguous communities is composed of primarily urban andsuburban communities, while the balance of the Company’s southern Minnesotamarket area consists primarily of rural areas and small towns.  Primary industries in the Company’s southernMinnesota market area include manufacturing, agriculture, health care,wholesale and retail trade, service industries and education. Major employersinclude IBM, Mayo Clinic, Hormel - a food processing company, and various othercompanies. The Company’s market area is also the home of Winona StateUniversity, Rochester Community and Technical College, University of Minnesota- Rochester Center, Winona State University - Rochester Center and Austin’sRiverland Community College.

 

The Company servesthe Iowa counties of Marshall and Tama through its branch offices located in Marshalltownand Toledo. Major industries in the area are Swift & Company - porkprocessors, Fisher Controls International - valve and regulator manufacturing,Lennox Industries - furnace and air conditioner manufacturing, Iowa VeteransHome - hospital care, Marshall Community School District - education, MarshallMedical & Surgical Center - hospital care and Meskwaki Casino - gamingoperations.

 

Based uponinformation obtained from the U.S. Census Bureau for 2001 (the last year forwhich information is available), the population of the six primary counties inthe Bank’s southern Minnesota market area was as follows:  Fillmore - 21,296; Freeborn - 32,300;Houston - 19,940; Mower - 38,631; Olmsted - 126,275; and Winona - 49,588. Themedian household income for these six counties ranged from $36,651 to$51,316.  With respect to Iowa, thepopulation of Marshall County was 39,438 and the population of Tama County was18,045. The median household income of these two counties ranged from $37,419to $38,268.

 

3

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The Company alsoserves a diverse high net worth customer base primarily in the seven countymetropolitan area of Minneapolis and St. Paul from Eagle Crest Capital Bank, adivision of Home Federal Savings Bank, located in Edina, Minnesota.  The Company serves a similar group ofindividuals and businesses in Olmsted county from its Eagle Crest Capital Banklocation in Rochester, Minnesota.

 

**LendingActivities**

 

***General.* **Historically, the Company has originated 15 and 30-year, fixed-ratemortgage loans secured by one-to-four family residences for its loanportfolio.  Over the past five years,the Company has focused on reducing interest rate risk and increasing interestincome by increasing its investment in shorter term and generally higheryielding commercial real estate and commercial business loans and reducing itsinvestment in longer term (greater than 15 year) one-to-four family real estateloans.  The Company continues tooriginate 15 and 30 year fixed rate mortgage loans, however, the majority ofthese loans are sold in the secondary mortgage market and adjustable ratemortgage loans that are fixed for an initial period of one, three or five yearsare placed into portfolio.  The Companyalso offers a competitive array of consumer loan products which includes bothopen lines and closed end home equity loans as well as other consumer loans.The home equity line of credit has an adjustable interest rate based upon theWall Street Journal prime rate plus a margin. Refer to Note 4 of the Notes toConsolidated Financial Statements in the Annual Report for more information onthe loan portfolio.

 

4

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The following table shows the composition of theCompany’s loan portfolio by fixed and adjustable-rate loans as of December 31:

 
|                                    |   | **2003**   |    | **2002**    |   | **2001**   |   | **2000**    |   | **1999**   |   |
|-----------------------------------------|--------|------------|---------|-------------|--------|------------|--------|-------------|--------|------------|--------|
| **(Dollars in thousands)**              |   | **Amount** |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| **Fixed-Rate Loans**                    |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate:                            |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family                      |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| GEM                                     |   | $          | 13,387  |        | 1.89   | %          | $      | 17,394      |   | 3.18       | %      | $ | 30,727 |   | 6.38 | % | $ | 47,811 |   | 9.08 | % | $ | 51,309 |   | 10.56 | % |
| Other                                   |   | 65,004     |    | 9.17        |   | 74,510     |   | 13.63       |   | 110,619    |   | 22.97 |   | 158,083 |   | 30.03 |   | 187,796 |   | 38.66 |   |
| Total one-to-four family                |   | 78,391     |    | 11.06       |   | 91,904     |   | 16.81       |   | 141,346    |   | 29.35 |   | 205,894 |   | 39.11 |   | 239,105 |   | 49.22 |   |
| Multi-family                            |   | 6,471      |    | 0.91        |   | 6,588      |   | 1.20        |   | 7,644      |   | 1.59 |   | 7,099 |   | 1.35 |   | 7,475 |   | 1.54 |   |
| GEM - multi-family                      |   | 61         |    | 0.01        |   | 64         |   | 0.01        |   | 68         |   | 0.01 |   | 71 |   | 0.01 |   | 74 |   | 0.02 |   |
| Commercial                              |   | 52,563     |    | 7.42        |   | 37,878     |   | 6.93        |   | 29,756     |   | 6.18 |   | 27,743 |   | 5.27 |   | 27,801 |   | 5.72 |   |
| Construction or development             |   | 17,215     |    | 2.43        |   | 17,234     |   | 3.15        |   | 15,542     |   | 3.22 |   | 2,126 |   | 0.40 |   | 5,011 |   | 1.03 |   |
| Total fixed-rate real estate loans      |   | 154,701    |    | 21.83       |   | 153,668    |   | 28.10       |   | 194,356    |   | 40.35 |   | 242,933 |   | 46.14 |   | 279,466 |   | 57.53 |   |
| Consumer loans:                         |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                 |   | 494        |    | 0.07        |   | 534        |   | 0.10        |   | 594        |   | 0.12 |   | 695 |   | 0.13 |   | 733 |   | 0.15 |   |
| Automobile                              |   | 14,754     |    | 2.08        |   | 11,062     |   | 2.02        |   | 6,624      |   | 1.38 |   | 6,363 |   | 1.21 |   | 4,532 |   | 0.93 |   |
| Home equity                             |   | 18,742     |    | 2.65        |   | 21,049     |   | 3.85        |   | 26,300     |   | 5.46 |   | 27,832 |   | 5.29 |   | 16,962 |   | 3.49 |   |
| Mobile home                             |   | 3,665      |    | 0.52        |   | 4,534      |   | 0.83        |   | 5,456      |   | 1.13 |   | 4,921 |   | 0.94 |   | 791 |   | 0.16 |   |
| Other                                   |   | 3,859      |    | 0.54        |   | 4,080      |   | 0.75        |   | 4,093      |   | 0.85 |   | 3,650 |   | 0.69 |   | 2,311 |   | 0.48 |   |
| Total consumer loans                    |   | 41,515     |    | 5.86        |   | 41,259     |   | 7.55        |   | 43,067     |   | 8.94 |   | 43,461 |   | 8.26 |   | 25,329 |   | 5.21 |   |
| Commercial business loans               |   | 51,609     |    | 7.28        |   | 42,272     |   | 7.73        |   | 37,123     |   | 7.71 |   | 27,821 |   | 5.28 |   | 18,936 |   | 3.90 |   |
| Total other loans                       |   | 93,123     |    | 13.14       |   | 83,531     |   | 15.28       |   | 80,190     |   | 16.65 |   | 71,282 |   | 13.54 |   | 44,265 |   | 9.11 |   |
| Total fixed-rate loans                  |   | 247,824    |    | 34.97       |   | 237,199    |   | 43.38       |   | 274,546    |   | 57.00 |   | 314,215 |   | 59.68 |   | 323,731 |   | 66.64 |   |
|                                    |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Adjustable-Rate Loans                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real estate:                            |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family                      |   | 65,924     |    | 9.30        |   | 59,662     |   | 10.91       |   | 74,102     |   | 15.38 |   | 106,994 |   | 20.32 |   | 105,569 |   | 21.73 |   |
| Multi-family                            |   | 25,008     |    | 3.53        |   | 9,113      |   | 1.67        |   | 6,657      |   | 1.38 |   | 4,920 |   | 0.93 |   | 724 |   | 0.15 |   |
| Commercial                              |   | 146,603    |    | 20.69       |   | 92,539     |   | 16.92       |   | 41,012     |   | 8.52 |   | 33,911 |   | 6.44 |   | 16,309 |   | 3.36 |   |
| Construction or development             |   | 78,131     |    | 11.02       |   | 44,102     |   | 8.07        |   | 31,435     |   | 6.53 |   | 18,085 |   | 3.44 |   | 11,035 |   | 2.27 |   |
| Total adjustable-rate real estate loans |   | 315,666    |    | 44.54       |   | 205,416    |   | 37.57       |   | 153,206    |   | 31.81 |   | 163,910 |   | 31.13 |   | 133,637 |   | 27.51 |   |
| Consumer (home equity and other)        |   | 64,391     |    | 9.09        |   | 55,162     |   | 10.09       |   | 36,064     |   | 7.49 |   | 27,435 |   | 5.21 |   | 22,907 |   | 4.72 |   |
| Commercial business loans               |   | 80,808     |    | 11.40       |   | 48,989     |   | 8.96        |   | 17,817     |   | 3.70 |   | 20,939 |   | 3.98 |   | 5,499 |   | 1.13 |   |
| Total adjustable-rate loans             |   | 460,865    |    | 65.03       |   | 309,567    |   | 56.62       |   | 207,087    |   | 43.00 |   | 212,284 |   | 40.32 |   | 162,043 |   | 33.36 |   |
| Total loans                             |   | 708,689    |    | 100.00      | %      | 546,766    |   | 100.00      | %      | 481,633    |   | 100.00 | % | 526,499 |   | 100.00 | % | 485,774 |   | 100.00 | % |
| Less                                    |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Loans in process                        |   | 11,298     |    |        |   | 6,826      |   |        |   | 4,692      |   |   |   | 2,953 |   |   |   | 2,771 |   |   |   |
| Unamortized discounts                   |   | 166        |    |        |   | 142        |   |        |   | 278        |   |   |   | 289 |   |   |   | 297 |   |   |   |
| Net deferred loan fees                  |   | 1,334      |    |        |   | 1,068      |   |        |   | 1,212      |   |   |   | 1,348 |   |   |   | 1,537 |   |   |   |
| Allowance for losses on loans           |   | 6,940      |    |        |   | 4,824      |   |        |   | 3,783      |   |   |   | 3,144 |   |   |   | 3,273 |   |   |   |
| Total loans receivable, net             |   | $          | 688,951 |        |   |       | $      | 533,906     |   |       |   | $ | 471,668 |   |   |   | $ | 518,765 |   |   |   | $ | 477,896 |   |   |   |

 

5

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The following table illustrates the interest ratematurities of the Company’s loan portfolio at December 31, 2003. Loans whichhave adjustable or renegotiable interest rates are shown as maturing in theperiod during which the contract is due. Scheduled repayments of principal arereflected in the year in which they are scheduled to be paid.

 
|                                      |   | **Real  Estate**        |    |                              |   |             |   |                         |   |                     |   |                         |   |       |   |
|-------------------------------------------|--------|-------------------------|---------|-----------------------------------|--------|------------------|--------|------------------------------|--------|--------------------------|--------|------------------------------|--------|------------|--------|
|                                      |   | **One-to-four  family** |    | **Multi-family  and  Commercial** |   | **Construction** |   | **Consumer**                 |   | **Commercial  Business** |   | **Total**                    |   |
| **Due During Years Ending  December 31,** |   | **Amount**              |    | **Weighted   Average  Rate**      |   | **Amount**       |   | **Weighted   Average  Rate** |   | **Amount**               |   | **Weighted   Average  Rate** |   | **Amount** |   | **Weighted   Average  Rate** |   | **Amount** |   | **Weighted   Average  Rate** |   | **Amount** |   | **Weighted   Average  Rate** |   |
|                                      |   |                    |    |                              |   |             |   |                         |   |                     |   |                         |   |       |   |   |   |   |   |   |   |   |   |   |   |
| 2004 (1)                                  |   | $                       | 14,969  |                              | 6.45   | %                | $      | 29,774                       |   | 6.22                     | %      | $                            | 30,481 |       | 6.12   | % | $ | 17,401 |   | 7.70 | % | $ | 65,675 |   | 5.36 | % | $ | 158,300 |   | 6.04 | % |
| 2005                                      |   | 8,356                   |    | 6.09                              |   | 20,048           |   | 6.90                         |   | 11,624                   |   | 6.32                         |   | 14,710     |   | 7.10 |   | 16,789 |   | 6.21 |   | 71,527 |   | 6.59 |   |
| 2006                                      |   | 8,277                   |    | 6.03                              |   | 43,369           |   | 6.75                         |   | 1,963                    |   | 5.99                         |   | 13,467     |   | 7.18 |   | 18,737 |   | 6.10 |   | 85,813 |   | 6.59 |   |
| 2007 through 2008                         |   | 15,974                  |    | 5.89                              |   | 40,413           |   | 6.81                         |   | 454                      |   | 6.13                         |   | 21,586     |   | 6.91 |   | 16,927 |   | 6.76 |   | 95,354 |   | 6.66 |   |
| 2009 through 2013                         |   | 37,878                  |    | 5.68                              |   | 62,076           |   | 6.82                         |   | 8,033                    |   | 4.68                         |   | 30,969     |   | 6.59 |   | 9,546 |   | 6.18 |   | 148,502 |   | 6.33 |   |
| 2014 through 2028                         |   | 68,920                  |    | 5.71                              |   | 34,422           |   | 5.92                         |   | 18,878                   |   | 5.30                         |   | 7,773      |   | 6.65 |   | 4,785 |   | 5.99 |   | 134,778 |   | 5.77 |   |
| 2029 and following                        |   | 14,416                  |    | 5.48                              |   | 0                |   | 0.00                         |   | 0                        |   | 0.00                         |   | 0          |   | 0.00 |   | 0 |   | 0.00 |   | 14,416 |   | 5.48 |   |
|                                      |   | $                       | 168,790 |                              |   |             | $      | 230,102                      |   |                     |   | $                            | 71,433 |       |   |   | $ | 105,906 |   |   |   | $ | 132,459 |   |   |   | $ | 708,690 |   |   |   |

 

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(1)                                  Includesdemand loans, loans having no stated maturity, and overdraft loans.

 

The total amount of loans due after December 31, 2004which have predetermined interest rates is $186.1 million, while the totalamount of loans due after such date which have floating or adjustable interestrates is $364.2 million.

 

6

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Under the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), theaggregate amount of loans that the Bank is permitted to make to any oneborrower is generally limited to 15% of unimpaired capital and surplus (25% ifthe security for such loan has a “readily ascertainable” value or 30% forcertain residential development loans). At December 31, 2003, based upon the 15% limitation, the Bank’sregulatory limit for loans-to-one borrower was approximately $10.8 million. AtDecember 31, 2003, the dollar amount of outstanding loans to threeborrowers or groups of related borrowers exceeded this amount, but some of theloans included in these loan totals were exempt from the lending limit due tothe “Direct Benefit and Common Enterprise Rules”. Some of the loans to one ofthe borrowers were secured by certificates of deposit or marketable securitiesheld by the Bank, which provided the Bank with an expanded lending limit.  The total loans outstanding to theseborrowers at December 31, 2003 were $13.8 million, $11.6 million, and $11.2million, respectively.  The amountsoutstanding, excluding those loans that were exempt from the loans to oneborrower limits because of the “Direct Benefit and Common Enterprise Rules”,were $8.8 million, $7.6 million and $6.2 million, respectively.  The largest borrowing relationship issecured by various manufacturing and food processing facilities as well asequipment.  The loans relating to thisborrowing relationship were performing in accordance with their terms atDecember 31, 2003.

 

All of the Bank’s lendingis subject to its written underwriting standards and to loan originationprocedures. Decisions on loan applications are made on the basis of detailedapplications and property valuations determined by an independent appraiser.The loan applications are designed primarily to determine the borrower’sability to repay. The more significant items on the application are verifiedthrough use of credit reports, financial statements, tax returns and/orconfirmations. The Bank also offers the Home Credit Plus Program which relieson the credit score of the loan applicant instead of income, asset andemployment verification procedures.  TheBank also offers low or alternative documentation underwriting procedures whichconform to Federal National Mortgage Association (FNMA) underwritingguidelines.

 

The Bank’s Mortgage andConsumer Loan Committee is responsible for reviewing and approving all loansover the Federal Home Loan Mortgage Corporation (FHLMC)/FNMA conforming loandollar limit (the Limit) originated by the Bank which are not sold in thesecondary loan market. The Limit was $322,700 for 2003 and $300,700 for2002.  Approval of one member of the Mortgageand Consumer Loan Committee was obtained on all loans above the Limit.

 

The Bank’s CommercialLoan Committee is responsible for reviewing and approving individual commercialloans or loans to borrowers with aggregate lending relationships ranging from$1.0 million to $7.5 million.  The Bank’sindividual commercial loan officers have the authority to approve loans whichmeet the guidelines established by the commercial loan policy for loans up to$250,000, subject to specific loan officer authority limits.  The Bank’s Commercial Loan OfficersCommittee has the authority to approve loans which meet the commercial loanpolicy guidelines that are less than $1.0 million.  Individual loans of $7.5 million or more, and loans to borrowerswith aggregate lending relationships that exceed that amount, must be approvedby the Board of Directors or its Executive Commercial Loan Committee.

 

The Bank generallyrequires title insurance on its mortgage loans as well as fire and extendedcoverage casualty insurance in amounts at least equal to the principal amountof the loan or the value of improvements on the property. The Bank alsorequires flood insurance to protect the property securing its interest when theproperty is located in a flood plain.

 

***One-to-Four Family Residential Real Estate Lending*.**  At December 31, 2003 the Company’sone-to-four family real estate loans, consisting of both fixed rate andadjustable rate loans, totaled $144.3 million, a decline of $7.3 million, from$151.6 million at December 31, 2002. This decrease in the one-to-four family loans is consistent with theCompany’s strategy of changing the composition of its portfolio towardcommercial and consumer loans.

 

The Company offersconventional fixed-rate one-to-four family loans that have maximum terms of 30years. In order to reduce interest rate risk, the Company sells the majority offixed rate loan originations or refinances with terms to maturity of 15 yearsor greater that are eligible for sale in the secondary market. The

 

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interest rates charged on the fixed-rate loan products are set based onthe FNMA delivery rates, as well as other competitive factors.   The Company also originates a limitednumber of fixed-rate loans with terms up to 30 years which are insured by theFederal Housing Authority (FHA), Veterans Administration (VA) and MinnesotaHome Finance Administration (MHFA).

 

The Company also offersone-year ARMs at a margin (generally 275 to 375 basis points) over the yield onthe Average Monthly One Year U.S. Treasury Constant Maturity Index for terms ofup to 30 years. The ARM loans offered by the Company allow the borrower toselect (subject to pricing) an initial period of one year, three years, or fiveyears between the loan origination and the date the first interest rate changeoccurs.  The ARMs generally have a 200basis point annual interest rate change cap and a lifetime cap of 600 basispoints over or under the initial rate. Initial interest rates offered on theARM loans during 2003 ranged from 100 basis points below the fully indexed loanrate to 100 basis points over that rate. All borrowers are qualified for theloan at the fully indexed rate. HMN’s originated ARMs do not permit negativeamortization of principal, generally do not contain prepayment penalties andare not convertible into fixed-rate loans.

 

In underwritingone-to-four family residential real estate loans, the Company evaluates theborrower’s credit history; ability to make principal, interest and escrowpayments; the value of the property that will secure the loan; and debt toincome ratios. Properties securing one-to-four family residential real estateloans made by the Company are appraised by independent fee appraisers.  The Company originates residential mortgageloans with loan-to-value ratios up to 100% for owner-occupied homes and up to90% for non-owner occupied homes; however, private mortgage insurance isgenerally required to reduce the Company’s ratio to 80% or less on mostloans.  The Company generally seeks tounderwrite its loans in accordance with secondary market standards.

 

The Company’s residentialmortgage loans customarily include due-on-sale clauses giving it the right todeclare the loan immediately due and payable in the event that, among otherthings, the borrower sells or otherwise disposes of the property subject to themortgage.

 

Fixed rate loans in theCompany’s portfolio include both GEM loans and conventional fixed-rateloans.  The GEM loans require paymentswhich increase after the first year. Under the GEM loans, the monthly paymentsrequired for the first year are established based on a 30-year amortizationschedule.  Depending upon the programselected, the payments may increase in the succeeding years by amounts rangingfrom 0% to 6.2%. Most of the GEM loans originated by the Company provide for atleast four annual payment increases over the first five years of the loan. Theincreased payments required under GEM loans are applied to principal and havethe effect of shortening the term to maturity; the GEM loans do not permitnegative amortization. The Company currently offers one GEM product with acontractual maturity of approximately 15 years. The GEMs are generally pricedbased upon loans with similar contractual maturities. The GEMs are popular withconsumers who anticipate future increases in income and who desire anamortization schedule of less than 30 years. The low mortgage interest rates over the past several years hasdecreased the demand for GEM loans as consumers have opted for shorter termfixed rate loans.

 

***Commercial Real Estate and Multi-Family Lending.*  **TheCompany originates permanent commercial real estate and multi-familyloans secured by properties located primarily in its market area. It alsopurchases commercial real estate and multi-family loans originated by thirdparties on properties outside of its market area.  The commercial real estate and multi-family loan portfolioincludes loans secured by motels, hotels, apartment buildings, churches, officebuildings, business facilities, shopping malls, nursing homes, golf courses,warehouses and other non-residential building properties primarily located inthe upper midwestern United States.

 

Permanent commercial realestate and multi-family loans are generally originated for a maximum term of 15years and may have longer amortization periods with balloon maturity features.The interest rates may be fixed for the term of the loan or have adjustablefeatures which are tied to prime or a published index. Commercial real estateand multi-family loans are generally written in amounts up to 80% of the lesserof the appraised value of the property or the purchase price and generally havea debt service coverage ratio of at least 120%. The debt service coverage isthe ratio of net cash from operations before debt service payments.  The Company may

 

8

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originate construction loans secured by commercial or multi-family realestate, or may purchase participation interests in third party originatedconstruction loans secured by commercial or multi-family real estate.

 

Appraisals on commercialreal estate and multi-family real estate properties are performed byindependent appraisers prior to the time the loan is made.  For transactions less than $250,000, the Companymay use an internal valuation.  Allappraisals on commercial and multi-family real estate are reviewed and approvedby a commercial loan officer, credit manager, commercial department manager, ora qualified third party.  The Bank’sunderwriting procedures require verification of the borrower’s credit history,income and financial statements, banking relationships and income projectionsfor the property. All commercial real estate and multi-family loans over $1.0million must be approved by a majority of the Commercial Loan Committee priorto closing.  The commercial loan policygenerally requires personal guarantees from the proposed borrowers.  An initial on-site inspection is generallyrequired for all collateral properties for loans with balances in excess of$250,000.  Independent annual reviewsare performed for aggregate commercial lending relationships that exceed$500,000.  The reviews cover financialperformance, documentation completeness and accuracy of loan risk ratings.

 

At December 31, 2003,the Company’s two largest commercial real estate loans totaled $10.8 millionand $9.9 million.  The first loan issecured by land to be developed in Rochester, Minnesota and the second loan issecured by a golf course development in Byron, Minnesota.  Both of these loans were performing atDecember 31, 2003.

 

Multi-family andcommercial real estate loans generally present a higher level of risk thanloans secured by one-to-four family residences. This greater risk is due toseveral factors, including the concentration of principal in a limited numberof loans and borrowers, the effects of general economic conditions on incomeproducing properties and the increased difficulty of evaluating and monitoringthese types of loans.  Furthermore, therepayment of loans secured by multi-family and commercial real estate istypically dependent upon the successful operation of the related real estateproject. If the cash flow from the project is reduced (for example, if leasesare not obtained or renewed), the borrower’s ability to repay the loan may beimpaired. At December 31, 2003, $2.2 million of loans in the commercialreal estate portfolio were nonperforming. There were three nonperforming loans in this category at December 31,2003 with the largest one being a $1.7 million loan secured by a hotel.  There can be no assurance that the amount ofnonperforming loans will not increase in the future.

 

***Construction Lending.***  The Company makes construction loans toindividuals for the construction of their residences and to builders for theconstruction of one-to-four family residences. It also makes some loans tobuilders for houses built on speculation. Construction loans also include commercial real estate loans.

 

Almost all loans toindividuals for the construction of their residences are structured aspermanent loans.  Such loans are made onthe same terms as residential loans, except that during the construction phase,which typically lasts up to seven months, the borrower pays interest only.Generally, the borrower also pays a construction fee at the time of originationequal to the origination fee plus other costs associated with processing theloan. Residential construction loans are underwritten pursuant to the sameguidelines used for originating residential loans on existing properties.

 

Construction loans tobuilders or developers of one-to-four family residences generally carry termsof one year or less. Such loans may permit the payment of interest from loanproceeds.

 

Construction loans toowner occupants are generally made in amounts up to 95% of the lesser of costor appraised value, but no more than 85% of the loan proceeds can be disburseduntil the building is completed. HMN generally limits the loan-to-value ratioson loans to builders to 80%. Prior to making a commitment to fund aconstruction loan, the Company requires a valuation of the property, financialdata, and verification of the borrower’s income. The Company obtains personalguarantees for substantially all of its construction loans to builders.  Personal financial statements of guarantorsare also obtained as part of the loan underwriting process. Construction loansare generally located in the Company’s market area.

 

9

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Construction loans areobtained principally through continued business from builders and developerswho have previously borrowed from the Bank, as well as referrals from existingcustomers and walk-in customers. The application process includes a submissionto the Bank of accurate plans, specifications and costs of the project to beconstructed. These items are used as a basis to determine the appraised valueof the subject property to be built.

 

At December 31, 2003construction real estate loans totaled $95.3 million of which one-to-fourfamily residential loans totaled $44.6 million, multi-family residentialtotaled $23.3 million and commercial real estate totaled $27.4 million.

 

The nature ofconstruction loans is such that they are more difficult to evaluate andmonitor.  The risk of loss on aconstruction loan is dependent largely upon the accuracy of the initialestimate of the property’s value upon completion of the project, experience ofthe builder, and the estimated cost (including interest) of the project. If theestimate of value proves to be inaccurate, the Company may be confronted, at orprior to the maturity of the loan, with a project having a value which isinsufficient to assure full repayment and/or the possibility of having to makesubstantial investments to complete and sell the project.  Because defaults in repayment may not occurduring the construction period it may be difficult to identify problem loans atan early stage.  In such cases, theCompany may be required to modify the terms of the loan.

 

***Consumer Lending.**** *The Company originates a variety of consumer loans, includinghome equity loans (open-end and closed-end), automobile, home improvement,mobile home, lot loans, deposit account and other loans for household andpersonal purposes.

 

Consumer loan terms varyaccording to the type and value of collateral, length of contract andcreditworthiness of the borrower. The Company’s consumer loans are made atfixed or adjustable interest rates, with terms up to 20 years for secured loansand up to three years for unsecured loans.

 

The Company’s home equityloans are written so that the total commitment amount, when combined with thebalance of any other outstanding mortgage liens, may not exceed 100% of theappraised value of the property.  Theclosed-end home equity loans are written with fixed or adjustable-rates withterms up to 15 years.  The open-end homeequity lines are written with an adjustable rate with terms up to 20 years, a10 year draw period which requires “interest only” payments and a 10 yearrepayment period which fully amortizes the outstanding balance.  The consumer may access the open-end homeequity line either by making a withdrawal at the Bank or writing a check on thehome equity line of credit account. Open and closed-end equity loans, which are generally secured by secondmortgages on the borrower’s principal residence, represented 69.1% of theconsumer loan portfolio at December 31, 2003.

 

The underwritingstandards employed by the Bank for consumer loans include a determination of theapplicant’s payment history on other debts and ability to meet existingobligations and payments on the proposed loan. Although creditworthiness of theapplicant is of primary consideration, the underwriting process also includes acomparison of the value of the security, if any, in relation to the proposedloan amount. Consumer loans may entail greater credit risk than do residentialmortgage loans, particularly in the case of consumer loans which are unsecuredor are secured by rapidly depreciable assets, such as automobiles or mobilehomes. In such cases, any repossessed collateral for a defaulted consumer loanmay not provide an adequate source of repayment of the outstanding loan balanceas a result of the greater likelihood of damage, loss or depreciation. Inaddition, consumer loan collections are dependent on the borrower’s continuingfinancial stability, and thus are more likely to be affected by adversepersonal circumstances. Furthermore, the application of various federal andstate laws, including bankruptcy and insolvency laws, may limit the amountwhich can be recovered on such loans. At December 31, 2003, $1.0 millionof the consumer loan portfolio was non-performing. There can be no assurancethat the amount of nonperforming loans will not increase in the future.

 

***Commercial Business Lending.* **In order to satisfy the demand forfinancial services to individuals and businesses in its market area, theCompany maintains a portfolio of commercial business loans primarily to retailand manufacturing operations and professional firms.  The Company’s commercial business loans generally have termsranging from six months to five years and may have either fixed or variableinterest rates.  The Company’s

 

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commercial business loans generally include personal guarantees and areusually, but not always, secured by business assets such as inventory,equipment, leasehold interests in equipment, fixtures, real estate and accountsreceivable. The underwriting process for commercial business loans includesconsideration of the borrower’s financial statements, tax returns, projectionsof future business operations and inspection of the subject collateral, if any.The Company has also purchased participation interests in commercial businessloans from third party originators. These loans generally have underlyingcollateral of inventory or equipment and repayment periods of less than tenyears.

 

Unlike residentialmortgage loans, which generally are made on the basis of the borrower’s abilityto make repayment from his or her income, and which are secured by realproperty whose value tends to be more easily ascertainable, commercial businessloans are of higher risk and typically are made on the basis of the borrower’sability to make repayment from the cash flow of the borrower’s business.  As a result, the availability of funds forthe repayment of commercial business loans may be substantially dependent onthe success of the business itself. Furthermore, the collateral securing theloans may depreciate over time, may be difficult to appraise and may fluctuatein value based on the success of the business. At December 31, 2003, $186,000 of loans in the commercial businessloan portfolio were non-performing. There can be no assurance that the amountof nonperforming loans will not increase in the future.

 

**Originations****, Purchasesand Sales of Loans and Mortgage-Backed and Related Securities**

 

Real estate loans aregenerally originated by the Company’s staff of salaried and commissioned loanofficers.  Loan applications are takenin all branch and loan production offices.

 

The Company originatesboth fixed and adjustable-rate loans, however, its ability to originate loansis dependent upon the relative customer demand for loans in its markets.  Demand for adjustable-rate loans is affectedby the interest rate environment. The Company originated for portfolio $25.4million of one-to-four family adjustable rate loans during 2003, an increase of$16.8 million, from $8.6 million in 2002 and 2001.  The Company also originated for portfolio $32.2 million of fixedrate one-to-four family loans during 2003, an increase of $12.4 million, from$19.8 million for 2002, compared to $13.4 million for 2001.

 

Duringthe past several years, the Company has focused its portfolio loan originationefforts on commercial real estate, commercial business and consumer loansbecause these loans have terms to maturity and adjustable interest ratecharacteristics which are generally more beneficial to the Company than singlefamily fixed-rate conventional loans. The Company originated $297.0 million of multi-family and commercialreal estate, commercial business and consumer loans (which excludes commercial realestate loans in construction or development) during the year ended December 31,2003, an increase of $95.8 million, from originations of $201.2 million for2002, compared to $109.6 million for 2001.

 

In order to supplementloan demand in the Company’s market area and geographically diversify its loanportfolio, The Company purchases real estate loans from selected sellers, withyields based upon current market rates. The Company carefully reviews and underwrites all loans to be purchasedto ensure that they meet the Company’s underwriting standards and the sellergenerally continues to service the purchased loans. The Company purchased$102.4 million of loans during 2003, an increase of $31.1 million, from $71.3million during 2002, compared to $12.4 million during 2001.  The majority of the purchased one-to-fourfamily loans have interest rates that are fixed for a one, three or five yearperiod and then adjust annually thereafter. In 2001, the Banks mortgage banking subsidiary, Home Federal Mortgage Services,LLC (HFMS), purchased loans available for sale from brokers and resold theseloans into the secondary market.  HFMSceased operation in 2002 which reduced subsequent purchases of loans availablefor sale.   The purchased commercialreal estate and commercial business loans have terms and interest rates thatare similar in nature to the Company’s originated commercial and businessportfolio.  All purchased loans arereviewed to determine that each loan meets certain underwriting requirements.Refer to Note 4 of the Notes to Consolidated Financial Statements in the AnnualReport for more information on purchased loans.

 

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The Company has somemortgage-backed and related securities which are held, based on investmentintent, in the “available for sale” portfolio. The Company purchased $15.1million of mortgage-backed securities during 2003, an increase of $5.0 million,from $10.1 million purchased in 2002, compared to no purchases in 2001.  The Company sold $22.3 million inmortgage-backed securities during 2003, an increase of $22.3 million, from nosales in 2002, compared to sales of $2.0 million in 2001. See — “InvestmentActivities.”

 

The following table shows the loan and mortgage-backedand related securities origination, purchase, acquisition, sale and repaymentactivities of the Company for the periods indicated.

 

**LOANSHELD FOR INVESTMENT**

 
|                                        |   | **Year Ended  December 31,** |    |
|---------------------------------------------|--------|------------------------------|---------|
| **(Dollars in thousands)**                  |   | **2003**                     |    | **2002** |   | **2001** |   |
| Originations by  type:                      |   |                         |    |   |   |   |   |
| Adjustable-rate:                            |   |                         |    |   |   |   |   |
| Real-estate - one-to-four  family           |   | $                            | 25,433  |   | 8,583 |   | 8,581 |   |
| -multi-family                               |   | 5,316                        |    | 866 |   | 1,765 |   |
| -commercial                                 |   | 47,647                       |    | 25,768 |   | 8,947 |   |
| -construction or  development               |   | 50,552                       |    | 63,145 |   | 49,314 |   |
| Non-real estate  – consumer            |   | 30,561                       |    | 36,498 |   | 21,199 |   |
| -commercial  business                       |   | 84,406                       |    | 48,866 |   | 13,262 |   |
| Total  adjustable-rate                      |   | 243,915                      |    | 183,726 |   | 103,068 |   |
|                                        |   |                         |    |   |   |   |   |
| Fixed-rate:                                 |   |                         |    |   |   |   |   |
| Real  estate-one-to-four family             |   | 32,181                       |    | 19,798 |   | 13,350 |   |
| -multi-family                               |   | 250                          |    | 0 |   | 56 |   |
| -commercial                                 |   | 42,370                       |    | 21,666 |   | 7,003 |   |
| -construction or  development               |   | 25,040                       |    | 16,335 |   | 16,731 |   |
| Non-real estate  - consumer                 |   | 38,640                       |    | 26,589 |   | 30,756 |   |
| -commercial  business                       |   | 47,841                       |    | 40,981 |   | 26,571 |   |
| Total fixed-rate                            |   | 186,322                      |    | 125,369 |   | 94,467 |   |
| Total loans  originated                     |   | 430,237                      |    | 309,095 |   | 197,535 |   |
|                                        |   |                         |    |   |   |   |   |
| Purchases:                                  |   |                         |    |   |   |   |   |
| Real  estate-one-to-four family             |   | 15,277                       |    | 11,819 |   | 0 |   |
| - mulit-family                              |   | 7,830                        |    | 0 |   | 0 |   |
| - commercial                                |   | 43,542                       |    | 23,305 |   | 2,371 |   |
| -construction or  development               |   | 25,365                       |    | 25,049 |   | 1,715 |   |
| Non-real estate  – commercial business |   | 10,396                       |    | 11,105 |   | 8,360 |   |
| Total loans  purchased                      |   | 102,410                      |    | 71,278 |   | 12,446 |   |
|                                        |   |                         |    |   |   |   |   |
| Sales and  repayments:                      |   |                         |    |   |   |   |   |
| Real estate -  commercial                   |   | 18,912                       |    | 162 |   | 2,398 |   |
| Construction or  development                |   | 431                          |    | 6,381 |   | 99 |   |
| Non-real estate  – commercial business |   | 4,105                        |    | 162 |   | 439 |   |
| Total sales                                 |   | 23,448                       |    | 6,705 |   | 2,936 |   |
| Transfers to  loans held for sale           |   | 3,555                        |    | 9,502 |   | 2,214 |   |
| Principal  repayments                       |   | 322,104                      |    | 243,828 |   | 221,495 |   |
| Total reductions                            |   | 349,107                      |    | 260,035 |   | 226,645 |   |
| Decrease in  other items, net               |   | (21,618                      | )       | (55,205 | ) | (28,202 | ) |
| Net increase  (decrease)                    |   | $                            | 161,922 |   | 65,133 |   | (44,866 | ) |

 

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**LOANSHELD FOR SALE**

 
|                                        |   | **Year Ended  December 31,** |       |
|---------------------------------------------|--------|------------------------------|------------|
| **(Dollars in thousands)**                  |   | **2003**                     |       | **2002** |   | **2001** |   |
| Originations by  type:                      |   |                         |       |   |   |   |   |
| Adjustable-rate:                            |   |                         |       |   |   |   |   |
| Real-estate –  one-to-four family      |   | $                            | 5,302      |   | 7,477 |   | 664 |   |
| - construction  or development              |   | 0                            |       | 268 |   | 0 |   |
| Total  adjustable-rate                      |   | 5,302                        |       | 7,745 |   | 664 |   |
|                                        |   |                         |       |   |   |   |   |
| Fixed-rate:                                 |   |                         |       |   |   |   |   |
| Real  estate-one-to-four family             |   | 269,475                      |       | 167,884 |   | 235,614 |   |
| -construction or  development               |   | 5,184                        |       | 3,667 |   | 2,559 |   |
| Total fixed-rate                            |   | 274,659                      |       | 171,551 |   | 238,173 |   |
| Total loans  originated                     |   | 279,961                      |       | 179,296 |   | 238,837 |   |
|                                        |   |                         |       |   |   |   |   |
| Purchases:                                  |   |                         |       |   |   |   |   |
| Real  estate-one-to-four family             |   | 0                            |       | 32,203 |   | 544,053 |   |
| Total loans  purchased                      |   | 0                            |       | 32,203 |   | 544,053 |   |
|                                        |   |                         |       |   |   |   |   |
| Sales and  repayments:                      |   |                         |       |   |   |   |   |
| Real estate –  one-to-four family      |   | 292,163                      |       | 274,602 |   | 724,219 |   |
| Total sales                                 |   | 292,163                      |       | 274,602 |   | 724,219 |   |
| Transfers from  loans held for investment   |   | (3,555                       | )          | (9,502 | ) | (2,214 | ) |
| Total reductions                            |   | 288,608                      |       | 265,100 |   | 722,005 |   |
| Net increase  (decrease)                    |   | $                            | (8,647     | ) | (53,601 | ) | 60,885 |   |
|                                        |   |                         |       |   |   |   |   |
| **MORTGAGE-BACKED AND RELATED  SECURITIES** |   |                         |       |   |   |   |   |
|                                        |   |                         |       |   |   |   |   |
|                                        |   | **Year Ended  December 31,** | ** ** |
| **(Dollars in thousands)**                  |   | **2003**                     | ** ** | **2002** | ** ** | **2001** | ** ** |
| Purchases:                                  |   |                         |       |   |   |   |   |
| Mortgage-backed  securities:                |   |                         |       |   |   |   |   |
| CMOs and REMICs  (1)                        |   | $                            | 15,139     |   | 10,063 |   | 0 |   |
| Total purchases                             |   | 15,139                       |       | 10,063 |   | 0 |   |
| Sales:                                      |   |                         |       |   |   |   |   |
| Mortgage-backed  securities:                |   |                         |       |   |   |   |   |
| CMOs and REMICs                             |   | 22,268                       |       | 0 |   | 2,069 |   |
| Total sales                                 |   | 22,268                       |       | 0 |   | 2,069 |   |
| Principal  repayments                       |   | (31,718                      | )          | (24,397 | ) | (7,081 | ) |
| Net decrease                                |   | $                            | (38,847    | ) | (14,334 | ) | (9,150 | ) |

 

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(1) Collateralized Mortgage Obligations and RealEstate Mortgage Investment Conduits

 

**ClassifiedAssets and Delinquencies**

 

***Classification of Assets*. **Federal regulations require that eachsavings institution classify its assets on a regular basis. In addition, inconnection with examinations of savings institutions, the Office of ThriftSupervision (OTS) and the Federal Deposit Insurance Corporation (FDIC)examiners may identify problem assets and, if appropriate, require them to beclassified.  There are threeclassifications for problem assets: substandard, doubtful and loss. Assets classified as substandard have one or more defined weaknesses andare characterized by the distinct possibility that the Bank will sustain someloss if the deficiencies are not corrected. Assets classified as doubtful have the weaknesses of those classified assubstandard, with additional characteristics that make collection orliquidation in full on the basis of currently existing facts, conditions andvalues questionable, and there is a high possibility of loss. An assetclassified as loss is considered uncollectible and of such little value thatcontinuance as an asset on the balance sheet of the institution is notwarranted.  Assets classified assubstandard or doubtful require the institution to establish prudent generalallowances for loan losses. If an asset, or portion thereof, is classified asloss, the institution must either establish specific allowances for loan lossesin the amount of 100% of the portion of the asset classified as loss, or chargeoff such amount. If an institution does not agree with an examiner’s classificationof an asset, it may appeal the determination to the OTS District Director orthe

 

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appropriate FDIC personnel, depending on the regulator.  On the basis of management’s review of itsassets, at December 31, 2003, the Bank classified a total of $5.2 millionof its loans and other assets as follows:

 
| **(Dollars in thousands)** |   | **One-to-Four  Family** |   | **Commercial  And  Multi-family** |   | **Consumer** |   | **Commercial  Business** |   | **Other  Assets** |   | **Total** |   |
|----------------------------|--------|-------------------------|--------|-----------------------------------|--------|--------------|--------|--------------------------|--------|-------------------|--------|-----------|--------|
|                       |   |                    |   |                              |   |         |   |                     |   |              |   |      |   |
| Substandard                |   | $                       | 1,291  |                              | 189    |         | 831    |                     | 465    |              | 348    |      | 3,124  |   |
| Doubtful                   |   | 0                       |   | 0                                 |   | 89           |   | 0                        |   | 0                 |   | 89        |   |
| Loss                       |   | 0                       |   | 1,674                             |   | 130          |   | 151                      |   | 0                 |   | 1,955     |   |
| Total                      |   | $                       | 1,291  |                              | 1,863  |         | 1,050  |                     | 616    |              | 348    |      | 5,168  |   |

 

The Bank’s classified assets consist ofnon-performing loans and loans and other assets of concern discussedherein.  As of the date hereof, theseasset classifications are materially consistent with those of the OTS and FDIC.

 

***DelinquencyProcedures.*** When a borrower fails to make a requiredpayment on a loan, the Company attempts to cure the delinquency by contactingthe borrower. A late notice is sent on all loans over 16 days delinquent.Additional written and verbal contacts may be made with the borrower between 30and 60 days after the due date. If the loan is contractually delinquent 90days, the Company sends a 30-day demand letter to the borrower and after theloan is contractually delinquent 120 days, institutes appropriate action toforeclose on the property. If foreclosed, the property is sold at a sheriff’s saleand may be purchased by the Company. Delinquent consumer loans are generallyhandled in a similar manner. The Company’s procedures for repossession and saleof consumer collateral are subject to various requirements under state consumerprotection laws.

 

Real estate acquired by the Company as a result offoreclosure or by deed in lieu of foreclosure is classified as real estate injudgment for six to twelve months and thereafter as real estate owned until itis sold. When property is acquired or expected to be acquired by foreclosure ordeed in lieu of foreclosure, it is recorded at the lower of cost or estimatedfair value, less the estimated cost of disposition. After acquisition, allcosts incurred in maintaining the property are expensed. Costs relating to thedevelopment and improvement of the property, however, are capitalized to theextent of fair value less disposition cost.

 

The following table sets forth the Company’s loandelinquencies by loan type, amount and percentage of type at December 31, 2003.

 
|                            |   | **Loans  Delinquent For:** |       | **Total  Delinquent** |       |
|---------------------------------|--------|----------------------------|------------|-----------------------|------------|
|                            |   | **60-89 Days**             |       | **90 Days  and Over** |       | **Loans** |   |
| **(Dollars in thousands)**      |   | **Number**                 | ** ** | **Amount**            | ** ** | **Percent  of Loan  Category** | ** ** | **Number** | ** ** | **Amount** | ** ** | **Percent  of Loan  Category** | ** ** | **Number** | ** ** | **Amount** | ** ** | **Percent  of Loan  Category** | ** ** |
| One-to-four  family real estate |   | 5                          |       | $                     | 573        |   | 0.40 | % | 16 |   | $ | 1,200 |   | 0.83 | % | 21 |   | $ | 1,773 |   | 1.23 | % |
| Nonresidential                  |   | 1                          |       | 648                   |       | 0.33 |   | 1 |   | 300 |   | 0.15 |   | 2 |   | 948 |   | 0.48 |   |
| Consumer                        |   | 37                         |       | 415                   |       | 0.39 |   | 23 |   | 1,032 |   | 0.97 |   | 60 |   | 1,447 |   | 1.37 |   |
| Commercial  business            |   | 1                          |       | 89                    |       | 0.07 |   | 0 |   | 0 |   | 0.00 |   | 1 |   | 89 |   | 0.07 |   |
| Total                           |   | 44                         |       | $                     | 1,725      |   | 0.24 | % | 40 |   | $ | 2,532 |   | 0.36 | % | 84 |   | $ | 4,257 |   | 0.60 | % |

 

14

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**InvestmentActivities**

 

HMN and the Bank utilizethe available for sale securities portfolio in virtually all aspects ofasset/liability management strategy. In making investment decisions, theInvestment-Asset/Liability Committee considers, among other things, the yieldand interest rate objectives, the credit risk position, and the Bank’s liquidityand projected cash flow requirements.

 

***Securities.* **Federally chartered savings institutions have the authorityto invest in various types of liquid assets, including United States Treasuryobligations, securities of various federal agencies, certain certificates ofdeposit of insured banks and savings institutions, certain bankers’acceptances, repurchase agreements and federal funds. Subject to variousrestrictions, the holding company of a federally chartered savings institutionmay also invest its assets in commercial paper, investment grade corporate debtsecurities and mutual funds whose assets conform to the investments that afederally chartered savings institution is otherwise authorized to makedirectly.

 

The investment strategyof HMN and the Bank has been directed toward a mix of high-quality assets(primarily government agency obligations) with short and intermediate terms tomaturity.  At December 31, 2003,the Company did not own any investment securities of a single issuer whichexceeded 10% of the Company’s stockholder’s equity other than U.S. governmentagency obligations.

 

The Bank invests aportion of its liquid assets in interest-earning overnight deposits of theFederal Home Loan Bank of Des Moines (FHLB) and various money market mutualfunds.  Other investments include highgrade medium-term (up to three years) federal agency notes, and a variety ofother types of mutual funds which invest in adjustable-rate, mortgage-backedsecurities, asset-backed securities, repurchase agreements and U.S. Treasuryand agency obligations.  The Companyinvests in the same type of investment securities as the Bank and also investsin taxable and tax exempt municipal obligations and corporate equities such aspreferred and common stock.  Refer to Note3 of the Notes to Consolidated Financial Statements in the Annual Report foradditional information regarding the Company’s securities portfolio.

 

15

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The following table set forth the composition of the Company’ssecurities portfolio, excluding mortgage-backed and related securities, at thedates indicated.

 
|                                                                                                               |   | **2003**        |    | **2002**         |   | **2001**          |    |
|--------------------------------------------------------------------------------------------------------------------|--------|-----------------|---------|------------------|--------|-------------------|---------|
|                                                                                                               |   | **Amort  Cost** |    | **Adjusted  To** |   | **Market  Value** |    | **% of  Total** |   | **Amort  Cost** |   | **Adjusted  To** |   | **Market  Value** |   | **% of  Total** |   | **Amort  Cost** |   | **Adjusted  To** |   | **Market  Value** |   | **% of  Total** |   |
| Securities available for sale:                                                                                     |   |            |    |             |   |              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Government agency obligations                                                                                 |   | $               | 86,658  |             | 930    |              | 87,588  |   | 67.32 | % | $ | 61,098 |   | 2,154 |   | 63,252 |   | 59.05 | % | $ | 34,576 |   | 210 |   | 34,786 |   | 41.04 | % |
| Municipal obligations                                                                                              |   | 177             |    | (7               | )      | 170               |    | 0.13 |   | 319 |   | (11 | ) | 308 |   | 0.29 |   | 728 |   | (9 | ) | 719 |   | 0.85 |   |
| Corporate debt                                                                                                     |   | 0               |    | 0                |   | 0                 |    | 0.00 |   | 1,061 |   | 16 |   | 1,077 |   | 1.01 |   | 9,546 |   | 96 |   | 9,642 |   | 11.37 |   |
| Corporate equity (1)                                                                                               |   | 700             |    | 0                |   | 700               |    | 0.54 |   | 1,300 |   | 191 |   | 1,491 |   | 1.39 |   | 4,821 |   | (91 | ) | 4,730 |   | 5.58 |   |
| Stock of federal agencies (1)                                                                                      |   | 3,500           |    | (343             | )      | 3,157             |    | 2.43 |   | 3,504 |   | (131 | ) | 3,373 |   | 3.15 |   | 3,768 |   | 21 |   | 3,789 |   | 4.47 |   |
| Subtotal                                                                                                           |   | 91,035          |    |             |   | 91,615            |    | 70.42 |   | 67,282 |   |   |   | 69,501 |   | 64.89 |   | 53,439 |   |   |   | 53,666 |   | 63.31 |   |
| Federal Home Loan Bank stock                                                                                       |   | 10,004          |    |             |   | 10,004            |    | 7.69 |   | 11,881 |   |   |   | 11,881 |   | 11.09 |   | 12,245 |   |   |   | 12,245 |   | 14.44 |   |
| Total investment securities and Federal Home Loan Bank stock                                                       |   | 101,039         |    |             |   | 101,619           |    | 78.11 |   | 79,163 |   |   |   | 81,382 |   | 75.98 |   | 65,684 |   |   |   | 65,911 |   | 77.75 |   |
|                                                                                                               |   |            |    |             |   |              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Average remaining life of investment securities excluding Federal  Home Loan Bank stock                            |   | 1.8  years      |    |             |   |              |    |   |   | 2.3  years |   |   |   |   |   |   |   | 2.8  years |   |   |   |   |   |   |   |
|                                                                                                               |   |            |    |             |   |              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other interest earning assets:                                                                                     |   |            |    |             |   |              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash equivalents                                                                                                   |   | 28,497          |    |             |   | 28,497            |    | 21.89 |   | 25,729 |   |   |   | 25,729 |   | 24.02 |   | 18,864 |   |   |   | 18,864 |   | 22.25 |   |
| Total                                                                                                              |   | $               | 129,536 |             |   |              | 130,116 |   | 100.00 | % | $ | 104,892 |   |   |   | 107,111 |   | 100.00 | % | $ | 84,548 |   |   |   | 84,775 |   | 100.00 | % |
| Average remaining life or term to repricing of investment securities  and other interest earning assets, excluding |   |            |    |             |   |              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal Home Loan Bank stock                                                                                       |   | 1.4  years      |    |             |   |              |    |   |   | 1.7  years |   |   |   |   |   |   |   | 2.1  years |   |   |   |   |   |   |   |

 

----

(1)Average life assigned to corporate equity holdingsand stock of federal agencies is five years.

 

16

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The composition andmaturities of the investment securities portfolio, excluding Federal Home LoanBank stock, mortgage-backed and related securities, are indicated in thefollowing table.

 
|                              |   | **December 31,  2003** |   |
|-----------------------------------|--------|-----------------------------|--------|
|                              |   | **1 Year  or Less**         |   | **After 1  through 5  Years** |   | **After 5  through 10  Years** |   | **Over  10 Years** |   | **No Stated  Maturity** |   | **Total  Securities** |   |   |   |
| **(Dollars in thousands)**        |   | **Amortized  Cost**         |   | **Amortized  Cost** |   | **Amortized  Cost** |   | **Amortized  Cost** |   | **Amortized  Cost** |   | **Amortized  Cost** |   | **Adjusted  To** |   | **Market  Value** |   |
| Securities available for sale:    |   |                        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agency securities |   | $                           | 24,915 |   | 61,638 |   | 0 |   | 105 |   | 0 |   | 86,658 |   | 930 |   | 87,588 |   |
| Municipal obligations             |   | 0                           |   | 0 |   | 177 |   | 0 |   | 0 |   | 177 |   | (7 | ) | 170 |   |
| Corporate equity                  |   | 0                           |   | 0 |   | 0 |   | 0 |   | 700 |   | 700 |   | 0 |   | 700 |   |
| Stock of federal agencies         |   | 0                           |   | 0 |   | 0 |   | 0 |   | 3,500 |   | 3,500 |   | (343 | ) | 3,157 |   |
| Total stock                       |   | $                           | 24,915 |   | 61,638 |   | 177 |   | 105 |   | 4,200 |   | 91,035 |   |   |   | 91,615 |   |
|                              |   |                        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average yield (1)        |   | 3.36                        | %      | 2.82 | % | 7.25 | % | 3.25 | % | 2.36 | % | 2.95 | % |   |   |   |   |

 

----

(1)  Yields arecomputed on a tax equivalent basis.

 

***Mortgage-Backed and Related Securities*. **In order to supplement loan productionand achieve its asset/liability management goals, the Company invests inmortgage-backed and related securities. All of the mortgage-backed and relatedsecurities owned by the Company are issued, insured or guaranteed eitherdirectly or indirectly by a federal agency or are rated “AA” or higher.  The Company had $13.0 million ofmortgage-backed and related securities classified as “available for sale” atDecember 31, 2003, compared to $51.9 at December 31, 2002 and $66.2 million atDecember 31, 2001.

 

Thecontractual maturities of the mortgage-backed and related securities portfoliowithout any prepayment assumptions at December 31, 2003 are as follows:

 
| **(Dollars in thousands)**                |   | **5 Years  or Less** |   | **5 to 10  Years** |   | **10 to 20  Years** |   | **Over 20  Years** |   | **December 31,  2003  Balance  Outstanding** |   |
|-------------------------------------------|--------|----------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|---------------------------------------------------|--------|
| Securities  available for sale:           |   |                 |   |               |   |                |   |               |   |                                              |   |
| Federal Home  Loan Mortgage Corporation   |   | $                    | 0      |               | 327    |                | 0      |               | 115    |                                              | 442    |   |
| Government  National Mortgage Association |   | 1                    |   | 0                  |   | 32                  |   | 0                  |   | 33                                                |   |
| Collateralized  Mortgage Obligations      |   | 150                  |   | 0                  |   | 8,035               |   | 4,389              |   | 12,574                                            |   |
| Total                                     |   | $                    | 151    |               | 327    |                | 8,067  |               | 4,504  |                                              | 13,049 |   |
|                                      |   |                 |   |               |   |                |   |               |   |                                              |   |
| Weighted average  yield                   |   | 6.57                 | %      | 6.61               | %      | 4.14                | %      | 4.06               | %      | 4.19                                              | %      |

 

At December 31,2003, the Company did not have any non-agency mortgage-backed or relatedsecurities in excess of 10% of its stockholders’ equity.

 

CMOs are securitiesderived by reallocating the cash flows from mortgage-backed securities or poolsof mortgage loans in order to create multiple classes, or tranches, ofsecurities with coupon rates and average lives that differ from the underlyingcollateral as a whole.  The terms tomaturity of any particular tranche is dependent upon the prepayment speed ofthe underlying collateral as well as the structure of the particular CMO.  Although a significant proportion of theCompany’s CMOs are in tranches which have been structured (through the use ofcash flow priority and “support” tranches) to give somewhat more predictablecash flows, the cash flow and hence the value of CMOs is subject to change.

 

At December 31, 2003, theCompany had $84,000 invested in CMOs which have floating interest rates thatchange either monthly or quarterly, compared to $43.6 million at December 31,2002 and $54.6 million at December 31, 2001.

 

17

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Mortgage-backed andrelated securities can serve as collateral for borrowings and, through salesand repayments, as a source of liquidity. In addition, mortgage-backed and related securities available for salecan be sold to respond to changes in economic conditions.

 

**Sourcesof Funds**

 

***General.* **The Bank’s primary sources of funds are retail and brokereddeposits, payments of loan principal, interest earned on loans and securities,repayments and maturities of securities, borrowings and other funds providedfrom operations.

 

***Deposits.* **The Bank offers a variety of deposit accounts having a wide range ofinterest rates and terms.  The Bank’sdeposits consist of passbook, negotiable order of withdrawal (NOW), moneymarket, non-interest bearing checking and certificate accounts (includingindividual retirement accounts) to retail and commercial businesscustomers.  The Bank relies primarily oncompetitive pricing policies and customer service to attract and retain thesedeposits.

 

The variety of depositaccounts offered by the Bank has allowed it to be competitive in obtainingfunds and to respond with flexibility to changes in consumer demand.  As customers have become more interest rateconscious, the Bank has become more susceptible to short-term fluctuations indeposit flows.  The Bank manages thepricing of its deposits in keeping with its asset/liability management,profitability and growth objectives. Based on its experience, the Bank believes that its passbook, NOW, andmoney market accounts are relatively stable sources of deposits.  However, the ability of the Bank to attractand maintain certificate deposits, and the rates paid on these deposits, hasbeen and will continue to be significantly affected by market conditions.

 

The following table setsforth the savings flows at the Bank during the periods indicated.

 
|                       |   | **Year Ended  December 31,** |    |
|----------------------------|--------|-----------------------------------|---------|
| **(Dollars in thousands)** |   | **2003**                          |    | **2002** |   | **2001** |   |
| Opening balance            |   | $                                 | 432,951 |   | 421,843 |   | 421,691 |   |
| Deposits                   |   | 2,498,532                         |    | 1,444,532 |   | 1,075,211 |   |
| Withdrawals                |   | (2,388,783                        | )       | (1,442,495 | ) | (1,091,668 | ) |
| Interest  credited         |   | 8,988                             |    | 9,071 |   | 16,609 |   |
| Ending balance             |   | 551,688                           |    | 432,951 |   | 421,843 |   |
|                       |   |                              |    |   |   |   |   |
| Net increase               |   | $                                 | 118,737 |   | 11,108 |   | 152 |   |
|                       |   |                              |    |   |   |   |   |
| Percent increase           |   | 27.43                             | %       | 2.63 | % | 0.04 | % |

 

18

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The following table sets forth the dollar amount ofsavings deposits in the various types of deposit programs offered by the Bankas of December 31:

 
|                                   |   | **2003**   |    | **2002**              |   | **2001**   |   |
|----------------------------------------|--------|------------|---------|-----------------------|--------|------------|--------|
| **(Dollars in thousands)**             |   | **Amount** |    | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   |
| Transactions and  Savings Deposits(1): |   |       |    |                  |   |       |   |   |   |   |   |   |   |
|                                   |   |       |    |                  |   |       |   |   |   |   |   |   |   |
| Non-interest  checking                 |   | $          | 37,629  |                  | 6.82   | %          | $      | 28,173 |   | 6.51 | % | $ | 18,148 |   | 4.30 | % |
| NOW Accounts –  0.39%(2)          |   | 61,271     |    | 11.11                 |   | 43,509     |   | 10.03 |   | 40,225 |   | 9.54 |   |
| Passbook  Accounts – 0.20%(3)     |   | 35,883     |    | 6.50                  |   | 41,033     |   | 9.48 |   | 32,738 |   | 7.76 |   |
| Money Market  Accounts – 1.23%(4) |   | 91,315     |    | 16.57                 |   | 49,510     |   | 11.44 |   | 45,002 |   | 10.67 |   |
| Total Non-Certificates                 |   | $          | 226,098 |                  | 41.00  | %          | $      | 162,225 |   | 37.46 | % | $ | 136,113 |   | 32.27 | % |
|                                   |   |       |    |                  |   |       |   |   |   |   |   |   |   |
| Certificates:                          |   |       |    |                  |   |       |   |   |   |   |   |   |   |
| 0.00 -  0.99%                     |   | $          | 1,525   |                  | 0.28   | %          | $      | 481 |   | 0.11 | % | $ | 0 |   | 0.00 | % |
| 1.00 -  1.99%                     |   | $          | 55,629  |                  | 10.08  | %          | $      | 22,522 |   | 5.20 | % | $ | 2,785 |   | 0.66 | % |
| 2.00 -  2.99%                     |   | 103,450    |    | 18.75                 |   | 72,161     |   | 16.67 |   | 34,924 |   | 8.28 |   |
| 3.00 -  3.99%                     |   | 71,691     |    | 12.99                 |   | 75,445     |   | 17.43 |   | 64,330 |   | 15.25 |   |
| 4.00 -  4.99%                     |   | 76,315     |    | 13.83                 |   | 74,818     |   | 17.28 |   | 64,097 |   | 15.19 |   |
| 5.00 -  5.99%                     |   | 16,621     |    | 3.01                  |   | 23,719     |   | 5.48 |   | 35,909 |   | 8.51 |   |
| 6.00 -  6.99%                     |   | 246        |    | 0.04                  |   | 1,468      |   | 0.35 |   | 70,282 |   | 16.66 |   |
| 7.00 -  7.99%                     |   | 113        |    | 0.02                  |   | 112        |   | 0.02 |   | 13,403 |   | 3.18 |   |
| Total  Certificates                    |   | 325,590    |    | 59.00                 |   | 270,726    |   | 62.54 |   | 285,730 |   | 67.73 |   |
| Total Deposits                         |   | $          | 551,688 |                  | 100.00 | %          | $      | 432,951 |   | 100.00 | % | $ | 421,843 |   | 100.00 | % |

 

----

(1)          Reflects rates paid ontransaction and savings deposits at December 31, 2003.

(2)          The rate on NOW accountsfor 2002 was 0.30% and 2001 was 0.64%.

(3)          The rate on PassbookAccounts for 2002 was 0.35% and 2001 was 0.75%.

(4)          The rate on Money MarketAccounts for 2002 was 1.16% and 2001 was 1.89%.

 

19

----

 

The following table showsrate and maturity information for the Bank’s certificates of deposit as ofDecember 31, 2003.

 
| **(Dollars in thousands)**                           |   |             |   |             |   |             |    |             |   |             |   |             |   |             |   |             |   |      |    |                  |   |
|------------------------------------------------------|--------|------------------|--------|------------------|--------|------------------|---------|------------------|--------|------------------|--------|------------------|--------|------------------|--------|------------------|--------|-----------|---------|-----------------------|--------|
| **Certificate accounts maturing in quarter ending:** |   | **0.00-  0.99%** |   | **1.00-  1.99%** |   | **2.00-  2.99%** |    | **3.00-  3.99%** |   | **4.00-  4.99%** |   | **5.00-  5.99%** |   | **6.00-  6.99%** |   | **7.00-  7.99%** |   | **Total** |    | **Percent  of Total** |   |
|                                                 |   |             |   |             |   |             |    |             |   |             |   |             |   |             |   |             |   |      |    |                  |   |
| March 31, 2004                                       |   | 596              |   | 16,523           |   | 20,354           |    | 263              |   | 6,485            |   | 4,161            |   | 194              |   | 0                |   | 48,576    |    | 14.92                 |   |
| June 30, 2004                                        |   | 380              |   | 9,743            |   | 19,380           |    | 464              |   | 8,736            |   | 10,033           |   | 42               |   | 0                |   | 48,778    |    | 14.98                 |   |
| September 30, 2004                                   |   | 85               |   | 7,969            |   | 13,678           |    | 9,653            |   | 10,851           |   | 920              |   | 0                |   | 0                |   | 43,156    |    | 13.25                 |   |
| December 31, 2004                               |   | 164              |   | 15,305           |   | 1,438            |    | 8,926            |   | 665              |   | 230              |   | 6                |   | 0                |   | 26,734    |    | 8.21                  |   |
| March 31, 2005                                       |   | 49               |   | 2,030            |   | 188              |    | 3,161            |   | 10,678           |   | 285              |   | 0                |   | 0                |   | 16,391    |    | 5.03                  |   |
| June 30, 2005                                        |   | 31               |   | 1,472            |   | 2,021            |    | 2,520            |   | 16,958           |   | 150              |   | 0                |   | 13               |   | 23,165    |    | 7.11                  |   |
| September 30, 2005                                   |   | 51               |   | 1,247            |   | 881              |    | 18,718           |   | 626              |   | 116              |   | 0                |   | 100              |   | 21,739    |    | 6.69                  |   |
| December 31, 2005                                    |   | 39               |   | 1,286            |   | 928              |    | 5,001            |   | 337              |   | 70               |   | 0                |   | 0                |   | 7,661     |    | 2.35                  |   |
| March 31, 2006                                       |   | 8                |   | 16               |   | 1,881            |    | 2,435            |   | 312              |   | 125              |   | 0                |   | 0                |   | 4,777     |    | 1.47                  |   |
| June 30, 2006                                        |   | 7                |   | 16               |   | 2,039            |    | 161              |   | 685              |   | 360              |   | 0                |   | 0                |   | 3,268     |    | 1.00                  |   |
| September 30, 2006                                   |   | 14               |   | 6                |   | 2,605            |    | 231              |   | 254              |   | 7                |   | 4                |   | 0                |   | 3,121     |    | 0.97                  |   |
| December 31, 2006                                    |   | 16               |   | 13               |   | 29,829           |    | 919              |   | 1,366            |   | 0                |   | 0                |   | 0                |   | 32,143    |    | 9.87                  |   |
| Thereafter                                           |   | 85               |   | 3                |   | 8,228            |    | 19,239           |   | 18,362           |   | 164              |   | 0                |   | 0                |   | 46,081    |    | 14.15                 |   |
| Total                                                |   | $                | 1,525  |             | 55,629 |             | 103,450 |             | 71,691 |             | 76,315 |             | 16,621 |             | 246    |             | 113    |      | 325,590 |                  | 100.00 | % |
|                                                 |   |             |   |             |   |             |    |             |   |             |   |             |   |             |   |             |   |      |    |                  |   |
| Percent of total                                     |   | 0.47             | %      | 17.09            | %      | 31.77            | %       | 22.02            | %      | 23.44            | %      | 5.10             | %      | 0.08             | %      | 0.03             | %      | 100.00    | %       |                  |   |
|                                                      |        |                  |        |                  |        |                  |         |                  |        |                  |        |                  |        |                  |        |                  |        |           |         |                       |        |  |

 

20

----

 

The following tableindicates the amount of the Bank’s certificates of deposit and other depositsby time remaining until maturity as of December 31, 2003.

 
|                                         |   | **Maturity**          |   |                     |   |
|----------------------------------------------|--------|-----------------------|--------|--------------------------|--------|
| **(Dollars in thousands)**                   |   | **3 Months  or Less** |   | **Over  3 to 6  Months** |   | **Over  6 to 12  Months** |   | **Over  12  months** |   | **Total** |   |
|                                         |   |                  |   |                     |   |   |   |   |   |   |   |
| Certificates of  deposit less than $100,000  |   | $                     | 35,683 |                     | 42,442 |   | 53,700 |   | 80,537 |   | 212,362 |   |
| Certificates of  deposit of $100,000 or more |   | 10,443                |   | 5,274                    |   | 15,187 |   | 75,894 |   | 106,798 |   |
| Public funds  less than $100,000             |   | 50                    |   | 50                       |   | 0 |   | 0 |   | 100 |   |
| Public funds of  $100,000 or more(1)         |   | 2,400                 |   | 1,012                    |   | 1,003 |   | 1,915 |   | 6,330 |   |
| Total  certificates of deposit               |   | $                     | 48,576 |                     | 48,778 |   | 69,890 |   | 158,346 |   | 325,590 |   |
| Passbook of  $100,000 or more                |   | $                     | 3,898  |                     | 0      |   | 0 |   | 0 |   | 3,898 |   |
| Accounts of  $100,000 or more                |   | $                     | 16,741 |                     | 6,286  |   | 16,190 |   | 77,809 |   | 117,026 |   |
|                                              |        |                       |        |                          |        |  |  |  |  |  |  |  |  |

 

----

(1)Deposits from governmental and other publicentities.

 

For additional information regarding the compositionof the Bank’s deposits, see Note 13 of the Notes to Consolidated FinancialStatements in the Annual Report.  Foradditional information on certificate maturities and the impact on theCompany’s liquidity see Liquidity starting on page 18 of the Annual Report.

 

***Borrowings.***  The Bank’s other available sources of funds include advances fromthe FHLB and other borrowings.  As amember of the FHLB, the Bank is required to own capital stock in the FHLB andis authorized to apply for advances.  EachFHLB credit program has its own interest rate, which may be fixed or variable,and range of maturities.  The FHLB mayprescribe the acceptable uses for these advances, as well as limitations on thesize of the advances and repayment provisions. Consistent with its asset/liability management strategy, the Bank hasutilized FHLB advances from time to time to extend the term to maturity of itsliabilities.  The Bank has also usedFHLB borrowings to fund loan demand and other investment opportunities and tooffset deposit outflows.  AtDecember 31, 2003, the Bank had $203.9 million of FHLB advancesoutstanding.  On such date, the Bank hada collateral pledge arrangement with the FHLB of Des Moines pursuant to whichthe Bank may borrow up to an additional $9.7 million for liquidity purposes.  Refer to Note 14 of the Notes toConsolidated Financial Statements in the Annual Report for more information onFHLB advances.

 

At December 31, 2002, HMNhad an undrawn $2.5 million revolving line of credit with a bank.  The credit line matured on November 15, 2003and was renewed in the first quarter of 2004 with a rate of prime minus 75basis points.

 

**Service Corporations of the Bank**

 

As a federally charteredsavings bank, the Bank is permitted by OTS regulations to invest up to 2% ofits assets in the stock of, or loans to, service corporation subsidiaries, andmay invest an additional 1% of its assets in service corporations where suchadditional funds are used for inner-city or community developmentpurposes.  In addition to investments inservice corporations, federal institutions are permitted to invest an unlimitedamount in operating subsidiaries engaged solely in activities in which afederal savings bank may engage directly.

 

OAI is a Minnesotacorporation that was organized in 1983 and operated as an insurance agencyuntil 1986 when its assets were sold. OAI remained inactive until 1993 when it began offering credit lifeinsurance, annuity and mutual fund products to the Bank’s customers and others.

 

TheBank owns a 51% interest in HFMS, a Delaware limited liability company, thatwas formed in 2001 to operate a mortgage banking and mortgage brokeragebusiness in Brooklyn Park, Minnesota. HFMS’s

 

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brokerage and production activity stopped in the third quarter of2002.  The company’s assets wereliquidated in 2003 and it is in the process of being dissolved.

 

HFHis a wholly owned Delaware corporation that was formed in 2002, and has itsprincipal office in Grand Cayman Islands. HFH is the holding company for HFREIT which invests in real estate loansacquired from the Bank.

 

The Bank owns an 80% interest in Federal TitleServices, LLC (FTS), a Minnesota limited liability company formed in 2003.  FTS operates a mortgage title servicesbusiness located in Minnetonka, Minnesota.

 

**Competition**

 

The Bank faces strongcompetition both in originating real estate, commercial and consumer loans andin attracting deposits.  Competition inoriginating loans comes primarily from mortgage bankers, commercial banks, creditunions and other savings institutions, which have offices in the Bank’s marketarea and those that operate through Internet banking operations throughout thecontinental United States.  The Bankcompetes for loans principally on the basis of the interest rates and loan feesit charges, the types of loans it originates and the quality of services itprovides to borrowers.

 

Competition for depositsis principally from money market and mutual funds, securities firms, commercialbanks, credit unions and other savings institutions located in the samecommunities and those that operate through Internet banking operationsthroughout the continental United States. The ability of the Bank to attract and retain deposits depends on itsability to provide an investment opportunity that satisfies the requirements ofinvestors as to rate of return, liquidity, risk, convenience and otherfactors.  The Bank competes for thesedeposits by offering a variety of deposit accounts at competitive rates,convenient business hours and a customer oriented staff.

 

**Other Corporations Owned by HMN**

 

HMN has one other whollyowned subsidiary, Security Finance Corporation (SFC).  SFC acts as an intermediary for the Bank in transacting like kindproperty exchanges for Bank customers.

 

**Employees**

 

At December 31,2003, the Company had a total of 223 employees including part-timeemployees.  None of the employees of theCompany or its subsidiaries are represented by any collective bargainingunit.  Management considers its employeerelations to be good.

 

**Regulation and Supervision**

 

The banking industry ishighly regulated, as a savings and loan holding company, HMN is subject toregulation by the OTS.  The Bank, afederally-chartered savings association, is subject to extensive regulation andexamination by the OTS, which is the Bank’s primary federal regulator.  The FDIC also has some authority to regulatethe Bank.  Subsidiaries of HMN and theBank may also be subject to state regulation and/or licensing in connectionwith certain insurance or mortgage banking activities.  HMN and the Bank are subject to numerouslaws and regulations.  These laws andregulations impose restrictions on activities, set minimum capital

 

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requirements, impose lending and deposit restrictionsand establish other restrictions. References in this section to applicable statutes and regulations arebrief and incomplete summaries only. You should consult the statutes and regulations for a full understandingof the details of their operation.

 

**HoldingCompany Regulation**

 

An entity that owns asavings association is a savings and loan holding company (SLHC).  If a holding company owns more than onesavings association, it is a multiple SLHC; if it owns only one savingsassociation, it is a unitary SLHC.  HMNis a unitary SLHC.  The Home Owners LoanAct (HOLA) historically limited multiple SLHCs and their non-associationsubsidiaries to financial activities and services and to activities authorizedfor bank holding companies, but unitary SLHCs, in the past, were not subject torestrictions on the activities that could be conducted by holding companies ortheir affiliates.

 

In November of 1999 the Gramm-Leach-Bliley Act (GLBAct) was signed into law.  The GLB Actmade significant changes to laws regulating the financial servicesindustry.  Changes included:  (1) a new framework under in which bankholding companies can own securities firms, insurance companies and otherfinancial companies; (2) prohibitions on new unitary SLHCs from engaging innon-financial activities or affiliating with non-financial entities; (3) newconsumer protections associated with the transfer and use of non-publicpersonal information by financial institutions; and (4) modifications to theFederal Home Loan Bank System.  UnitarySLHCs, such as HMN, that were in existence or had an application filed with theOTS on or before May 4, 1999, are not subject to the new restrictions onunitary SLHCs.  As a result, the GLB Actdid not affect HMN’s ability to control non-financial firms or engage innon-financial activities.

 

Acquisitions by Savingsand Loan Holding Companies. Acquisition of a savings association or a savings and loan holdingcompany is generally subject to OTS approval and the public must have anopportunity to comment on the proposed acquisition.  Without prior approval from the OTS, HMN may not acquire,directly or indirectly, more than 5% of the voting stock of a savingsassociation.

 

Examination and Reporting.  Under HOLA and OTS regulations HMN, as aSLHC, must file periodic reports with the OTS. In addition, HMN must comply with OTS record keeping requirements.  HMN is subject to holding companyexamination by the OTS.  The OTS maytake enforcement action if the activities of a SLHC constitute a serious riskto the financial safety, soundness or stability of a subsidiary savingsassociation.

 

Affiliate Transactions.  The Bank, as a holding company subsidiarythat is a depository institution, is subject to both qualitative andquantitative limitations on transactions with HMN and HMN’s othersubsidiaries.  *See* “Transactions withAffiliates and Insiders”.

 

Capital Adequacy.  HMN is not currently subject to regulatorycapital requirements, the Bank is subject to various capital requirements.  See “Capital Requirements”.

 

**Bank Regulation**

 

As a federally-charteredsavings association, the Bank is subject to regulation and supervision by theOTS.  Federal law authorizes the Bank asa federal savings association, to conduct, subject to various conditions andlimitations, business activities that include: accepting deposits and paying interest on them; making and buying loanssecured by residential and other real estate; making a limited amount ofconsumer loans; making a limited amount of commercial loans; investing incorporate obligations, government debt securities, and other securities; andoffering various banking, trust, securities and insurance agency services toits customers.

 

OTS regulations placelimits on the Bank’s lending and investment powers.  Savings associations are expected to conduct lending activitiesin a prudent, safe and sound manner. OTS regulations set aggregate limits on certain types of loans includingcommercial, commercial  real estate, andconsumer loans.  OTS regulations alsoestablish limits on loans to a single borrower.  As of December 31, 2003, the Bank’s loan limit to one borrowerwas approximately $10.8 million.  Afederal savings association generally may not invest in

 

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noninvestment-grade debt securities. A federal savings association may establish subsidiaries to conduct anyactivity the association is authorized to conduct and may establish servicecorporation subsidiaries for limited preapproved activities.

 

Qualified Thrift LenderTest.  Savingsassociations, including the Bank, must be qualified thrift lenders (QTL).  A savings association generally satisfiesthe QTL requirement if at least 65% of a specified asset base consists ofthings such as loans to small businesses and loans to purchase or improvedomestic residential real estate. Savings associations may qualify as QTLs in other ways.  Savings associations that do not qualify asQTLs are subject to significant restrictions on their operations.  If the Bank fails to meet QTL requirementsthe Bank and HMN would face certain limitations, including limits on HMN’sability to control non-financial firms. As of December 31, 2003, the Bank met the QTL test.

 

OTS Assessments.  HOLA authorizes the OTS to chargeassessments to recover the costs of examining savings associations and theiraffiliates.  The assessment is donesemi-annually.  The OTS bases theassessment on three factors: 1) asset size; 2) condition; and 3) complexity of theinstitution.  The Bank’s OTS assessmentfor the year ended December 31, 2003, was approximately $149,000.

 

Transactions withAffiliates and Insiders. Banks and savings associations are subject to affiliate and insidertransaction restrictions.  Therestrictions prohibit or limit a savings association from extending credit to,or entering into certain transactions with affiliates, principal stockholders,directors and executive officers of the savings association and itsaffiliates.  The term “affiliate”generally includes a holding company, such as HMN, and any company under commoncontrol with the savings association. Federal law limits transactions between the Bank and any one affiliateto 10% of the Bank’s capital and surplus and with all affiliates in theaggregate to 20%.** **In addition, thefederal law governing unitary savings and loan holding companies prohibits theBank from making any loan to any affiliate whose activity is not permitted fora subsidiary of a bank holding company. This law also prohibits the Bank from making any equity investment inany affiliate that is not its subsidiary. The Bank is currently in compliancewith these requirements.

 

Dividend Restrictions.  Federal law limits the ability of adepository institution, such as the Bank, to pay dividends or make othercapital distributions.  The Bank, as asubsidiary of a savings and loan holding company, must file a notice with theOTS before the proposed declaration of a dividend or approval of a proposedcapital distribution by its board of directors and must obtain prior approvalfrom the OTS if it fails to meet certain regulatory conditions. No dividendswere declared or distributed by the Bank in 2003.

 

**Deposit Insurance**

 

The FDIC insures thedeposits of the Bank.  The FDICadministers two separate deposit insurance funds, the Bank Insurance Fund (BIF)and the Savings Association Insurance Fund (SAIF).  The BIF is a deposit insurance fund for commercial banks and somestate-chartered savings associations. The SAIF is a deposit insurance fund for most savings associations.** **The Bank is a member of the SAIF.

 

The FDIC has establisheda risk-based system for setting deposit insurance assessments.  Under the risk-based assessment system, aninstitution’s insurance assessments vary according to the level of capital theinstitution holds and the degree to which it is the subject of supervisoryconcern.  In addition, regardless of thepotential risk to the insurance fund, federal law requires the FDIC toestablish assessment rates that will maintain each insurance fund’s ratio ofreserves to insured deposits at $1.25 per $100.  Both funds currently exceed this reserve ratio.  During 2003, the assessment rate for bothSAIF and BIF deposits ranged from zero to 0.27% of covered deposits.  The Bank qualified for the lowest rate onSAIF deposits in 2003 and thus paid $0 in 2003.  It is possible that the reserve ratio will fall below 1.25% andaccordingly, it is possible the Bank will have to pay deposit insuranceassessments in 2004 or subsequent years.

 

In addition to depositinsurance assessments, the FDIC is authorized to collect assessments againstinsured deposits to be paid to the Financing Corporation (FICO) to service FICOdebt incurred in the 1980s.  The FICOassessment rate is adjusted quarterly. In 2003 the Bank paid an assessment ofapproximately $72,000.

 

24

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**Capital Requirements**

 

The federal bankregulatory agencies, including the OTS, have a risk-based capital framework inplace.  The regulators use a combinationof risk based guidelines and leverage ratios to evaluate capital adequacy.

 

The following table setsforth the current regulatory requirement for capital ratios for savingsassociations as compared with the Bank’s capital ratios at December 31, 2003:

 
|                    |   | **Core or  Tier 1  Capital to Adjusted  Total Assets** |   | **Tangible  Capital to  Assets** |   | **Core or  Tier 1  Capital to Risk-  Weighted Assets** |   | **Total  Capital to  Risk-Weighted  Assets** |   |
|-------------------------|--------|-------------------------------------------------------------|--------|----------------------------------|--------|-------------------------------------------------------------|--------|----------------------------------------------|--------|
|                    |   |                                                        |   |                             |   |                                                        |   |                                         |   |
| Regulatory  Minimum     |   | 3.00                                                        | %(1)   | 1.50                             | %      | 4.00                                                        | %      | 8.00                                         | %      |
| The Bank’s  Actual |   | 8.03                                                        | %      | 8.03                             | %      | 10.19                                                       | %      | 11.06                                        | %      |

 

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(1)  Most savings associations are required tomaintain a leverage ratio of 4.00% or more.

 

**Capital Categories and PromptCorrective Action**

 

The Federal DepositInsurance Corporation Improvement Act of 1991 (FDICIA) created a statutoryframework that increased the importance of meeting applicable capitalrequirements.  FDICIA established fivecapital categories:  (1)well-capitalized; (2) adequately capitalized; (3) undercapitalized; (4)significantly undercapitalized; and (5) critically undercapitalized.  The activities in which a depositoryinstitution may engage and regulatory responsibilities of federal bankregulatory agencies vary depending upon whether an institution iswell-capitalized, adequately capitalized or under capitalized.  Under capitalized institutions are subjectto various restrictions such as limitations on dividends and growth.  A depository institution’s category dependsupon where its capital levels are in relation to relevant capital measures,which include a risk-based capital measure and certain other factors.  The federal banking agencies (including theOTS) adopted regulations that implement this statutory framework.  Under these regulations, an institution isgenerally treated as well-capitalized if its ratio of total capital to risk-weightedassets is 10.00% or more, its ratio of core capital to risk-weighted assets is6.00% or more, its ratio of core capital to adjusted total assets (leverageratio) is 5.00% or more, and it is not subject to any federal supervisory orderor directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a totalrisk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capitalratio of not less than 4.00%, and a leverage ratio of not less than 4.00%.  Any institution that is neither wellcapitalized nor adequately capitalized will be consideredundercapitalized.  The Bank currently isconsidered well capitalized.

 

**Other Regulations and ExaminationAuthority**

 

The FDIC has adoptedregulations to protect the deposit insurance funds and depositors, includingregulations governing the deposit insurance of various forms of accounts.  Federal regulation of depositoryinstitutions is intended for the protection of depositors (and the BIF and theSAIF), and not for the protection of stockholders or other creditors.  In addition, federal law requires that inany liquidation or other resolution of any FDIC-insured depository institution,claims for administrative expenses of the receiver and for deposits in U.S.branches (including claims of the FDIC as subrogee of the insured institution)shall have priority over the claims of general unsecured creditors.

 

The OTS may sanction anyOTS-regulated bank that does not operate in accordance with OTS regulations,policies and directives.  The FDIC hasadditional authority to terminate insurance of accounts, after notice andhearing, upon a finding that the insured institution is or has engaged in anyunsafe or unsound practice that has not been corrected, is operating in anunsafe or unsound condition, or has violated any applicable law, regulation,rule, or order of or condition imposed by the FDIC.

 

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**Federal Home Loan Bank (FHLB) System**

 

The Bank is a member ofthe FHLB of Des Moines (FHLB), which is one of the 12 regional Federal HomeLoan Banks (FHB), that administers the home financing credit function ofsavings associations.  Each FHB servesas a reserve or central bank for its members within its assigned region.  It is funded primarily from proceeds derivedfrom the sale of consolidated obligations of the FHB System.  It makes loans or advances to members inaccordance with policies and procedures established by the board of directorsof the FHB.  These policies andprocedures are subject to the regulation and oversight of the Federal HousingFinancing Board.  All advances from theFHLB are required to be fully secured by sufficient collateral as determined bythe FHB.  Long-term advances arerequired to be used for residential home financing and small business andagricultural loans.

 

As a member, the Bank isrequired to purchase and maintain stock in the FHLB of Des Moines.  As of December 31, 2003, the Bank had$10.0 million in FHLB stock, which was in compliance with thisrequirement.  The Bank receivesdividends on its FHLB stock and over the past five calendar years dividendshave averaged approximately 4.6%.

 

**Federal Reserve Regulation**

 

Under Federal ReserveBoard regulations, the Bank is required to maintain reserves againsttransaction accounts (primarily interest-bearing and noninterest-bearingchecking accounts).  Because reservesmust generally be maintained in cash or in noninterest-bearing accounts, theeffect of the reserve requirements is to increase an institution’s cost offunds.  These regulations generallyrequire that the Bank maintain reserves against net transaction accounts.  The reserve levels are subject to adjustmentby the Federal Reserve Board.  A savingsassociation, like other depository institutions maintaining reservableaccounts, may, under certain conditions, borrow from the Federal Reserve Bankdiscount window.

 

Numerous otherregulations promulgated by the Federal Reserve Board or the OTS affect thebusiness operations of the Bank.  Theseinclude regulations relating to privacy, equal credit access, electronic fundtransfers, collection of checks, lending and savings disclosures, andavailability of funds.

 

**Community Reinvestment Act**

 

The CommunityReinvestment Act (CRA) requires financial institutions regulated by the federalfinancial supervisory agencies to ascertain and help meet the credit needs oftheir delineated communities, including low-to moderate-income neighborhoodswithin those communities, while maintaining safe and sound bankingpractices.  The regulatory agencyassigns one of four possible ratings to an institution’s CRA performance and isrequired to make public an institution’s rating and written evaluation.  The four possible ratings of meetingcommunity credit needs are outstanding, satisfactory, needs improvement andsubstantial noncompliance.  Underregulations that apply to all CRA performance evaluations after July 1, 1997,many factors play a role in assessing a financial institution’s CRAperformance.  The institution’sregulator must consider its financial capacity and size, legal impediments,local economic conditions and demographics, including the competitiveenvironment in which it operates.  Theevaluation does not rely on absolute standards, and the institutions are notrequired to perform specific activities or to provide specific amounts or typesof credit.  The Bank maintains a CRAstatement for public viewing, as well as an annual CRA highlights document.  These documents describe the Bank’s creditprograms and services, community outreach activities, public comments and otherefforts to meet community credit needs. The Bank’s last CRA exam was November 11, 2001 and the Bank received a“Satisfactory” rating.

 

**Bank Secrecy Act**

 

The Bank Secrecy Act requiresfinancial institutions to keep records and file reports that are determined tohave a high degree of usefulness in criminal, tax and regulatory matters, andto implement counter-money laundering programs and compliance procedures.  It was amended by the USA Patriot Act.  See “USA Patriot Act of 2001” below.

 

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**USA Patriot Act of 2001**

 

Enacted in response tothe terrorist attacks in New York, Pennsylvania and Washington, D.C. onSeptember 11, 2001, the USA Patriot Act of 2001 (the Patriot Act) is intendedto strengthen U.S. law enforcement’s and the intelligence communities’ abilityto work cohesively to combat terrorism on a variety of fronts. The Patriot Actcontains anti-money laundering and financial transparency law modifications andrequires various regulation including: due diligence requirements for financialinstitutions that administer, maintain or manage private bank accounts orcorrespondent accounts for non-U.S. persons; standards for verifying customeridentification at the time of account opening; rules to promote cooperationamong financial institutions, regulators, and law enforcement entities inidentifying parties that may be involved in terrorism or money laundering;filing of reports with the Treasury Department’s Financial Crimes EnforcementNetwork for certain transactions in currency; and filing of suspicious activity reports by financial institutions ifthey believe a customer may be violating U.S. laws and regulations. The impact onBank operations from the Patriot Act will ultimately depend on the types ofcustomers served by the Bank.

 

**Forward-looking Information**

 

This Form 10-K and other reports issued by theCompany, including other reports filed with the Securities and ExchangeCommission, may contain “forward-looking” statements that deal with futureresults, plans or performance. In addition, the Company’s management may makesuch statements orally to the media, or to securities analysts, investors orothers.  Forward-looking statements dealwith matters that do not relate strictly to historical facts. The Company’sfuture results may differ materially from historical performance andforward-looking statements about the Company’s expected financial results orother plans are subject to a number of risks and uncertainties. These include,but are not limited to, possible legislative changes and adverse economic,business and competitive developments such as shrinking interest margins;deposit outflows; reduced demand for financial services and loan and leaseproducts; changes in accounting policies and guidelines, or monetary and fiscalpolicies of the federal government; changes in credit and other risks posed bythe Company’s loan and investment portfolios; technological, computer-relatedor operational difficulties; adverse changes in securities markets; results oflitigation or other significant uncertainties.

 

**ITEM2.   PROPERTIES**

 

The Company leasesthe corporate office at 1016 Civic Center Drive NW, Rochester, Minnesota and ownedthe buildings and land for 9 of its 11 full service branches. The remaining twofull service branches are leased, as well as the Eagle Crest Capital Banklocation at 5201 Eden Avenue, Suite 170, Edina, Minnesota and the title companyoffice located at 13911 Ridgedale Drive, Suite 450, Minnetonka, Minnesota.  The Bank uses all properties except for thetitle company office, which is used by Federal Title Services, LLC. All theproperties are located in Minnesota, except for two full service branches locatedin Iowa.

 

**ITEM3.  LEGAL PROCEEDINGS**

 

From time to time, theBank and HMN are involved as plaintiff or defendant in various legalproceedings arising in the normal course of its business. While the ultimateoutcome of these various legal proceedings cannot be predicted with certainty,it is the opinion of management that the resolution of these legal actionsshould not have a material effect on HMN’s consolidated financial condition orresults of operations.

 

**ITEM4.   SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

None.

 

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**PARTII**

 

**ITEM5.   MARKET FOR THE REGISTRANT’S COMMONEQUITY AND RELATED SECURITY HOLDER MATTERS**

 

The information onpages 19, 38, 48 and the back cover page of the Annual Report to SecurityHolders for the year ended December 31, 2003 is incorporated herein byreference.

 

**ITEM6.   SELECTED FINANCIAL DATA**

 

The information onpage 5 of the Annual Report to Security Holders for the year ended December 31,2003 is incorporated herein by reference.

 

**ITEM7.   MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The information onpages 6 through 21 of the Annual Report to Security Holders for the year endedDecember 31, 2003 is incorporated herein by reference.

 

**ITEM7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

The information onpages 20 and 21 of the Annual Report to Security Holders for the year endedDecember 31, 2003 is incorporated herein by reference.

 

**ITEM8.   FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The information onpages 22 through 48 of the Annual Report to Security Holders for the year endedDecember 31, 2003 is incorporated herein by reference.

 

**ITEM9.   CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM9A.   CONTROLS AND PROCEDURES**

 

***Evaluation of disclosure controls and procedures.***  An evaluation was carried out under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of the Company’s disclosure controls and procedures(as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of the end of the period covered by thisannual report.  Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that the Company’s disclosure controls and procedures are effectiveto ensure that information required to be disclosed by the Company in reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in SEC rules andforms.

 

***Changes in internal controls.*** Nochange in the Company’s internal control over financial reporting wasidentified in connection with the evaluation required by Rule 13a-15(d) of theExchange Act that occurred during

 

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the period covered bythis report and that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**PARTIII**

 

**ITEM10.   DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT**

 

The information requiredby this Item is incorporated by reference from the information under thecaptions “Director Nominees,” “Directors Continuing in Office After AnnualMeeting,” “Director Emeritus,” “Board of Directors’ Meetings and Committees”(excluding any information not related to the audit committee) and “Section16(a) Beneficial Ownership Reporting Compliance” in our definitive proxystatement for the Annual Meeting of Stockholders to be held on April 27, 2004.

 

HMN has adopted a Code ofEthics that applies to our principal executive officer, principal financialofficer, principal accounting officer, controller and other persons performingsimilar functions.  We have posted theCode of Ethics on our website located at www.hmnf.com.  We intend to post on our website anyamendment to, or waiver from, a provision of our Code of Ethics that applies toour principal executive officer, principal financial and accounting officer,controller and other persons performing similar functions within five businessdays following the date of such amendment or waiver.

 

**Executive Officers of the Registrant Who Are Not Directors**

 

Officers are electedannually by the Board of Directors of HMN and the Bank.  The business experience of each executiveofficer of both HMN and the Bank who is not also a director of HMN is set forthbelow.

 

***Dwain C. Jorgensen.***  Mr. Jorgensen, age 55, is Senior VicePresident Operations of HMN and the Bank. Mr. Jorgensen has held such positions since 1998.  From 1989 to 1998, he served as VicePresident, Controller and Chief Accounting Officer of HMN and the Bank. From1983 to 1989, Mr. Jorgensen was an Assistant Vice President and OperationsOfficer with the Bank.

 

***Jon J. Eberle.***  Mr.Eberle, age 38, is Chief Financial Officer, Senior Vice President and Treasurerof HMN and the Bank.  Mr. Eberle wasappointed to these positions in 2003. Prior to that he had served as a Vice President since 2000 and as theController since 1998.  From 1994 to1998, he served as the Director of Internal Audit for HMN and the Bank.

 

**ITEM11.   EXECUTIVE COMPENSATION**

 

The information requiredby this Item is incorporated by reference from the information under thecaptions “Executive Compensation” (excluding information under caption“Compensation Committee Report on Executive Compensation” and “StockholderReturn Performance Presentation”), “Compensation Committee Interlocks andInsider Participation” and “Director Cash Compensation” in our definitive proxystatement for the Annual Meeting of Stockholders to be held on April 27, 2004.

 

**ITEM12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The informationrequired by this Item is incorporated by reference from the information underthe captions “Security Ownership of Management and Certain Beneficial Owners”in our definitive proxy statement for the Annual Meeting of Stockholders to beheld on April 27, 2004.

 

Thefollowing table provides information as of December 31, 2003 for compensationplans under which equity securities may be issued.

 

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| **Plan Category**                                       |   | **(a)  Number of Securities to be  issued upon exercise of  outstanding options,  warrants and rights** |   | **(b)  Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **(c)  Number of securities remaining  available for future issuance under  equity compensation plans (excluding  securities reflected in column (a)) (1)** |    |
|---------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
| Equity  compensation plans approved by shareholders     |   | 374,718                                                                                                 |   | $                                                                                       | 13.85  |                                                                                                                                                        | 213,434 |   |
| Equity  compensation plans not approved by shareholders |   | 0                                                                                                       |   | 0                                                                                       |   | 0                                                                                                                                                           |    |
| Total                                                   |   | 374,718                                                                                                 |   | $                                                                                       | 13.85  |                                                                                                                                                        | 213,434 |   |

 

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(1)                                  Includessecurities available for future issuance under stockholder approvedcompensation plans other than upon the exercise of an option, warrant or right,as follows: 9,397 shares under the Company’s Amended and Restated Stock Optionand Incentive Plan dated July 29, 1998 and 187,590 shares under the Company’s2001 Omnibus Stock Plan.

 

**ITEM13.   CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The informationrequired by this Item is incorporated by reference from the information under thecaptions “Certain Transactions” in our definitive proxy statement for theAnnual Meeting of Stockholders to be held on April 27, 2004.

 

**ITEM14.   PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

The informationrequired by this Item is incorporated by reference from the information underthe captions “Audit Fees, Audit-Related Fees, Tax Fees and All Other Fees” inour definitive proxy statement for the Annual Meeting of Stockholders to beheld on April 27, 2004.

 

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**PART IV**

 

**ITEM 15.****   EXHIBITS, FINANCIAL STATEMENT SCHEDULES ANDREPORTS ON FORM 8-K**

 

**(a)  FinancialStatements, Financial Statement Schedules and Exhibits**

 

**1. Financial Statements**

 

The followinginformation appearing in the Registrant’s Annual Report to Security Holders forthe year ended December 31, 2003, is incorporated by reference in this Form10-K Annual Report as Exhibit 13.

 
| **Annual Report Section**                                                         | **Pages in  2003 Annual Report** |
|-----------------------------------------------------------------------------------|----------------------------------|
| Five Year Consolidated Financial Highlights                                       | 5                                |
|                                                                              |                             |
| Consolidated Balance Sheets —                                                |                             |
| December 31,  2003 and 2002                                                       | 22                               |
|                                                                              |                             |
| Consolidated Statements of Income —                                          |                             |
| Each of the  Years in the Three-Year Period Ended December 31, 2003               | 23                               |
|                                                                              |                             |
| Consolidated Statements of Comprehensive Income —                            |                             |
| Each of the  Years in the Three-Year Period Ended December 31, 2003               | 23                               |
|                                                                              |                             |
| Consolidated Statement of Stockholders’                                      |                             |
| Equity — Each of  the Years in the Three-Year Period Ended December 31, 2003 | 24                               |
|                                                                              |                             |
| Consolidated Statements of Cash Flows —                                      | 25                               |
| Each of the  Years in the Three-Year Period Ended December 31, 2003               |                             |
|                                                                              |                             |
| Notes to Consolidated Financial Statements                                        | 26-44                            |
|                                                                              |                             |
| Independent Auditors’ Report                                                 | 45                               |
|                                                                              |                             |
| Selected Quarterly Financial Data                                                 | 46-47                            |
|                                                                              |                             |
| Other Financial Data                                                              | 48                               |
|                                                                              |                             |
| Common Stock Price Information                                                    | 48                               |

 

**2. Financial Statement Schedules**

 

All financialstatement schedules have been omitted as information is not required under therelated instructions, is not applicable or has been included in the Notes toConsolidated Financial Statements.

 

31

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**3.             Exhibits**

 
| **Regulation S-K  Exhibit Number** |   | **Document**                                                                                  |   | **Reference  to Prior  Filing or  Exhibit  Number  Attached Hereto** |   | **Sequential  Page  Numbering  Where Attached  Exhibits Are  Located in This  Form 10-K Report** |
|------------------------------------|--------|-----------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------|
| 2                                  |   | Agreement and Plan of Merger dated July 1, 1997                                               |   | 1*                                                                   |   | Not applicable                                                                                   |
| 3.1                                |   | Amended and Restated Certificate of Incorporation                                             |   | 2*                                                                   |   | Not applicable                                                                                   |
| 3.2                                |   | Amended and Restated By-laws                                                                  |   | Exhibit 3.2                                                          |   | Filed electronically                                                                             |
| 4                                  |   | Form of Common Stock Certificate                                                              |   | 3*                                                                   |   | Not applicable                                                                                   |
| 10.1†                         |   | Change in Control Agreement for Mr. McNeil dated as  of March 1, 2004                         |   | Exhibit 10.1                                                         |   | Filed electronically                                                                             |
| 10.2†                         |   | Employment Agreement for Mr. McNeil dated as of  November 1, 2000                             |   | 6*                                                                   |   | Not applicable                                                                                   |
| 10.3†                         |   | Form of Change in Control Agreement for Executive  Officers                                   |   | Exhibit 10.3                                                         |   | Filed electronically                                                                             |
| 10.4†                         |   | Separation Agreement for Mr. Johnson dated as of  March 17, 2003                              |   | 8*                                                                   |   | Not applicable                                                                                   |
| 10.5†                         |   | Directors Deferred Compensation Plan                                                          |   | 4*                                                                   |   | Not applicable                                                                                   |
| 10.6†                         |   | Amended and Restated HMN Financial, Inc. Recognition  and Retention Plan dated July 29, 1998  |   | 5*                                                                   |   | Not applicable                                                                                   |
| 10.7†                         |   | Amended and Restated HMN Financial, Inc. Stock  Option and Incentive Plan dated July 29, 1998 |   | 5*                                                                   |   | Not applicable                                                                                   |
| 10.8†                         |   | HMN Financial, Inc. 2001 Omnibus Stock Plan                                                   |   | 7*                                                                   |   | Not applicable                                                                                   |
| 13                                 |   | Portions of Annual Report to security holders  incorporated by reference                      |   | Exhibit 13                                                           |   | Filed electronically                                                                             |
| 21                                 |   | Subsidiaries of Registrant                                                                    |   | Exhibit 21                                                           |   | Filed electronically                                                                             |
| 23                                 |   | Consent of KPMG LLP dated March 12, 2004                                                      |   | Exhibit 23                                                           |   | Filed electronically                                                                             |
| 31.1                               |   | Rule 13a-14(a)/15d-14(a) Certifications of Chief  Executive Officer                           |   | Exhibit 31.1                                                         |   | Filed electronically                                                                             |
| 31.2                               |   | Rule 13a-14(a)/15d-14(a) Certifications of Chief  Financial Officer                           |   | Exhibit 31.2                                                         |   | Filed electronically                                                                             |
| 32.1                               |   | Section 1350 Certifications of Chief Executive  Officer                                       |   | Exhibit 32.1                                                         |   | Filed electronically                                                                             |
| 32.2                               |   | Section 1350 Certifications of Chief Financial  Officer                                       |   | Exhibit 32.2                                                         |   | Filed electronically                                                                             |

 

----

† Management contract of compensatory arrangement.

 

1*            Incorporated byreference to the same numbered exhibit to the Company’s Current Report on Form8-K dated July 1, 1997, filed on July 10, 1997.

2*            Incorporated byreference to the same numbered exhibit to the Company’s Quarterly Report onForm 10-Q for the period ended March 31, 1998 (File No. 0-24100).

3*          Incorporated by referenceto the same numbered exhibit to the Company’s Registration Statement on FormS-1 dated April 1, 1994 (File No. 33-77212).

4*          Incorporated by referenceto the same numbered exhibit to the Company’s Annual Report on Form 10-K forthe period ended December 31, 1994 (File No. 0-24100).

5*          Incorporated by referenceto the same numbered exhibit to the Company’s Quarterly Report on Form 10-Q forthe period ended September 30, 1998 (File No. 0-24100).

 

32

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6*            Incorporatedby reference to the same numbered exhibit to the Company’s Annual Report onForm 10-K for the period ended December 31, 2000 (File No. 0-24100).

7*            Incorporated byreference to Exhibit B to the Company’s Proxy Statement for its Annual Meetingof Stockholders held on April 24, 2001 (File no. 0-24100).

8*           Incorporated byreference to Exhibit B to the Company’s Annual Report on Form 10-K for theperiod ended December 31, 2002 (File No. 0-24100).

 

**(b) Reports on Form 8-K:**

 

(1)  On October23, 2003, HMN reported its financial results for its third fiscal quarter endedSeptember 30, 2003.

 

(2)  On January22, 2004, HMN reported its financial results for its fourth fiscal quarter andyear-ended December 31, 2003.

 

33

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                                  |   | HMN FINANCIAL, INC.              |
|---------------------------------------|--------|----------------------------------|
|                                  |   |                             |
| Date:   March 12, 2004 |   | By:                              | /s/ Michael McNeil |   |
|                                  |   | Michael McNeil, President        |
|                                  |   | (Duly Authorized Representative) |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated.

 

 
| By:    | /s/ Timothy R. Geisler       |   | By:                                                  | /s/ Jon J. Eberle                            |   |
|--------|------------------------------|--------|------------------------------------------------------|----------------------------------------------|--------|
|   | Timothy R. Geisler, Chairman |   | Jon J. Eberle, Sr. Vice President, CFO and Treasurer |
| Date:  | March 12, 2004               |   |                                                 | (Principal Financial and Accounting Officer) |
|   |                         |   | Date:                                                | March 12, 2004                               |

 

 
| By:    | /s/ Michael McNeil            |   |   |                         |                   |
|--------|-------------------------------|--------|--------|------------------------------|------------------------|
|   | Michael McNeil, President     |   |   |                         |
|   | (Principal Executive Officer) |   |   |                         |
| Date:  | March 12, 2004                |   |   |                         |
|   |                          |   |   |                         |
|   |                          |   |   |                         |
| By:    | /s/ Allan R. DeBoer           |   |   | By:                          | /s/Duane D. Benson     |   |
|   | Allan R. DeBoer, Director     |   |   | Duane D. Benson, Director    |
| Date:  | March 12, 2004                |   | Date:  | March 12, 2004               |
|   |                          |   |   |                         |
|   |                          |   |   |                         |
| By:    | /s/ Roger P. Weise            |   |   | By:                          | /s/ Susan K. Kolling   |   |
|   | Roger P. Weise, Director      |   |   | Susan K. Kolling, Director   |
| Date:  | March 12, 2004                |   | Date:  | March 12, 2004               |
|   |                          |   |   |                         |
|   |                          |   |   |                         |
| By:    | /s/ Mahlon C. Schneider       |   |   | By:                          | /s/ Michael J. Fogarty |   |
|   | Mahlon C. Schneider, Director |   |   | Michael J. Fogarty, Director |
| Date:  | March 12, 2004                |   | Date:  | March 12, 2004               |

 

34

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**INDEX TO EXHIBITS**

 
| **Regulation S-K  Exhibit Number** |   | **Document**                                                                          |   | **Sequential  Page Numbering  Where Attached  Exhibits Are  Located in This  Form 10-K Report** |
|------------------------------------|--------|---------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------|
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 3.2                        |   | Amended and Restated By-Laws                                                          |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 10.1                       |   | Change in Control Agreement for Mr. McNeil dated March  1, 2004                       |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 10.3                       |   | Form of Change in Control Agreement for incorporated  by reference Executive Officers |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 13                         |   | Portions of Annual Report to security holders  incorporated by reference              |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 21                         |   | Subsidiaries of Registrant                                                            |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 23                         |   | Consent of KPMG, LLP dated March 12, 2004                                             |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 31.1                       |   | Rule 13a-14(a)/15d-14(a) Certifications of Chief  Executive Officer                   |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 31.2                       |   | Rule 13a-14(a)/15d-14(a) Certifications of Chief  Financial Officer                   |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 32.1                       |   | Section 1350 Certifications of Chief Executive  Officer                               |   | Filed electronically                                                                            |
|                               |   |                                                                                  |   |                                                                                            |
| Exhibit 32.2                       |   | Section 1350 Certifications of Chief Financial  Officer                               |   | Filed electronically                                                                            |

 

35

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