Item 1.
BUSINESS.
Business Operations and Products
PSB Holdings, Inc. (“PSB”) owns and operates Peoples State Bank (“Peoples”) a commercial community bank headquartered in Wausau, WI. Since 1962, Peoples has sought to meet the financial needs of local business owners and their families for the betterment of our communities. Peoples serves approximately 14,800 retail households and commercial businesses representing over $600 million in total assets through its year-end staff of 126 full time employees and our north central Wisconsin network of eight full service locations including five in the greater Wausau, WI area, and locations in Rhinelander, Minocqua, and Eagle River, WI.
We operate as a local community bank, but offer virtually the same products as larger regional banks. We are engaged in general commercial and retail banking and serve individuals, businesses, and governmental units. We offer most forms of commercial lending, including lines and letters of credit, secured and unsecured term loans, equipment and lease financing, and commercial mortgage lending. Commercial customers may use available cash management and lockbox services in addition to merchant banking products. In addition, we provide a full range of personal banking services, including checking accounts, savings and time accounts, installment, credit and debit cards, and other personal loans, as well as long-term fixed rate mortgage loans. We offer customers automated teller machines, online computer banking, and mobile banking for 24 hour customer service capabilities. Commercial customers may also make electronic deposits via our on-site deposit product. New services are frequently added to our commercial and retail banking departments. In addition to these traditional banking products, we offer brokerage services including the sale of annuities, mutual funds, and other investments to our customers and the general public. We recognize many opportunities for continued growth in products, customers, assets, and profits.
Commercial related loans represent our largest type of asset and approximately 18% of our customer base measured by household/business units. Our typical commercial customers are local small to medium sized business owners with annual sales of up to $50 million. We provide a growing suite of deposit and cash management products in addition to meeting customer credit needs. We build customer relationships on a frequent face to face basis and deliver value by providing capital and liquidity management advice and recommendations specific to our customers’ businesses. Since inception, we have maintained low loan loss ratios through conservative lending practices, emphasis on knowing our customer by establishing deep relationships with each of them, and maintaining focus on communities with which we are familiar.
Peoples has a long tradition of strong retail banking products. This emphasis has allowed us to be a leader in local residential real estate lending consistently resulting in number one or number two market share based on mortgage filings. The majority of our residential real estate loans are sold on the secondary market with servicing rights retained. We also maintain a diversified portfolio of local core deposits, including Peoples Rewards Checking, a product introduced in 2006 which pays above market deposit rates to depositors that meet qualifying criteria. The reward qualifications include debit card usage, ACH deposit or payments, and electronic delivery of monthly periodic statements. Rewards Checking provides funding at an all-in cost competitive with equivalent mid-term wholesale funding and has brought nearly 2,500 new customers to Peoples since introduction. We believe the combination of the key consumer banking products of competitive residential mortgage financing and Rewards Checking as the primary transaction interest-bearing and retail savings account builds a profitable core retail customer base with ongoing growth potential.
We meet the needs of customers with an emphasis on customer service, flexibility, and local decision making. Customers and prospects are identified and served on a face to face basis through relationships directly with bank staff. Virtually all of our customers live or work or have relationships with those within the bank’s primary market area in north central Wisconsin and our employees are substantial participants in community activities for the betterment of our market area.
More information on PSB, its operations and financial results including annual and quarterly reports on Forms 10-K and 10-Q, is available free of charge at our investor relations website, www.psbholdings.com. Alternatively, you may contact us directly at 1-888-929-9902 to receive paper or electronic copies of information filed with the United States Securities and Exchange Commission without cost. Bid and ask prices for sales of PSB common stock are quoted on the OTC Bulletin Board under the stock symbol PSBQ.
Competitive Position
There is a mix of retail, health care, manufacturing, agricultural, and service businesses in the areas we serve. We have substantial competition in our market areas. Much of this competition comes from companies that are larger and have greater resources than us. We compete for deposits and other sources of funds with other banks, savings associations, credit unions, finance companies, mutual funds, life insurance companies, and other financial and non financial companies. Many of these nonbank competitors offer products and services which are functionally equivalent to the products and services we offer, and new bank and nonbank competitors continue to enter our markets on a regular basis.
Our relative size (compared to other area community banks, thrifts, and credit unions) allows us to offer a wide array of financial service products. Although we are larger than a typical community bank, traditional community bank customer service and flexibility differentiate us from larger financial service providers. Therefore, we can offer better service to customers disenfranchised by poor service received from larger banks and perception of government “bailouts” given to larger banks while allowing customers to continue their practice of one-stop shopping and service support. We can compete against smaller local community banks and credit unions by continuing the same level of service these customers expect, but giving them an expanded and competitively priced product lineup due in part to economies of scale and access to wholesale funding sources and capital at comparatively lower cost.
Based on publicly available deposit market share information as of June 30, 2010, the following is a list of the largest FDIC insured banks in each of our primary markets and a comparison of our deposit market share to these primary competitors. The Wausau-Marathon County, Wisconsin MSA is our largest market in which we have the second largest market share. As in most Wisconsin communities, M&I Bank holds the largest market share and represents the greatest opportunity to increase deposits from competitors.
Our primary source of income is loan interest income earned on commercial and residential loans made to local customers. We originate and sell long-term fixed rate mortgage loans to the secondary market and service future payments on these loans for a substantial amount of fee income. Depositors pay us various service fees, including overdraft charges and commercial service fees, which contribute to noninterest income. Deposits raised from local customers provide the most significant source of funding to provide loans and credit products to customers. Loan product sales in excess of local deposit growth are supplemented by wholesale and national funding such as brokered deposits, FHLB advances, and repurchase agreements. We do not have a dependence on any major customers. The primary sources of revenue are outlined below:
We have traditionally pursued a market expansion plan that included de novo branching into adjacent market areas previously identified as offering favorable long-term business prospects. Full-service bank branches were opened in Eagle River, Rhinelander, Minocqua, and Weston, Wisconsin during 2001 through 2005. During those periods, we believed opening in adjacent markets capitalized on existing management resources and minimized costs for name recognition and awareness while increasing the speed in which customers are obtained via new locations while improving convenience of service for existing customers. Since 2005, organic asset growth has come from existing branch locations. However, we intend to pursue opportunities to acquire additional bank subsidiaries or banking offices primarily out of our current market area so that, at any time, we may be engaged in some tentative or preliminary discussions for such purposes with officers, directors, or principal stockholders of other holding companies or banks. We also actively search for key sales personnel in new or adjacent markets which would permit us to open a de novo lending operation or branch location to generate new market growth.
Current banking law provides us with a competitive environment and competition for our products and services is likely to continue. For example, current federal law permits adequately capitalized and managed bank holding companies to engage in interstate banking on a broad scale. In addition, financial holding companies are permitted to conduct a broad range of banking, insurance, and securities activities. Banking regulators generally permit the formation of new banks if those banks are able to raise the necessary capital, and some large financial institutions such as investment banks also hold banking charters. We believe that the combined effects of more interstate banking and expansion via branching of existing competitors and large investment banks are likely to increase the overall level of competition and attract competitors who will compete for our customers.
In addition to competition, our business is and will continue to be affected by general economic conditions, including the level of interest rates and the monetary policies of the Federal Reserve and actions of the U.S. Treasury Department (see “Regulation and Supervision”). This competition may cause us to seek out opportunities to provide additional financial services to replace or supplement traditional net interest income.
Organizational Structure
Our organizational structure is commonly referred to as a “one bank holding company.” Our parent company, PSB Holdings, Inc., was formed in a 1995 tax-free reorganization and is the 100% owner of Peoples State Bank, its only significant subsidiary. This holding company structure permits more active market based trading of the banking operation’s common stock as well as providing various vehicles in which to obtain equity capital to inject into the bank subsidiary. To facilitate the issuance of junior subordinated debentures in connection with a pooled trust preferred capital issue during 2005, the holding company also owns common stock in PSB Holdings Statutory Trust I. The holding company has no significant revenue producing activities other than ownership of Peoples State Bank.
Since its formation in 1962, all day to day revenue and expense producing activities are conducted by Peoples State Bank. Peoples employs a wholly owned Nevada subsidiary, PSB Investments, Inc., to hold and manage virtually all of the Bank’s investment securities portfolio including the activities of pledging securities against customer deposits and repurchase agreements as needed.
All of our products and services are directly or indirectly related to the business of community banking and all of our activity is reported as one segment of operations. Therefore, revenues, profits and losses, and assets are all reported in one segment and represent our entire operations. We maintain a traditional retail and commercial banking business model and do not regularly employ or sell stand-alone derivative instruments to hedge cash flow and fair value risks. As of February 4, 2011, we operated with 124 full-time equivalent (“FTE”) employees, including 17 FTE employed on a part time basis. As is common in the banking industry, none of our employees are covered by a collective bargaining agreement.
Regulation and Supervision
Regulation
We are subject to regulation under both federal and state law. PSB Holdings, Inc. is a registered bank holding company and is subject to regulation and examination by the Federal Reserve pursuant to the Federal Bank Holding Company Act of 1956. Peoples State Bank is subject to regulation and examination by the Federal Deposit Insurance Corporation (“FDIC”) and, as a Wisconsin chartered bank, by the Wisconsin Department of Financial Institutions.
The Federal Reserve expects a bank holding company to be a source of strength for its subsidiary banks. As such, we may be required to take certain actions or commit certain resources to Peoples State Bank when we might otherwise choose not to do so. Under federal and state banking laws, we are subject to regulations which govern our capital adequacy, loans and loan policies (including the extension of credit to affiliates), deposits, payment of dividends, establishment of branch offices, mergers and other acquisitions, investments in or the conduct of other lines of business, management personnel, interlocking directorates, and other aspects of our operations. Bank regulators with jurisdiction over us generally have the authority to impose civil fines or penalties and to impose regulatory sanctions for noncompliance with applicable banking regulations and policies. In particular, bank regulators have broad authority to take corrective action if we fail to maintain required minimum capital. Information concerning our compliance with applicable capital requirements is set forth in Item 8 in Note 19 of our Notes to Consolidated Financial Statements.
Banking laws and regulations have undergone periodic revisions that have often had a direct or indirect effect on our operations and the competitive environment. Such laws and regulations are often, if not continuously, subject to review and possible revision. The Gramm-Leach-Bliley Act of 1999 eliminated many of the barriers to affiliation among banks, insurance companies, and other securities or financial services companies. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”) requires banks and other financial services companies to implement additional policies and procedures designed to address, among other things, money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, and currency crimes. “Check 21” legislation involves the replacement of paper check records with digital copies in order to speed processing.
Beginning in 2008, the banking industry experienced dramatic governmental intervention in an effort to support the capital needs of certain large banks, to spur growth in bank lending, and to increase consumer and business confidence in the banking industry as a whole through passage of the Troubled Asset Relief Program (“TARP”). TARP provided various support to the industry, some available to all banks, and some available to specific large institutions deemed to require exceptional assistance. Through programs generally available to all banks, TARP increased the insurance limit on certain deposit accounts and provided an FDIC guarantee for certain debt issued by banks and bank holding companies through the Temporary Liquidity Guarantee Program (“TLGP”), and invested government funds into some banks in the form of preferred stock through the Capital Purchase Program (“CPP”), among other actions. Also during 2008, the U.S. Treasury Department placed the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”) into conservatorship to prevent the potential bankruptcy of both companies. At the time, there was a fear that a potential collapse of FNMA and FHLMC would exacerbate a decline in credit available for origination of residential home mortgages and to precipitate a systematic failure of banks and the banking system. Placement of FNMA and FHLMC into conservatorship placed Treasury capital investment above existing private common stock and preferred stock investors, effectively wiping out the value of such investments, creating banking industry losses from the write-down of substantial existing equity investments in FNMA and FHLMC.
During 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was passed. Dodd-Frank is expected to make sweeping changes to the banking industry and introduced a wide range of regulation including, but not limited to, a new Consumer Financial Protection Bureau, limitations on the use of current and future trust preferred capital financing vehicles, limitations on debit card interchange income, payment of interest on commercial demand deposits, changes and increases to deposit insurance, higher minimum capital requirements and extended federal interstate branching powers. The banking industry expects these changes to substantially increase the compliance burden and cost on the industry which could increase consolidation and mergers between banks to better manage these new compliance and capital demands through economies of scale.
During 2009, our application to receive TARP CPP capital from the U.S. Treasury was approved. However, we declined participation due to concern such capital would be perceived by customers or prospects as a bailout due to negative perceptions by many of larger national banks receiving such funds. PSB also retained the right to issue unsecured capital notes with FDIC guarantee under the TLGP program, but did not exercise this right or issue such unsecured notes. Peoples is a participant in the TLGP Program within the Transaction Account Guarantee (“TAG”) Program of TLGP and continues participation in the Program through December 31, 2012 as required by Dodd-Frank. Under this program, customers in noninterest bearing demand accounts are fully 100% guaranteed against loss by the FDIC.
Many of the Dodd-Frank provisions will not have an immediate impact on us as our existing trust preferred regulatory capital continues to be eligible as Tier 1 capital, and many of the provisions are specifically directed to much larger banking institutions. However, limitations on large bank pricing of debit card interchange income is expected to indirectly impact revenue available from debit card usage, reducing or eliminating this area of fee income. In addition, new Federal Reserve guidance effective during 2010 contained in Regulation E limits our ability to process transactions that would overdraft a customer’s account thereby reducing the level of overdraft fee income collected unless the customer had previously “opted in” to the overdraft program. We expect our customers to incur fewer overdraft transactions in the future in response to the Regulation E changes.
In December 2010, the U.S. Treasury introduced a new small bank capital program known as the “Small Business Lending Fund” established by the Small Business Jobs Act with funding up to $30 billion in an effort to spur small business lending. Under the program, only available to well performing banks less than $10 billion in assets such as us, banks may issue preferred stock to the U.S. Treasury with a variable dividend rate that could later be fixed as low as 1% depending on the level of small business lending growth during the first 10 quarters following issuance of the preferred stock. The preferred stock dividend later resets to 9% on the 4 ½ year anniversary of the preferred stock issue until repaid. We are evaluating whether such temporarily low cost capital could be used to spur lending and income growth and are investigating other costs and limitations associated with the government plan.
Most recently, the U. S. Treasury initiated discussion on methods to reform the U.S. Housing Finance Sector and the government sponsored enterprises, Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA), and the Federal Home Loan Banks (FHLB). Some Treasury proposals involve changes to minimum servicing fees paid to mortgage servicers such as PSB, and whether the United States government should continue to support or guarantee the credit risk associated with long-term fixed rate mortgages on behalf of mortgage investors. We actively originate long-term fixed rate mortgages that are sold to and serviced for FNMA and the FHLB. Depending on the scope and timing of future regulatory changes, including these regarding housing financing, it is likely these changes will affect the competitive environment in which we operate or increase our costs of regulatory compliance and, accordingly, may have a material adverse effect on our consolidated financial condition, liquidity, or results of operations.
Monetary Policy
Our earnings and growth are affected by the monetary and fiscal policies of the federal government and governmental agencies. The Federal Reserve has a direct and indirect influence on our cost of funds used for lending and its actions have a substantial effect on interest rates, the general availability of credit, and the economy as a whole. These policies therefore affect the growth of bank loans and deposits and the rates charged for loans and paid for deposits. Federal Reserve policies, in particular, have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future. We are not able to anticipate the future impact of such policies and practices on our growth or profitability.
Item 1A.
Item 1A.
RISK FACTORS.
Forward-Looking Statements
This Annual Report on Form 10-K, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7, contains forward-looking statements that involve risks, uncertainties, and assumptions. Forward-looking statements are not guarantees of performance. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of PSB Holdings, Inc. and its consolidated subsidiaries (hereinafter referred to as “PSB,” or “we,” or “our,” or “us”) may differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements. Forward-looking statements may be identified by, among other things, expressions of beliefs or expectations that certain events may occur or are anticipated, and projections or statements of expectations. Risks, uncertainties, and assumptions relating to forward-looking statements include changes in interest rates, deterioration of the credit quality of our loan portfolio, the adequacy of our allowance for loan losses, inadequate liquidity, disruptions in the financial markets, economic conditions in our market area, the loss of business or inability to operate profitably because of competition, failure to comply with or changes in government regulations, the inability to execute expansion plans, increased funding costs, changes in customers’ preferences for types and sources of financial services, loss of key personnel, the inability to implement required technologies, problems in the operation of our information technology systems, unforeseen problems in the operation of our business, failure to maintain and enforce adequate internal controls, the inability of our principal subsidiary to pay dividends, lack of marketability of our common or other equity stock, the effect of certain organizational anti-takeover provisions, unforeseen liabilities arising from current or prospective claims or litigation, changes in accounting principles and tax laws, and unexpected disruption in our business. These and other risks, uncertainties, and assumptions are described under the caption “Risk Factors” in Item 1A of this Annual Report on Form 10-K and from time to time in our other filings with the Securities and Exchange Commission after the date of this report. We assume no obligation, and do not intend, to update these forward-looking statements.
An investment in PSB Holdings, Inc. common stock involves a significant degree of risk. The following paragraphs describe what we believe are the most significant risks of investing in PSB common stock. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations. We cannot assure you
that any of the events discussed in the risk factors below will not occur. If they do, our business, financial condition or results of operations could be materially and adversely affected.
We are subject to interest rate risk.
Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions, the competitive environment within our markets, consumer preferences for specific loan and deposit products, and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the amount of interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect our ability to originate loans and obtain deposits as well as the fair value of our financial assets and liabilities. If the interest we pay on deposits and other borrowings increases at a faster rate than the interest we receive on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest we receive on loans and other investments falls more quickly than the interest we pay on deposits and other borrowings. Management uses simulation analysis to produce an estimate of interest rate exposure based on assumptions and judgments related to balance sheet growth, new products, and pricing. Simulation analysis involves a high degree of subjectivity and requires estimates of future risks and trends. Accordingly, there can be no assurance that actual results will not differ from those derived in simulation analysis due to the timing, magnitude, and frequency of interest rate changes, changes in balance sheet composition, and the possible effects of unanticipated or unknown events. Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected, and/or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.
We are subject to credit risk.
There are inherent risks associated with our lending and deposit activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in central and northern Wisconsin where we operate. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans.
We are subject to regulatory risk.
We are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds, and the banking system as a whole, not shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy, and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations or regulatory policies, changes in the interpretation or implementation of statutes, regulations or policies, and/or continuing to become subject to heightened regulatory practices, requirements, or expectations, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, increase required capital levels that could dilute existing shareholders, limit the types of financial services and products that we may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to appropriately comply with laws, regulations, or policies (including internal policies and procedures designed to prevent such violations) could result in sanctions by regulatory agencies, civil money penalties, reputational damage, and have a material adverse effect on our business, financial condition, and results of operations.
Various factors may cause our allowance for loan losses to increase.
We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management’s estimate of probable losses within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political, and regulatory conditions, and unknown losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a degree of subjectivity and requires that we make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments that can differ somewhat from those of our own management. In addition, if charge-offs in future periods exceed the allowance for loan losses (i.e., if the loan loss allowance is inadequate), we will need additional loan loss provisions to increase the allowance for loan losses. Additional provisions to increase the allowance for loan losses, should they become necessary, would result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations.
We are subject to liquidity risk.
Market conditions or other events could negatively affect the level or cost of funding, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner, and without adverse consequences. Although management has implemented strategies to maintain sufficient and diverse sources of funding to accommodate planned as well as unanticipated changes in assets and liabilities under both normal and adverse conditions, any substantial, unexpected, and/or prolonged change in the level or cost of liquidity could have a material adverse effect on our financial condition and results of operations. For example, a significant portion of the investment security portfolio has been pledged for repurchase agreements or municipal deposits, leaving them unavailable for liquidation in the event of a liquidity crisis. A deep and prolonged disruption in the markets could have the effect of significantly restricting the accessibility of cost-effective capital and funding which could have a material adverse effect on our financial condition and results of operations.
Disruptions in financial markets may adversely affect us.
During 2007 through 2009, certain credit markets experienced difficult conditions, extraordinary volatility, and rapidly widening credit spreads and, therefore, provided significantly reduced availability of liquidity for many borrowers. Future uncertainties in these markets present significant challenges, particularly for the financial services industry. As a financial services company, our operations and financial condition are affected by economic and market conditions. For example, the need for funding by some large national banking organizations may increase certificate of deposit costs for participants in the brokered deposit market relative to other sources of funding such as Federal Home Loan Bank (“FHLB”) advances or repurchase agreements. Because the brokered certificate market provides the Company with the largest pool of potential new funding, higher wholesale certificate of deposit costs has an adverse impact on our net interest margin. During periods of market disruption, it is difficult to predict how long such economic conditions could exist, which of our products could ultimately be affected, and whether management’s actions will effectively mitigate these external factors. Accordingly, such factors could materially and adversely impact our financial condition and results of operations.
We operate in a highly competitive industry and market areas.
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national and super-regional banks as well as smaller community banks within the various markets in which we operate. However, we also face competition from many other types of financial institutions, including, without limitation, savings associations, credit unions, mortgage banking companies, finance companies, mutual funds, insurance companies, investment management firms, investment banking firms, broker-dealers, and other local, regional, and national financial services firms. The financial services industry could become even more competitive as a result of legislative, regulatory, and technological changes and continued consolidation. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Our ability to compete successfully depends on a number of factors, including, among other things:
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our ability to develop and execute strategic plans and initiatives;
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our ability to develop, maintain and build upon long-term customer relationships based on quality service, high ethical standards, and safe, sound assets;
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our ability to expand our market position;
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the scope, relevance, and pricing of products and services offered to meet customer needs and demands;
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the rate at which we introduce new products and services relative to our competitors; and
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industry and general economic trends.
Failure to perform in any of these areas could significantly weaken our competitive position, adversely affect our growth and profitability, and have a material adverse effect on our financial condition and results of operations.
Our profitability depends significantly on economic conditions in the central and northern Wisconsin geographic regions in which we operate.
Our success depends primarily on economic conditions in the markets in which we operate due to concentrations of loans and other business activities in geographic areas where our branches are principally located. The regional economic conditions in areas in which we conduct our business have an impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions caused by inflation, recession, an act of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets, or other factors, such as severe declines in
the value of homes and other real estate, could also impact these regional economies and, in turn, have a material adverse effect on our financial condition and results of operations.
Failure to maintain regulatory capital levels deemed to be “well capitalized” could limit our availability of wholesale funding and the level of rates that may be paid to local depositors, reducing our liquidity, increasing our costs, and limiting our ability to achieve asset growth.
To be considered “well capitalized” by banking regulatory agencies, we are subject to minimum capital levels defined by banking regulation that are based on total assets and risk adjusted assets. This highest regulatory capital designation is required to unilaterally participate in the brokered certificate of deposit market. In addition, being considered well capitalized is a key component of risk classification used by the Federal Home Loan Bank (“FHLB”) and the Federal Reserve concerning the amount of credit available to us and the type and amount of collateral required against such advances. Failure to retain the well capitalized regulatory designation would both limit the available of, and increase the cost of wholesale funding, which has been an important source of funding for growth. In addition, banks not considered to be well capitalized are subject to a cap on interest rates paid to depositors as published by the FDIC. Such depositor interest rate caps could impede our ability to raise local deposits to replace wholesale funding sources no longer available if we were not considered to be well capitalized which could have a material adverse effect on our business, financial condition, and results of operations.
We are subject to deposit insurance premiums and assessment by the FDIC to capitalize the Deposit Insurance Fund used to protect depositors in the event of a bank failure.
The Federal Deposit Insurance Corporation (“FDIC”) as an agency of the federal government is responsible for managing and supervising the Depository Insurance Fund (“DIF”) which is available to reimburse certain depositors against loss in the event of bank failure, in general up to $250,000 per depositor. Due to a significant number of recent bank failures, DIF resources have declined due to payouts to depositors. Members of the FDIC, which include essentially all of the United States banking industry, have in the past been the sole source of DIF funds. During 2009, the FDIC increased industry wide premiums, charged a special assessment, and collected a prepayment of premiums for estimated amounts due to the fund through 2012. Such actions were intended to recapitalize the DIF for costs related to future anticipated bank failures. As a member of the FDIC, our subsidiary Peoples State Bank is subject to ongoing FDIC insurance premiums and assessment. We are not able to reasonably predict the likelihood, amount, or timing of future FDIC insurance cost increases. If the rate of bank failures in the United States accelerated, we could be subject to increased premiums and special assessments to further recapitalize the DIF which would increase our deposit insurance expense and reduce our net income.
Potential acquisitions may disrupt our business and dilute shareholder value.
Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
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potential exposure to unknown or contingent liabilities of the acquired company;
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exposure to potential asset quality issues of the acquired company;
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difficulty and expense of integrating the operations and personnel of the acquired company;
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potential disruption to our business;
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potential diversion of our management’s time and attention;
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the possible loss of key employees and customers of the acquired company;
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difficulty in estimating the value (including goodwill) of the acquired company;
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difficulty in estimating the fair value of acquired assets, liabilities, and derivatives of the acquired company; and
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potential changes in banking or tax laws or regulations that may affect the acquired company.
We may evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, future mergers or acquisitions involving cash, or debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.
Our funding costs may increase if consumers decide not to use banks as their primary source to invest liquid or other personal assets.
While the banking industry has historically held a majority of available deposits, generational factors and trends in using other non-banking providers for investment of funds may reduce the level of deposits available to fund banking assets and increase the cost of funding. Demographic trends in the United States point to a growing transfer of wealth to the next generation in the following decades that could accelerate this transfer of wealth out of the banking system and into other non-banking providers. If this change occurs, our funding costs could increase and adversely affect our results of operations.
We may lose fee income and deposits if a significant portion of consumers decide not to use banks to complete their financial transactions.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks at one or both ends of the transaction. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits.
We may not be able to attract and retain skilled people.
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people can be intense and we may not be able to hire or retain the people we want or need. Although we maintain employment agreements with certain key employees, and have incentive compensation plans aimed, in part, at long-term employee retention, the unexpected loss of services of one or more of our key personnel could still occur, and such events may have a material adverse impact on our business because of the loss of the employee’s skills, knowledge of our market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.
We may not be able to implement new technologies necessary to remain competitive with other financial institutions.
The financial services industry continually undergoes rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Our largest competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
Our information systems may experience an interruption or breach in security.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security of these systems or unsuccessful conversion of such core system could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure, interruption, or security breach of our information systems, there can be no assurance that any such failure, interruption, or security breach will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failure, interruption, or security breach of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We are subject to operational risk.
We, like all businesses, are subject to operational risk, which represents the risk of loss resulting from human error, inadequate or failed internal processes and systems, and external events. Operational risk also encompasses compliance (legal) risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, regulations, prescribed practices, or ethical standards. Although we seek to mitigate operational risk through a system of internal controls, resulting losses from operational risk could take the form of explicit charges, increased operational costs, harm to our reputation, or foregone opportunities, any and all of which could have a material adverse effect on our financial condition and results of operations.
Our internal controls and procedures may fail or be circumvented.
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition, and results of operations.
Unexpected liabilities resulting from current or future claims or contingencies may have a material adverse effect on our business, financial condition, and results of operations.
We may be involved from time to time in a variety of litigation arising out of our business. Our insurance may not cover all claims that may be asserted against us, regardless of merit or eventual outcome, and such claims may harm our reputation. In addition, we may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms, if at all. Should the ultimate judgments or settlements in any actual or threatened claims or litigation exceed our insurance coverage, they could have a material adverse effect on our business, operating results, and financial condition.
We rely on dividends from our Peoples State Bank subsidiary for virtually all of our funds.
PSB is a legal entity separate and distinct from its subsidiary, Peoples State Bank. PSB receives substantially all of its cash flow from dividends from Peoples State Bank. These dividends are PSB’s principal source of funds to pay interest and principal on its debt and dividends on its common stock. Various laws and regulations limit the amount of dividends that Peoples State Bank may pay to PSB. Also, PSB’s right to participate in a distribution of assets upon Peoples State Bank’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event Peoples State Bank is unable to pay dividends to PSB, PSB may not be able to service its debt, pay its other obligations, or pay dividends on its common stock. The inability to receive dividends from Peoples State Bank could have a material adverse effect on PSB’s financial condition and results of operations.
Investors may not be able to liquidate their PSB common stock when desired because there is no active public trading market for PSB stock.
There is no active public established trading market for PSB stock. As a result, investors may not be able to resell shares at the price or time they desire. In addition, because our shares are thinly traded, there is oftentimes a significant spread between the “bid” and “ask” prices for our shares. These and other factors limit, to some extent, our ability to raise capital by selling additional shares of our stock.
Our articles of incorporation could make more difficult or discourage an acquisition of PSB.
Our articles of incorporation require the approval of two-thirds of all shares outstanding in order to effect a merger, share exchange, or other reorganization. This provision may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price, or otherwise adversely affect the market price of our common stock.
Our earnings may be adversely affected by changes in accounting principles and in tax laws.
Changes in U.S. generally accepted accounting principles could have a significant adverse effect on the Company’s reported financial results. Although these changes may not have an economic impact on our business, they could affect our ability to attain targeted levels for certain performance measures. We, like all businesses, are subject to tax laws, rules, and regulations. Changes to tax laws, rules, and regulations, including changes in the interpretation or implementation of tax laws, rules, and regulations by the Internal Revenue Service (the “IRS”) or other governmental bodies, could affect us in substantial and unpredictable ways. The Federal government could also choose to assess excise or other income related taxes targeted at the banking industry in response to widespread financial disruptions or perceived industry abuses that impacted taxpayers as a whole. Such changes could subject us to additional costs, among other things. Failure to appropriately comply with tax laws, rules, and regulations could result in sanctions by regulatory agencies, civil money penalties, and/or reputational damage, which could have a material adverse effect on our business, financial condition, and results of operations.
Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business.
Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, and/or cause us to incur additional expenses. Although management has established disaster recovery plans and procedures, the occurrence of any such event could have a material adverse effect on our business, financial condition, and results of operations.
Item 1B.
Item 1B.
UNRESOLVED STAFF COMMENTS.
Not applicable.
Item 2.
Item 2.
PROPERTIES.
Our administrative offices are housed in the same building as Peoples State Bank’s primary customer service location at 1905 West Stewart Avenue in Wausau, Wisconsin. Our other Wisconsin branch locations, in the order they were opened for business, include Rib Mountain, Marathon, Wausau (Eastside), Eagle River (in the Trig’s grocery store), Rhinelander, Minocqua, and Weston. The branch in the Trig’s grocery store occupies leased space within the supermarket designed for community banking operations. We own the other seven locations without encumbrance, and these locations are occupied solely by us and are suitable for current operations.
Based on information filed with regulators by other banking organizations headquartered in Wisconsin with at least $100 million in total assets, the average age of our banking facilities is in line with other banks. In addition, our average revenues and number of accounts per branch are similar to the state average, giving us adequate capacity for organic growth within existing markets reducing the need for significant further investment in existing facilities.
Item 3.
Item 3.
LEGAL PROCEEDINGS.
We are subject to claims and litigation in the ordinary course of business, but we do not believe that any of these claims or litigation matters that are currently outstanding will have a material adverse effect on our consolidated financial position, results of operations, or liquidity.
Item 4.
Item 4.
RESERVED.
PART II
Item 5.
Item 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market
PSB common stock bid and ask prices are quoted on the OTC Bulletin Board under the stock symbol “PSBQ.” There is no active established public trading market in our common stock and transactions in the stock are limited and sporadic. Approximately 3% of average shares outstanding traded during 2010 compared to 6% of shares outstanding during 2009.
Through 2007, we maintained an informal annual share repurchase program of up to 1% of outstanding shares per year, in addition to periodic tender offers for stock or other announced buyback programs when deemed advantageous. During 2008, traditional bank capital markets were severely disrupted due to an ongoing recessionary economy and decline in confidence in the nation’s banking system, which dramatically increased our cost and limited the availability of equity capital. To preserve existing capital, we did not repurchase any shares of our common stock during the three years ended December 31, 2010.
Holders
As of December 31, 2010, there were approximately 842 holders of record of our common stock. Some of our shares are held in “street” name brokerage accounts and the number of beneficial owners of these shares is not known and therefore not included in the foregoing number.
Dividends
We have paid regular and increasing dividends since our inception in 1995. We expect to continue our practice of paying semi-annual dividends on our common stock, although the payment of future dividends will continue to depend upon our earnings, capital requirements, financial condition, and other factors. The principal source of funds for our payment of dividends is dividend income received from our bank subsidiary. When declared, dividends are paid to all stockholders, including employees holding shares of unvested restricted stock as described in Item 8, Note 18 of the Notes to Consolidated Financial Statements. Payment of dividends by Peoples State Bank to PSB Holdings, Inc. is subject to various limitations under banking laws and regulations. To maintain a risk adjusted total capital ratio above the 10% regulatory minimum, the maximum amount of dividends that could have been paid by Peoples State Bank at December 31, 2010, was approximately $17.5 million. Furthermore, any Bank dividend distributions to PSB above customary levels are subject to approval by the FDIC, the Bank’s primary federal regulator.
Market Prices and Dividends
Price ranges of over-the-counter quotations and dividends declared per share on our common stock for the periods indicated are:
Prices detailed for the common stock represent the bid prices reported on the OTC Bulletin Board. The prices do not reflect retail mark-up, mark-down, or commissions, and may not necessarily represent actual transactions.
Item 6.
Item 6.
SELECTED FINANCIAL DATA.
Table 1: Earnings Summary and Selected Financial Data (dollars in thousands, except per share data)
Item 7.
Item 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Management’s discussion and analysis (“MD&A”) reviews significant factors with respect to our financial condition and results of our operations for each of the three years in the period ended December 31, 2010. The following MD&A concerning our operations is intended to satisfy three principal objectives:
·
Provide a narrative explanation of our financial statements that enables investors to see the company through the eyes of management.
·
Enhance the overall financial disclosure and provide the context within which our financial information should be analyzed.
·
Provide information about the quality of, and potential variability of, our earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
Management’s discussion and analysis, like other portions of this Annual Report on Form 10-K, includes forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, our anticipated future financial performance involves risks and uncertainties that may cause actual results to differ materially from those described in our forward-looking statements. A cautionary statement regarding forward-looking statements is set forth under the caption “Forward-Looking Statements” in Item 1A of this Annual Report on Form 10-K. This discussion and analysis should be considered in light of that cautionary statement.
This discussion should be read in conjunction with the consolidated financial statements, notes, tables, and the selected financial data presented elsewhere in this report. All figures are in thousands, except per share data and per employee data.
EXECUTIVE LEVEL OVERVIEW
Results of Operations
Earnings reached a record high of $3.04 per share in 2010 (on net income of $4,754) compared to earnings of $2.00 per share in 2009 (on net income of $3,116). During 2010, higher net interest margin increased tax equivalent net interest income $2,103, or 11.8%, while income also benefited from a $2,186, or 45%, decline in credit and foreclosure losses compared to 2009. Net interest income increased primarily from maintenance of interest rate floors on adjustable rate loans while deposit costs continued to fall. Offsetting this increase to income was decreased noninterest and fee income, down $213 during 2010, or 3.8%, primarily from 2009 recognition of a large gain on sale of securities. Other expense increases were from increased salaries and employee benefits of $1,015, up 13.6%, and higher other operating expense (excluding foreclosure costs) of $362, or 5.8%. Salaries and benefits expense increased primarily from an annual increase in base pay, fewer deferred loan origination costs, and increased year-end incentive and profit sharing expense based on net income levels achieved.
During 2011, we expect net interest income to remain similar to that seen during 2010, assuming low levels of organic asset growth. The initial period of a rising interest rate environment is expected to reduce net interest margin and potentially net interest income as funding costs increase with rising rates but floating rate loan yields remain at their floors for a time. During 2011, credit and foreclosure costs are expected to remain high, as we continue to work through existing problem loans and foreclosed assets in addition to expected higher levels of troubled debt restructured loans. Due to higher long-term interest rates on residential mortgages causing a decline in mortgage refinance activity, and regulatory changes impacting overdraft and debit card interchange income, we expect noninterest income to decline in 2011 compared to 2010.
Earnings were $2.00 per share in 2009 (on net income of $3,116) compared to earnings of $2.13 per share in 2008 (on net income of $3,301). However, both years experienced nonrecurring items related to sale of securities and disposal of premises and equipment. Pro-forma net income before these special items was $2,859 in 2009 and $3,909 in 2008, a net income decline of 27% during 2009. The 2009 decline was due to significantly higher provision for loan losses, loss on sale of foreclosed assets, and higher FDIC insurance expense. Offsetting a portion of these increased expenses were increases in net interest income from higher net interest margin and record levels of mortgage banking income. Each of these factors was influenced by falling market interest rates occurring during the national recession then in effect.
Liquidity
Total assets increased $14,239, or 2.3%, at December 31, 2010 compared to December 31, 2009. The majority of the increase was in cash and cash equivalents, up $13,994, as core deposits increased $16,186, or 4.9%. A decline in net loans receivable of $5,832, or 1.3%, primarily from lower commercial related loans was offset by increased investment securities and purchased bank certificates of deposit totaling $4,678, up 4.4%. An increase in other borrowings and stockholders’ equity of $7,521 along with the increase in deposits previously mentioned contributed to a reduction in wholesale deposits and FHLB advances of $11,089 during 2010. Brokered deposits, FHLB advances and wholesale repurchase agreements were $137,765 at December 31, 2010, down $18,089, or 11.6%, from $155,854 at December 31, 2009
The core deposit increase in 2010 was driven by a $9,989 increase in our Rewards Checking high yielding NOW account and a large $7,167 commercial money market account opened during 2010 by a related party. In addition, 2010 funding levels were increased $8,585 at December 31, 2010 from a local commercial customer overnight repurchase agreement opened during 2010. The large commercial account balances are seasonal and expected to fluctuate significantly during 2011. Asset growth during 2011 is expected to be negatively impacted by a decline in these large deposit balances combined with projected low levels of organic loan and asset growth.
Our most significant sources of liquidity and wholesale funding include federal funds purchased from correspondent banks, FHLB advances, brokered certificates of deposit, and Federal Discount Window advances. In addition to the federal funds sold position of $30,503, we have $211,101 of unused funding available at December 31, 2010, which is considered adequate to meet customer, operational, and growth needs during 2011. Most of our wholesale funding sources require either pledging of assets, maintenance of well-capitalized regulatory status, or additional purchases of FHLB capital stock (or all of these items) to continue or expand participation in the funding program. In particular, approximately $25 million of potential FHLB advance funding considered available at December 31, 2010 would require additional purchase of their capital stock, which pays a nominal dividend and for which no trading market exists.
Total assets increased $36,368, or 6.4% to $606,854 at December 31, 2009 compared to 2008. The majority of the increase over 2008 included increased cash and cash equivalents and increased commercial real estate mortgage lending. Local deposits increased $18,584, or 5.1% (primarily from increased Rewards Checking NOW balances and governmental deposits) while wholesale funding increased $8,284, or 5.3% during 2009 (primarily brokered deposits). Another $7,000 in funding was received from issuance of 8% Senior Subordinated Notes to bolster our regulatory total capital position.
Capital Resources
We are considered well-capitalized under regulatory capital rules with total risk adjusted capital of 14.27% at December 31, 2010 compared to 12.49% at December 31, 2009. Current regulations require a minimum total risk adjusted capital ratio of 10.00% to be considered well-capitalized. During 2010, total risk weighted assets declined from recognition of certain five or more family real estate mortgage loans as subject to 50% risk weighting, rather than the 100% risk weighting assigned in prior years. In addition, we were relieved of a guarantee liability on customer debt to a correspondent bank during 2010 which further reduced risk weighted assets and increased the total risk adjusted capital ratio. These changes, along with retained 2010 net income, increased total regulatory capital significantly higher than 2009. On a book basis, total tangible common equity reflected on the December 31, 2010 Consolidated Balance Sheets was 7.52% compared to 6.97% at December 31, 2009. In response to recent legislation, banking regulatory agencies are expected to announce higher minimum capital standards for banks to be considered well capitalized during 2011.
We issued $7,000 of 8% senior subordinated notes during 2009 which mature in 2019. Approximately 23% of our total regulatory capital is comprised of debt instruments including junior and senior debentures and notes which, unlike common stock, require quarterly payments of interest. Therefore, although no current plans exist, future capital needs during the next several years would likely be met by issuance of our authorized common or preferred stock as needed. Due to relatively high cost of capital options, we do not expect to buyback significant treasury stock shares during 2011, although we do expect to continue to pay our traditional semi-annual cash dividend assuming continued profitable operations and projections of adequate future capital levels for growth and credit risk. In addition, potential growth through merger and acquisition activities should be expected to drain excess capital levels and increase the likelihood of a new common or preferred stock capital raise, potentially diluting existing stockholders.
Off-Balance-Sheet Arrangements and Contractual Obligations
Our largest volume off-balance sheet activity involves our servicing of payments and related collection activities on approximately $260 million of residential 1 to 4 family mortgages sold to FHLB and FNMA, up from $238 million at December 31, 2009. Serviced mortgage loans continue to increase from customer refinance activity, a trend which began during 2009 when serviced loans increased $52 million, or 28%, and continued with serviced loans increasing $22 million , or 9.4% during 2010. We do not expect to see such significant growth in serviced loans in future years. Recent proposals by the U.S. Treasury concerning FNMA and the FHLB could reduce the amount of annual servicing income (currently .25% of serviced mortgage balances annually) paid to us to service future mortgages originated and sold to them.
We have provided a credit enhancement against FHLB loss on approximately 27% of the serviced principal, up to a maximum guarantee of $1.9 million in the aggregate. However, we would incur such loss only if the FHLB first lost $2.0 million on this loan pool of approximately $70 million. No sold loans have received our credit enhancement guarantee of principal since October 2008 and we have no intentions of originating future loans with the guarantee.
Since inception of our pools containing guarantees to the FHLB in 2000, only $0.2 million of $425 million of loans originated with guarantees have incurred a principal loss, all of which has been borne by the FHLB within their First Loss Account.
All loans sold to FHLB or FNMA in which we retain the loan servicing are subject to underwriting representations and warranties made by us as the originator and we are subject to annual underwriting audits from both entities. Our representations and warranties would allow FHLB or FNMA to require us to repurchase inadequately originated loans for any number of underwriting violations. We have originated loans to these secondary market providers since 2000 and have never been required to repurchase a loan for underwriting or servicing violations and do not expected to be required to repurchase loans in the near term.
We provide various commitments to extend credit for both commercial and consumer purposes totaling approximately $98 million at December 31, 2010 compared to $88 million at December 31, 2009. These lending commitments are a traditional and customary part of lending operations and many of the commitments are expected to expire without being drawn upon.
Our primary long-term contractual obligations are related to repayment of funding sources such as FHLB advances, long-term other borrowings, and customer time deposits, which make up 93% of our total long-term contractual obligations. For all contractual obligations outstanding at December 31, 2010, 35% will require repayment or refinancing during 2011 although 92% of these 2011 obligations represent time deposits taken in the normal course of business.
RESULTS OF OPERATIONS
Earnings
Table 1 of Item 6 of this Annual Report on Form 10-K presents various financial performance ratios and measures for each of the five years in the period ended December 31, 2010. A number of separate or nonrecurring factors impacted our earnings during the past several years. Table 2 presents our net income for each of the five years in the period ended December 31, 2010, before certain tax-adjusted nonrecurring income and expense items.
Table 2: Summary Operating Income
2010 compared to 2009
Earnings reached a record high of $3.04 per share during 2010, an increase of 52% over 2009 earnings of $2.00 per share. Increased earnings were led by higher net interest income of $2,148 (up 12.7% from increased net interest margin) and significantly lower credit and foreclosure costs, down $2,186 (45%) from 2009. 2010 earnings also benefited from continued high levels of mortgage banking refinance income, which although less than in 2009, continued at historically high levels. Service fees increased $338, or 23.3% from changes to our customer courtesy overdraft program during 2010 which recognized increased customer overdraft activity.
These increases to income were offset by higher salaries and employee benefits, up $1,105 (13.6%) from several factors including an annual increase in base wages, lower deferral of direct loan origination expenses, and higher year-end incentive costs from meeting income growth goals. Data processing costs increased $217, or 22.7%, due in part to conversion to a new service bureau data processing system and related training and implementation costs. Because the initial data processing contract called for reduced fees during the initial implementation period, data processing fees are expected to increase significantly during 2011.
Return on average assets and average equity was .79% and 10.59%, respectively during the year ended December 31, 2010 compared to return on average assets and average equity of .54% and 7.38%, respectively, during the year ended December 31, 2009.
During 2011, we expect net margin to decline slightly compared to levels seen during 2010 combined with low organic earning asset growth for similar levels of net interest income compared to 2010. Rising interest rates are expected to pressure net interest margin and income as “in the money” interest rate floors begin to lose value while funding costs rise. Credit and foreclosure costs are expected to remain high with amounts at least as high as those seen during 2010. 2011 mortgage banking income is expected to decline 30% to 35% ($500) compared to the amounts seen during 2010 as long-term mortgage rates rise over historically low levels seen during the past year with the majority of borrowers already having refinanced their long-term fixed rate residential mortgages. Lastly, expected regulatory limitations on bank debit card interchange income are expected to reduce noninterest income. Taken together, we expect 2011 noninterest income to be lower than seen during 2010.
2009 compared to 2008
Earnings were $2.00 per share during 2009 on net income of $3,116 which declined 6% from 2008 earnings of $2.13 per share on net income of 3,301. However, earnings per share before special or nonrecurring items were $1.83 in 2009 on pro-forma net income of $2,859 compared to $2.52 in 2008 on pro-forma net income of $3,909, a decline of $1,050, or 27%. The net decline in 2009 was due primarily to significantly greater credit related costs including combined provision for loan losses and loss on foreclosed assets expense of $4,830 during 2009 compared to $891 in 2008, an increase of over 500%. These increased credit costs reduced 2009 net income by approximately $2,387 after income tax benefits compared to 2008. During 2009, the ongoing national economic recession that began during 2008 reduced borrower ability to repay loans due to us, increasing current net charge offs during 2009 as well as our estimate of future charge offs from existing economic factors. The majority of the loss on foreclosed assets was a $1,004 loss on a large land development foreclosure taken to auction during 2009.
In addition to credit losses, FDIC insurance expense premiums increased from $284 in 2008 to $986 in 2009 as Deposit Insurance Fund (“DIF”) reserves declined from payouts to certain depositors of failed banks in the United States. FDIC insured banks as an industry were required to pay increased quarterly premiums as well as a special assessment to recapitalize the DIF. Increased 2009 FDIC insurance expense lowered net income by approximately $425 after tax benefits compared to 2008.
Offsetting these increased expenses, tax adjusted net interest income and mortgage banking income increased $3,365 during 2009 compared to 2008 due to falling market interest rates caused by the economic recession. The low interest rate environment prompted customers to refinance residential mortgages with us which we subsequently sold on the secondary market. We also increased net interest income as very low short-term interest rates were used to fund moderately longer dated and higher yielding loans and securities including adjustable rate loans with interest rate floors. These factors increased 2009 net income by approximately $2,039 after tax expense.
Return on average assets and average equity was .54% and 7.38%, respectively during the year ended December 31, 2009 compared to return on average assets and average equity of .61% and 8.63%, respectively, during the year ended December 31, 2008. Excluding the 2008 FNMA preferred stock write-down, return on average assets would have been .72% during 2008 and return on average equity would have been 10.20%.
2008 compared to 2007
Earnings per share declined from $2.64 per diluted share during 2007 to $2.13 per share during 2008. However, two significant non-recurring items impact the comparison of earnings between 2008 and 2007. During 2008, earnings per share were reduced $.39 per share ($600) from recognition of other than temporary impairment to the historical cost basis of our investment in FNMA preferred stock. During 2007, earnings increased $.13 per share ($200) from a favorable decision in Tax Court. If these non-recurring items were excluded as shown in Table 2, diluted earnings per share would have been $2.52 in 2008 compared to $2.50 during 2007. Although earning assets grew by 7.4% during 2008 compared to 2007, net interest income increased only slightly during 2008 due to a decline in net interest margin. In addition, the provision for loan losses increased to $885 during 2008 compared to $480 during 2007. The combination of lower net interest margin and increased loan loss provision costs caused 2008 income to remain similar to 2007 despite growth in earning assets.
Return on average assets and average equity was .61% and 8.63%, respectively, during the year ended December 31, 2008. Return on average assets and average equity was .82% and 11.79%, respectively, during the year ended December 31, 2007. Excluding the 2008 FNMA preferred stock write-down and the prior year Tax Court decision reduction to tax expense, return on average assets would have been .72% and .78% during 2008 and 2007, respectively, and return on average equity would have been 10.20% and 11.22% during 2008 and 2007, respectively.
Balance Sheet Changes and Analysis
Summary balance sheets at December 31 for each of the five years in the period ended December 31, 2010 are presented in Table 1 of Item 6 to this Annual Report on Form 10-K. Total assets increased $14,239, or 2.3%, during the year ended December 31, 2010, after increasing $36,368 (6.4%) during the year ended December 31, 2009 and increasing $36,301 (6.8%) during the year ended December 31, 2008. The asset growth rate declined during 2010 compared to prior years from lower new customer credit originations resulting in a net decline in loans receivable totaling $5,832, or 1.3% (primarily commercial real estate loans). Presented in Table 3 below is a summary balance sheet for the five years ended December 31, 2010 as a percentage of total assets.
Table 3: Summary Balance Sheet as a Percent of Total Assets
2010 compared to 2009
Total assets were $621,093 at December 31, 2010 compared to $606,854 at December 31, 2009, an increase of $14,239, or 2.3%. The majority of the increase was reflected in increased cash and cash equivalents, up $13,994, or 53% during 2010. Commercial related loans declined $9,128 (2.7%) as locally owned small and medium sized business credit demand declined and we continued to work out of existing problem credits. Offsetting the decline in loan balances were increased investment securities and purchased certificates of deposit, which increased $4,678, or 4.4%, and an increase in residential mortgage lending, up $4,506, or 4.4%.
Core deposits increased $16,186, or 4.9% during 2010, although increases in interest bearing demand and money market deposits of $25,512 (13.6%) offset a $7,819 decline (7.0%) in local certificates of deposit. The combination of low customer loan demand and unusually high local competitor certificate of deposit pricing lessoned our demand for local certificate of deposit funding and contributed to the decline in balances. At December 31, 2010, money market funding included $7,167 from a new account relationship obtained during the year from a related party. In addition to the increase in local deposits, overnight repurchase agreement funding from local customers (reflected as other borrowings) increased $10,101, or 128%, during 2010 from acquisition of a new account relationship totaling $8,585 at December 31, 2010. These two large commercial relationships totaling $15,752 at December 31, 2010 are seasonal and expected to decline during 2011.
Increased local deposits were used to repay wholesale deposits and FHLB advances during 2010, which declined $11,089, or 8.2%. All wholesale funding, including brokered deposits, FHLB advances, and wholesale other borrowings declined $18,089, or 11.6%, to $137,765 during 2010 compared to $155,854 at December 31, 2009 and $150,349 at December 31, 2008. Wholesale funding to total assets was 22.2% and 25.7% at December 31, 2010, and 2009, respectively.
2009 compared to 2008
Total assets were $606,854 at December 31, 2009 compared to $570,486 at December 31, 2008, an increase of $36,368. The majority of the increase came from increased cash and cash equivalents of $13,165 (up nearly 100%) and increased commercial real estate mortgage loans of $13,255 (up 6.9%). All other gross loans increased $1,588 (less than a 1% change) and investment securities increased $3,255 (up 3.2%). Foreclosed properties also increased $3,255, primarily from addition of a large land development loan taken to auction for sale during 2009 in which some properties were not sold due to the auction reserve not being met. These properties represented $2,050 of total foreclosed properties held at December 31, 2009.
The increase in cash at December 31, 2009 was due to receipt of large governmental entity deposits related to year-end tax collections and certain balance sheet strategies to extend the average fixed rate term of wholesale funding at the same time these government funds increased.
Other assets of $5,612 as reflected on the December 31, 2009 Consolidated Balance Sheets increased $3,757 over the prior year due to prepayment of estimated FDIC insurance premiums through 2012 as required by the DIF. This prepayment represented $2,535 of the other asset increase during 2009.
Core deposits provided much of the funding for 2009 asset growth and increased $29,916 (up 10.0%). This increase was partially offset by a decline in local jumbo certificates of deposit greater than $100 of $11,332 (down 18.0%). Taken together, local deposits increased $18,584, or 5.1% during 2009. The decline in local large certificates was driven by very low wholesale brokered certificate interest rates with such certificates and other wholesale deposits increasing $12,346 (up 19.0%). A new capital issue of 8% Senior Subordinated Notes raised $7,000 of funding while maturing FHLB advances were paid down by $6,841 (down 10.5%). All wholesale funding, including brokered deposits, FHLB advances, and wholesale other borrowings grew $5,505, or 3.7%, to $155,854 during 2009 compared to $150,349 at December 31, 2008. Wholesale funding to total assets was 25.7% and 26.4% at December 31, 2009, and 2008, respectively.
Net Interest Income
Net interest income represents the difference between interest earned on loans, securities, and other interest-earning assets, and the interest expense associated with the deposits and borrowings that fund them. Interest rate fluctuations together with changes in volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. Additionally, net interest income is impacted by the sensitivity of the balance sheet to change in interest rates, contractual maturities, and repricing frequencies. Net interest income is our most significant item of revenue generated by operations.
Table 4 presents changes in the mix of average earning assets and interest bearing liabilities for the three years ending December 31, 2010. In general, net interest income earned on loans and savings and demand deposits is greater than that earned on securities and time deposits. Therefore, a balance sheet that contains a growing allocation of loans funded by a growing allocation of savings and demand deposits would normally provide greater net interest income than a growing allocation of securities funded by a growing allocation of time deposits.
Table 4: Mix of Average Interest Earning Assets and Average Interest Bearing Liabilities
Tables 5, 6, and 7 present average balance sheet data and related average interest rates on a tax equivalent basis and the impact of changes in the earnings assets base for the three years in the period ended December 31, 2010.
Table 5: Average Balances and Interest Rates
(1) Nonaccrual loans are included in the daily average loan balances outstanding.
(2) The yield on tax-exempt loans and securities is computed on a tax-equivalent basis using a tax rate of 34%.
(3) Loan fees are included in total interest income as follows: 2010 - $678, 2009 - $678, 2008 - $394.
Table 6: Interest Income and Expense Volume and Rate Analysis
(1)
The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
(2)
The yield on tax-exempt loans and investment securities has been adjusted to its fully taxable equivalent using a 34% tax rate.
Table 7: Yield on Earning Assets
2010 compared to 2009
Cost of funding continued to decline much faster than loan yields during 2010 as loan yields were supported by placement of interest rate floors on floating rate loans. Tax adjusted net interest income increased 11.8% during 2010 with net interest margin increasing to 3.51% from 3.25% in 2009. The coupon rate on approximately 23% of gross loans at December 31, 2010 was supported by an average interest rate floor approximately 150 basis points greater than the normal adjustable rate.
Impacts during and following the close of a national recession and government actions to support the economy, including actions by the Federal Reserve, reduced funding costs while loan yields declined more slowly as credit spreads remained high for borrower risk across the banking industry. During 2010, loan yields were stable at 5.77% compared to 5.76% during 2009, while the cost of deposits (including noninterest bearing deposits) declined .47% to 1.53% from 2.00% during 2009. This .48% improvement in loan yields compared to deposit costs drove net interest margin to increase from 3.25% to 3.51% during 2010, an increase of .26%. Tempering the increase in loan to deposit spreads was a decline in yields on securities and other earnings assets of .71% to 3.93% while non-deposit liability funding (including Senior Subordinated Note and junior subordinated debenture funding) declined just .16% to 3.64%. Average nonaccrual loans totaled $10,506 during 2010 compared to $12,190 during 2009. Based on the average loan yield during 2010, the decrease in nonaccrual loans increased net interest margin by approximately 2 basis points during 2010 compared to 2009. For the year, cumulative average nonaccrual loans reduced net interest margin by approximately 11 basis points.
Average earning assets grew $20,493, or 3.7% during 2010, driven by an increase in overnight interest bearing funds of $7,912, or (138%) and an increase in average loans of $8,029, or 1.8%. Average interest bearing liabilities increased $19,929, or 4.2% during 2010. The primary source of increased average local funding was in our Rewards Checking product, which increased $11,651, or 36.9% during 2010 after growing $14,815, or 88.2% during 2009.
Tax adjusted net interest income increased $2,103, or 11.8% to $19,911 during 2010 compared to $17,808 in 2009. An increase in average earning assets (changes in volume) contributed $480 of the increase in net interest income while changes in rate from an increase in net interest margin contributed $1,623 of the increase.
As short term interest rates reached historically low levels during 2010, yields on adjustable rate loans tied to the prime and 30 day LIBOR rates had the potential to reprice to rates less than 3.00%. To avoid the negative impacts to net interest margin and to appropriately price for credit risk in the current market, we had begun to systematically insert interest rate floors on commercial related adjustable rate loans and residential mortgage home equity lines of credit upon renewal during 2009 and continued this practice during 2010. At December 31, 2010, approximately 94% of our $111 million in adjustable rate loans carried a contractual interest rate floor and of those loans with floors, approximately 98% carried current loan yields in excess of the normal adjustable rate coupon due to the interest rate floor. The weighted average amount in which actual loan yields were supported by the “in the money” loan rate floor was approximately 150 basis points on $102 million of adjustable rate loans at December 31, 2010. The annualized increase to net interest income and net interest margin was approximately $1,537 and .27%, respectively based on these existing loan floors and average total earning assets for the year ended December 31, 2010 if interest rates were assumed to remain the same. During a period of rising short-term interest rates, we expect average funding costs (which are not currently subject to contractual caps on the interest rate) to rise while the yield on loans with interest rate floors would remain the same until such loans’ adjustable rate index caused coupon rates to exceed the loan rate floor. The speed in which short-term interest rates increase is expected to have a significant impact on net interest income from loans with interest rate floors. Quickly rising short-term rates would allow adjustable rate loans with floors to reprice to rates higher than the existing floor more quickly, impacting net interest income less adversely than if short-term rates rose slowly or deliberately.
Because a future increase in short-term funding rates could cause a mismatch between floating rate loan yields and short-term funding costs due to existing interest rate floors, such positions are modeled and reviewed as part of our asset-liability management strategy each quarter. Current interest rate simulations based on more extreme rate scenarios such as short-term rates up 500 basis points combined with a flattening of the yield curve during a 12 month period could reduce net interest income by 4.9% to 5.0% ($580 to $587 after tax impacts) per year during the first two years of the rate increase. We seek to minimize this interest rate risk exposure in part by extending the average fixed rate period of wholesale funding, which is approximately 22% of total assets.
During 2011, we expect net interest margin to decline slightly from that seen during 2010 as deposit rates stabilize and we consider the prospect of rising short-term interest rates (lowering the current benefit to net interest income from loan rate floors) later in the year. In addition, yield on securities is expected to trend significantly lower which impacts approximately 19% of total average earning assets. The most likely scenario in a 2011 rising rate environment is for quarterly net interest margin to decline as the year progresses. Higher net interest margin during periods of low loan growth has been an important driver of increased net income. Even if market rates remain the same during 2011, a decline in net margin without offsetting loan growth would decrease net income.
2009 compared to 2008
Cost of funding declined much faster than loan yields during 2009 in part due to systematic insertion of loan interest rate floors upon renewal during the year. Tax adjusted net interest income increased nearly 17% during 2009 with net interest margin increasing to 3.25% from 2.98% in 2008. The coupon rate on approximately 24% of gross loans at December 31, 2009 was supported by an average interest rate floor 150 basis points greater than the normal adjustable rate.
During 2009, falling short-term interest rates caused by a national recession and government actions to support the economy, including actions by the Federal Reserve, reduced funding costs while loan yields declined more slowly as credit spreads increased for borrower risk across the banking industry. During 2009, loan yields declined .46% to 5.76% while the cost of deposits (including noninterest bearing deposits) declined .86% to 2.00%. This .40% improvement in loan yields compared to deposit costs drove net interest margin to increase from 2.98% to 3.25% during 2009, an increase of .27%. Tempering the increase in loan to deposit spreads was a decline in yields on securities and other earnings assets of .52% to 4.64% while non-deposit liability funding (including Senior Subordinated Note and junior subordinated debenture funding) declined just .30% to 3.80%. Average nonaccrual loans totaled $12,190 during 2009 compared to $6,810 during 2008. Based on the average loan yield during 2009, the increase in nonaccrual loans lowered net interest margin by approximately 6 basis points during 2009 compared to 2008.
Average earning assets grew $35,121, or 6.9% during 2009, driven by an increase in average loans of $29,836, or 7.4%. Average interest bearing liabilities increased $28,474, or 6.3% with the remaining source of average funding coming from a 8.1% increase in noninterest bearing deposits ($4,105) and increased stockholders’ equity of $3,960. The primary source of increased average local funding was in our Rewards Checking product, which increased $14,815, or 88.2% during 2009.
Tax adjusted net interest income increased $2,555, or 16.8% to $17,808 during 2009 compared to $15,253 in 2008. An increase in average earning assets (changes in volume) contributed $1,164 of the increase in net interest income while changes in rate from an increase in net interest margin contributed $1,391 of the increase.
As short term interest rates continued to fall during 2009, yields on adjustable rate loans tied to the prime and 30 day LIBOR rates had the potential to reprice at very low yields. To avoid the negative impacts to net interest margin and to appropriately price for credit risk in the current market, we began to systematically insert interest rate floors on commercial related adjustable rate loans and residential mortgage home equity lines of credit upon renewal. At December 31, 2009, approximately 85% of our $129 million in adjustable rate loans carried a contractual interest rate floor and of those loans with floors, approximately 97% carried current loan yields in excess of the normal adjustable rate coupon due to the interest rate floor. The weighted average amount in which actual loan yields were supported by the “in the money” loan rate floor was approximately 150 basis points on $106 million of adjustable rate loans at December 31, 2009. The annualized increase to net interest income and net interest margin was approximately $1,588 and .28%, respectively based on these existing loan floors and total average earning assets for the year ended December 31, 2009 if interest rates were assumed to remain the same.
Net interest income during 2009 benefited from incremental investment income from a leveraged security purchase completed late in 2007. In the transaction, we purchased approximately $15,000 in mortgage backed securities funded by $13,500 of a mix of floating rate and fixed rate structured repurchase agreement funding. The initial spread on the transaction was 1.39% at closing. During 2009, an increase in credit spreads on mortgage related products combined with falling short-term rates worked together to increase the transaction spread to an average of 2.97% during 2009 compared to an average spread of 2.24% during 2008. This transaction added approximately $99 in additional net interest income during 2009 compared to 2008 and approximately $401 of total gross leveraged investment net interest income during 2009. Details on the structure of the related purchase agreements can be found in Item 8, Note 10 of the Notes to Consolidated Financial Statements. The funding source for this leverage security transaction reset from a short-term floating rate to a long-term fixed rate late in 2009, reducing the current transaction spread to less than 1.00%. The decline in transaction spread reduced 2010 net interest income from this arrangement by approximately $266 compared to 2009.
2008 compared to 2007
Average earnings assets grew 7.4% ($35,385), but tax adjusted net interest income increased only 2.4% ($357) during 2008 compared to 2007. Due to a decline in net interest margin from 3.12% in 2007 to 2.98% in 2008, the increase of $939 to net interest income from earning asset growth was offset $582 from the impact of a lower margin. The yield on average loans fell 91 basis points from 7.13% to 6.22% from the impact of falling interest rates during 2008, particularly short-term rates such as the prime rate. During 2008, the prime rate fell from 7.25% to 3.25%, which lowered the loan yield on the adjustable rate loan portfolio. During 2008, approximately 34% of the loan portfolio were adjustable rate loans. Deposit rates also declined during 2008, by 81 basis points, from 4.07% to 3.26%. Because loans make up a substantial majority of earning assets, and deposits make up a substantial majority interest bearing liabilities, a decline in loan yields greater than in deposit costs led to a decline in the net yield on interest-earning assets. Loan yields in 2008 were also depressed by an increase in nonaccrual loans compared to 2007. During 2008, average nonaccrual loans totaled $6,810 compared to $3,469 during 2007. Based on the average loan yield during 2008, the increase in nonaccrual loans lowered net interest margin by 4 basis points during 2008 compared to 2007.
Net interest income during 2008 benefited from incremental investment income from a leveraged security purchase completed late in 2007 discussed previously. The initial spread on the transaction was 1.39% at closing. However, during 2008, an increase in credit spreads on mortgage related products combined with falling short-term rates worked together to increase the transaction spread to an average of 2.24% during 2008. This transaction added approximately $270 in additional net interest income during 2008 compared to 2007.
Interest Rate Sensitivity
We incur market risk primarily from interest-rate risk inherent in our lending and deposit taking activities. Market risk is the risk of loss from adverse changes in market prices and rates. We actively monitor and manage our interest-rate risk exposure. The measurement of the market risk associated with financial instruments (such as loans and deposits) is meaningful only when all related and offsetting on- and off-balance sheet transactions are aggregated, and the resulting net positions are identified. Disclosures about the fair value of financial instruments that reflect changes in market prices and rates can be found in Item 8, Note 22 of the Notes to Consolidated Financial Statements.
Our primary objective in managing interest-rate risk is to minimize the adverse impact of changes in interest rates on net interest income and capital, while adjusting the asset-liability structure to obtain the maximum yield-cost spread on that structure. We rely primarily on our asset-liability structure reflected on the Consolidated Balance Sheets to control interest-rate risk. In general, longer-term earning assets are funded by shorter-term funding sources allowing us to earn net interest income on both the credit risk taken on assets and the yield curve of market interest rates. However, a sudden and substantial change in interest rates may adversely impact earnings, to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. We do not engage in significant trading activities to enhance earnings or for hedging purposes.
Our overall strategy is to coordinate the volume of rate sensitive assets and liabilities to minimize the impact of interest rate movement on the net interest margin. Table 8 represents our earnings sensitivity to changes in interest rates at December 31, 2010. It is a static indicator which does not reflect various repricing characteristics and may not indicate the sensitivity of net interest income in a changing interest rate environment, particularly during periods when the interest yield curve is flattening or steepening. The following repricing methodologies should be noted:
1.
Money market deposit accounts are considered fully repriced within 90 days. Rewards Checking NOW accounts are considered fully repriced within one year. Other NOW and savings accounts are considered “core” deposits as they are generally insensitive to interest rate changes. These deposits are generally considered to reprice beyond five years.
2.
Nonaccrual loans are considered to reprice beyond 5 years.
3.
Assets and liabilities with contractual calls or prepayment options are repriced according to the likelihood of the call or prepayment being exercised in the current interest rate environment.
4.
Measurements taking into account the impact of rising or falling interest rates are based on a parallel yield curve change that is fully implemented within a 12-month time horizon.
Table 8 reflects a liability sensitive (“negative”) gap position during the next year, with a cumulative one-year gap ratio as of December 31, 2010 of 93.0% compared to a negative gap of 87.6% at December 31, 2009. In general, a current negative gap would be unfavorable in a rising interest rate environment but favorable in a falling rate environment. However, net interest income is impacted not only by the timing of product repricing, but the extent of the change in pricing which could be severely limited from local competitive pressures. This factor can result in changes to net interest income from changing interest rates different than expected from review of the gap table.
Table 8: Interest Rate Sensitivity Analysis
We use financial modeling policies and techniques to measure interest rate risk. These policies are intended to limit exposure of earnings at risk. A formal liquidity contingency plan exists that directs management to the least expensive liquidity sources to fund sudden and unanticipated liquidity needs (Refer to the section labeled “LIQUIDITY” contained in this Annual Report on Form 10-K). We also use various policy measures to assess interest rate risk as described below.
Interest Rate Risk Limits
We balance the need for liquidity with the opportunity for increased net interest income available from longer term loans held for investment and securities. To measure the impact on net interest income from interest rate changes, we model interest rate simulations on a quarterly basis. Our policy is that projected net interest income over the next 12 months will not be reduced by more than 15% given a change in interest rates of up to 200 basis points. Table 9 presents the projected impact to net interest income by certain rate change scenarios and the change to the one year cumulative ratio of rate sensitive assets to rate sensitive liabilities.
Table 9: Net Interest Margin Rate Simulation Impacts
Note:
Simulations after December 2007 reflect net interest income changes from a down 100 basis point scenario, rather than a down 200 basis point scenario as dictated by internal policy due to the currently low level of relative short-term rates.
To assess whether interest rate sensitivity beyond one year helps mitigate or exacerbate the short-term rate sensitive position, a quarterly measure of core funding utilization is made. Core funding is defined as liabilities with a maturity in excess of 60 months and capital. Core deposits including DDA, NOW, and non-maturity savings accounts (except high yield NOW such as Rewards Checking deposits and money market accounts) are also considered core long-term funding sources. The core funding utilization ratio is defined as assets that reprice in excess of 60 months divided by core funding. Our target for the core funding utilization ratio is to remain at 80% or below given the same 200 basis point changes in rates that apply to the guidelines for interest rate risk limits exposure described previously. Our core funding utilization ratio after a projected 200 basis point increase in rates was 76.7% at December 31, 2010 compared to 81.6% and 75.6% at December 31, 2009 and 2008, respectively.
The increase in the core funding utilization ratio at December 31, 2009 compared to 2008 in the up 200 basis point scenario was due to projected extension in principal payments on residential mortgage loans held in the loan portfolio as well as residential mortgage related securities held in the investment securities portfolio. At December 31, 2009, in the up 200 basis point scenario, securities and loan principal to reprice in 5 years or longer increased approximately $16,635, or 25%. Over 80% of this change was due to changes related to residential mortgage loans or related securities. Although above the internal target of 80%, this level was considered manageable and monitored quarterly.
At December 31, 2010, internal interest rate simulations that maintained the current shape of the yield curve (often referred to as “parallel yield curve shifts”) estimated relatively small projected changes to future years’ net interest income, even with more extreme interest rate changes such as up 400 basis points during a 24 month period. However, if interest rates were to increase more quickly than anticipated and if the yield curve flattened at the same time, such as in a “flat up 500 basis point” change occurring during 2011, net interest income would decline during the first two years of the simulation in amounts ranging from 4.9% to 5.0% of the base simulation’s net interest income. When the yield curve flattens, repriced short-term funding cost, such as for terms of 1 year or less increases, while maturing fixed rate balloon loans, such as with terms from 3 to 5 years, increase much less. During flattening periods, assets and liabilities may reprice at the same time but to a much different extent.
During the next two years, interest rates could rise to levels significantly greater than today and exhibit a flattening interest yield curve. To minimize such interest rate risk, we extend the average fixed term of our wholesale funding portfolio of brokered certificates and FHLB advances. Extending such funding may decrease net interest income in the current environment (since funding with short-term interest rate costs would be less expensive), but does provide protection against rising interest rates in future years. We anticipate the average fixed term of the wholesale funding portfolio to continue to exceed approximately 30 months during 2011 as it did during 2010. Wholesale funding was 22.2% of total assets at December 31, 2010.
During 2010, our junior subordinated debentures issued during 2005 reset to a floating rate scheduled to change quarterly with a spread over the 90 day LIBOR rate. At that time, we entered into an interest rate swap maturing in September 2017 to convert those floating rate payments to a fixed rate of 4.42%, down from the prior fixed rate of 5.82%. The decrease in fixed interest rate is expected to reduce interest expense on the junior subordinated debentures by $105 per year.
Investment Securities Portfolio
The investment securities portfolio is intended to provide us with adequate liquidity, flexible asset/liability management, and a source of stable income. During 2009 and 2008, all securities were classified as available for sale and reported at fair value. Unrealized gains and losses were excluded from earnings, but reported as other comprehensive income in a separate component of stockholders’ equity, net of income tax. However, during 2010, the municipal security portfolio and nonrated trust preferred securities and senior subordinated notes with fair value totaling $54,130 (including unrealized gain of $2,552) were transferred from securities available for sale to securities available for maturity. These securities were transferred to better reflect our intent and practice to hold these long-term securities until maturity and to minimize potential volatility to stockholders’ equity from future changes in unrealized gains and losses in a rising interest rate environment. As securities held to maturity, changes in unrealized gains and losses after the transfer date but prior to maturity are not reflected in stockholders’ equity and these securities are recorded at amortized cost. The unrealized gain of $2,552 on the security transfer date will be amortized against the new cost basis (equal to transfer date fair value) over the remaining life of the securities. Table 10 presents the fair value of securities held by us at December 31, 2010, 2009, and 2008.
Table 10: Investment Securities Distribution - At Fair Value
At December 31, 2010 and 2009, our securities portfolio did not contain securities of any single issuer where the aggregate carrying value of such securities exceeded 10% of stockholders’ equity, except for combined senior debentures and guaranteed mortgage related securities issued by U.S. Agencies such as the FHLB, FNMA, or FHLMC.
Securities with an approximate carrying value (fair value) of $60,111, and $51,189, at December 31, 2010 and 2009, respectively, were pledged primarily to secure public deposits, customer overnight repurchase agreements (classified as other borrowings), and for other purposes required by law, representing approximately 57% and 49% of securities eligible for pledging at December 31, 2010 and 2009, respectively.
As a member of the FHLB system, we are required to hold stock in the FHLB based on borrowings advanced to Peoples State Bank. This stock has a purchase cost and par value of $100 per share. We held $3,250 of FHLB Chicago stock at December 31, 2010 and 2009. The current capital stock level supports FHLB total advances of $65,000. The stock is recorded at cost which approximates market value. Transfer of the stock is substantially restricted. The FHLB may pay dividends in both cash and additional shares of stock. No dividends were paid during 2010 or 2009. The FHLB of Chicago currently operates under a capital management plan required by their regulatory oversight body, the Federal Housing Finance Agency. The capital plan prevents the FHLB from repurchasing capital shares from members or from paying dividends unless certain earning and capital minimums are met. During February 2011, the FHLB of Chicago declared an annualized cash dividend on their capital stock equal to .10% of par value. We cannot predict if the quarterly cash dividend will continue or when it may be increased. Due to a heightened level of regulatory oversight and in recognition of stock transfer restrictions, our investment in FHLB stock has been evaluated for impairment, with no other than temporary impairment write-down deemed necessary at December 31, 2010.
Table 11 categorizes securities by scheduled maturity date as of December 31, 2010 and does not take into account the existence of optional calls held by the security issuer. Therefore, actual funds flow from maturing securities may be different than presented below. Maturity of mortgage backed securities and collateralized mortgage obligations, some of which call for scheduled monthly payments of principal and interest, are categorized by average principal life of the security. Yields by security type and maturity are based on amortized security cost.
Table 11: Investment Securities Maturities and Rates
(1) Weighted average yields on tax-exempt securities have been calculated on a tax-equivalent basis using a rate of 34%.
2010 compared to 2009
During 2010, fair value of investments in obligations of states and political subdivisions as shown in Table 10 increased $2,628, or 5.6% while agency mortgage related securities increased $6,987, or 15.1%, and agency debentures declined $9,186, or 90%. Agency debentures matured during a period of very low reinvestment rates for similar securities so funds were invested in U.S. Agency collateralized mortgage obligations (“CMOs”). Upon purchase, the CMOs carried average principal lives generally
ranging from 3 to 5 years with well defined repayment cash flows. Since residential mortgage backed investment pools carried greater risk of repayment extension in a rising rate environment, pay downs received on the pools were also reinvested into CMOs.
During 2010, we continued purchase of Qualified School Construction Bonds started in 2009 and held $4,995 and $3,872 of such bonds at December 31, 2010 and 2009, respectively. These bonds do not carry a stated interest rate, but instead pay a federal income tax credit as a fixed percentage of the bond principal that we use to offset our federal taxable income. At December 31, 2010, this portfolio carried a tax adjusted yield of 4.98% and an average stated maturity of approximately 6.6 years and were considered a general obligation of the issuing local government authority. Virtually all of our municipal investment holdings are considered general obligations of the local taxing authority. Approximately 79% of all municipal obligations in the portfolio were from issuers in Wisconsin.
The privately issued residential mortgage obligations held of $980 as shown in Table 10 are rated AAA and represent fully amortizing mortgage loan pools originated during 2004 or prior years which are considered to carry very low risk of loss. These whole loan pools include loans which could be classified as conforming loans with FNMA or FHLMC except that loan principal was greater than the jumbo loan limit of these agencies at the time the loans were originated. Principal repayment of these securities is not guaranteed against loss by any government agency but is wholly dependent on borrower repayments and strength of the home values in the collateral pool.
The non-rated trust preferred securities were issued by three banks headquartered in Wisconsin with management teams known to us including Johnson Financial Group, Inc., River Valley Bancorporation, Inc., and Northern Bankshares, Inc. The non-rated senior subordinated notes were issued by McFarland State Bank, a subsidiary of Northern Bankshares, Inc. We regularly review the financial performance of these banks which included a significant net loss at Johnson Financial Group, Inc. during 2010 after a nominal net income during 2009. However, all of the banks operate with strong franchises and carry other factors such as majority family ownership which supports our senior capital position in these securities.
The fair value of the investment portfolio as a percentage of book value based on original amortized cost trended higher for most of 2010 as falling market reinvestment rates improved the value of fixed rate securities already held in our portfolio. However, transfer of the municipal security portfolio during 2010 from securities available for sale to securities held to maturity increased the amortized cost basis to the fair value of the securities at the time of transfer. Following the transfer, longer-term interest rates increased, which caused fair value of fixed rate municipal securities to fall below their new book value. At December 31, 2010, fair value was 100.3% of amortized cost compared to 102.8% of amortized cost at December 31, 2009. Fair value of municipal securities at the transfer date is reflected in stockholders’ equity as comprehensive income and will be amortized against the new cost basis over the remaining life of the securities. Refer to Note 3 of the Notes to Consolidated Financial States for additional information. The net unrealized gain on securities transferred to securities held to maturity and recorded as a component of stockholders’ equity was $1,471, net of taxes of $929 at December 31, 2010. The net unrealized gain on securities available for sale, recorded as a component of stockholders’ equity, was $1,071, net of deferred taxes of $669 at December 31, 2010. Unrealized securities gains and losses, net of income tax effects, do not impact the level of regulatory capital under current banking regulations. We believe investment security yields have a stabilizing effect on net interest margin during periods of interest rate swings and expect to hold existing securities until maturity or repayment unless such funds are needed for liquidity due to unexpected loan growth or depositor withdrawals or if the sale is beneficial to our interest rate risk and return profile. Periods of rising interest rates would likely decrease the unrealized fair value of fixed rate securities in our portfolio.
Because we anticipate short-term interest rates could be higher in 2011 we expect to reinvest maturing securities cash flow into securities with average lives generally between 3 to 4 years and to minimize growth in our municipal securities portfolio whose securities have fixed terms generally from 10 to 11 years. These actions are designed to reduce our interest rate and market risks inherent in the Consolidated Balance Sheets. In addition, agency securities are considered to be a higher quality collateral asset for pledging purposes than municipal securities, which increases contingency liquidity sources.
2009 compared to 2008
During 2009, investments in obligations of states and political subdivisions increased $9,914, or 27% while agency mortgage related securities declined $4,647, or 9% from scheduled and prepayments of loan pool principal and agency senior debentures decreased $2,280, or 18%. We increased our investment allocation to municipal securities due to significantly higher yields and expectations of continued taxable income to maximize the benefit of tax-exempt securities. During 2009, we also began to purchase Qualified School Construction Bonds and held $3,872 of such bonds at December 31, 2009. These bonds do not carry a stated interest rate, but instead pay a federal income tax credit as a fixed percentage of the bond principal that we use to offset our federal taxable income. At December 31, 2009, this portfolio carried a tax adjusted yield of 6.08% and an average stated maturity of approximately 8 years and were considered a general obligation of the issuing local government authority. Virtually all of our municipal investment holdings are considered general obligations of the local taxing authority. Approximately 82% of all municipal obligations in the portfolio at December 31, 2009 were from issuers in Wisconsin.
The fair value of the investment portfolio as a percentage of book value improved during 2009 as falling market reinvestment rates increased the value of fixed rate securities already held in our portfolio. At December 31, 2009, fair value was 102.8% of amortized cost compared to 102.3% of amortized cost at December 31, 2008. The net unrealized gain on securities available for
sale, recorded as a separate component of stockholders’ equity, was $1,776, net of deferred taxes of $1,154 at December 31, 2009 compared to an unrealized gains of $1,450, net of deferred taxes of $829 at December 31, 2008.
Loans Receivable
Total loans as presented in Table 12 include loans held for sale to the secondary market and expected final fully disbursed principal on construction loans not yet fully disbursed at year-end.
Table 12: Loan Composition
Commercial real estate loans are originated for a broad range of business purposes including non-owner occupied office rental space, multi-family rental units, owner occupied manufacturing facilities, and owner occupied retail sales space. Approximately 57% of fully disbursed commercial real estate loans are considered to be owner occupied. We have little lending activity for agricultural purposes. Our management is involved in the communities we serve and believes it has a strong understanding of the local economy, its business leaders, and trends in successful business development. Based on this knowledge, we offer flexible terms and efficient approvals which have allowed us to grow and manage this type of lending.
As part of the asset/liability and interest rate sensitivity management strategy, we generally do not retain long-term 15 to 30 year fixed rate mortgages in our own portfolio. Therefore, it is our practice to sell the majority of long-term fixed rate mortgage loan originations to secondary market agencies in exchange for a fee. From time to time, we retain second mortgage loans, on certain high value homes requiring total financing above the conforming secondary market limit, after selling the first mortgage into the secondary market. In addition, some local borrowers require mortgage financing that does not fit one of the secondary market programs or the borrower prefers us to hold the loan in our own portfolio. First and second mortgage loans on the balance sheet generally carry fixed rate balloon payment terms of five years or less.
Consumer and individual loans include short-term personal loans, automobile and recreational vehicle installment loans, and credit card loans. We experience extensive competition from local credit unions offering low rates on installment loans and therefore direct resources toward more profitable lending categories such as residential fixed rate mortgages and commercial real estate lending. However, due to income tax advantages, many customers borrow on a tax deductible home equity line of credit
for many purposes formerly funded by a consumer installment loan. Therefore, we consider consumer purpose lending to be represented by the combination of consumer and individual lending and residential mortgage home equity.
2010 compared to 2009
Total loans receivable presented in Table 12 decreased $3,738, or .8%, to $445,124 during 2010 after increasing 2.7% to $448,862 during 2009. When combined with real estate construction and development loans, commercial real estate mortgage loans decreased $5,070 at December 31, 2010 compared to December 31, 2009. This decline was offset by a $4,796, or 7.2%, increase in closed end residential mortgage loans. Although we normally sell originations of long-term fixed rate residential mortgages, late in 2010 we retained $10,589 of such loan originations with an average fully amortizing term of 215 months and a fixed rate of 4.53% using investment security cash flows due to very low security reinvestment rates. The decline in commercial real estate loans was due in part to work out of a problem construction and development loan with a loan balance of $3,446 at December 31, 2009 that was resolved in 2010 with net amounts transferred to foreclosed assets of $1,700. The transfer represented 56% of all loan principal transferred to foreclosed assets during 2010.
All construction and land development loans, including commercial and 1-4 family residential construction loan commitments were approximately 7.9% of total loans receivable at December 31, 2010 compared to 9.6% at December 31, 2009. Loans in this classification are primarily short-term loans that provide financing for the acquisition or development of commercial real estate, such as multi-family or other commercial development projects. We retain permanent financing on these projects following completion of construction in a majority of cases. Construction loans also include residential new construction single family homes originated in the normal course of business which are typically sold in the secondary market upon completion of construction.
Local commercial customer demand for increased credit for expansion decreased significantly during the second half of 2009 and remained low during all of 2010 with commercial related loans declining in 3 out of 4 quarters. We expect relatively low levels of organic net loan growth during 2011. Based on availability of local funding during 2011, we may seek out participation purchased loans originated by other banks on properties in Wisconsin with an emphasis on credit quality as the primary purchase criteria if local loan growth is not available to meet budgeted asset growth. Total participation loans purchased and held in our loan portfolio totaled $13,305, or 3.0% of gross loans presented in Table 12 at December 31, 2010 compared to $16,004, or 3.6% of gross loans at December 31, 2009.
2009 compared to 2008
Total loans receivable presented in Table 12 increased $11,872, or 2.7%, to $448,862 during 2009 after increasing 7.8% to $436,990 during 2008. When combined with real estate construction and development loans, commercial real estate mortgage loans increased $9,802 at December 31, 2009 compared to December 31, 2008. An increase in home equity lines of credit of $2,846 was offset by a decline in residential real estate mortgages of $1,330. A significant amount of loans totaling $7,593 were transferred to foreclosed properties during 2009 which decreased year over year loan receivable net growth. Local commercial customer demand for increased credit for expansion decreased significantly during the second half of 2009.
All construction and land development loan commitments, including commercial and 1-4 family residential construction loans were approximately 9.6% of total disbursed loans receivable at December 31, 2009 compared to 13.0% at December 31, 2008. The decline in construction and development loans was due in part to foreclosure of a development of vacation homes and vacant lots during 2009. The loan balance of $5,525 was reduced by auction proceeds and write downs, with $2,050 remaining in foreclosed assets at December 31, 2009. This transfer to foreclosed assets represented 70% of all loan principal transferred to foreclosed assets during 2009.
Table 13 categorizes loan principal by scheduled maturity at December 31, 2010, and does not take into account any prepayment options held by the borrower. The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic conditions. At December 31, 2010, no concentrations existed in our portfolio in excess of 10% of total loans except for a geographical concentration of borrowers and collateral located in Marathon County, Wisconsin in which we have the majority of our branches and operations representing approximately 70% of the loan portfolio.
Table 13: Loan Maturity Distribution and Interest Rate Sensitivity
Credit Quality
Provision for Loan Losses
The loan portfolio is the primary asset subject to credit risk. Credit risk is controlled through the use of credit standards, review of potential borrowers, and loan payment performance. An allowance for loan losses is maintained for incurred losses inherent but yet unidentified in the loan portfolio due to past conditions as well as for specifically identified problem loans. The allowance for loan losses represents our estimate of an amount adequate to provide for potential losses in the loan portfolio based on current economic conditions. Provisions to the allowance for loan losses are recorded as a reduction to income. Actual loan loss charge offs are charged against the allowance for loan losses.
The adequacy of the allowance for loan losses is assessed via ongoing credit quality review and grading of the loan portfolio, past loan loss experience, trends in past due and nonperforming loans, existing economic conditions, loss exposure by loan category, and estimated future losses on specifically identified problem loans. We have an internal risk analysis and review staff that continuously reviews loan quality. Accordingly, the amount charged to expense is based on our multi-factor evaluation of the loan portfolio. It is our policy that when available information confirms that specific loans, or portions thereof, including impaired loans, are uncollectible, these amounts are promptly charged off against the allowance. In addition to coverage from the allowance for loan losses, nonperforming loans are secured by various collateral including business, real estate and consumer collateral. Loans charged off are subject to ongoing review and specific efforts are taken to maximize recovery of principal, accrued interest, and related expenses.
Nonperforming assets decreased $685, or 4.0%, to $16,389 (2.64% of total assets) at December 31, 2010, from $17,074 (2.81% of total assets) at December 31, 2009 as fewer borrowers became significantly delinquent in response to stabilized, but depressed general and local economic conditions. Provision for estimated loan losses also declined to $1,795 in 2010 from $3,700 in 2009. The provision for loan losses decreased during 2010 compared to 2009 due to smaller average specific reserves required for newly identified problem loans. Loss on foreclosed assets remained high at $849 but declined from $1,130 in 2009 whose loss was from the sale and write-down of one large credit relationship partially sold at auction late in 2009. Approximately 46% of total nonperforming assets are made up of seven individual nonperforming assets at December 31, 2010 greater than $500. Total nonperforming assets as a percentage of common equity including the allowance for loan losses were 29.99% at December 31, 2010 compared to 34.23% at December 31, 2009 and 26.11% at December 31, 2008.
Table 14: Loan Loss Experience
The allocation of the year-end allowance for loan losses for each of the past five years based on our estimate of loss exposure by category of loans is shown in Table 15. Our allocation methodology focuses on changes in the size and character of the loan portfolio, current economic conditions, the geographic and industry mix of the loan portfolio, and historical losses by category. The total allowance is available to absorb losses from any segment of the portfolio. Management allocates the allowance for loan losses by pools of risk and by loan type. We combine estimates of the allowance needed for loans analyzed individually and loans analyzed on a pool basis. The determination of allocated reserves for larger commercial loans involves a review of individual higher-risk transactions, focused on loan grading, and assessment of specific loss content and possible resolutions of problem credits. While we use available information to recognize losses on loans, future adjustments may be necessary based on changes in economic conditions and future impacts to specific borrowers.
During 2011, we expect to continue to evolve our methodology used to assess adequacy of our allowance for loan losses to more proactively identify credit problems by industry classification and to incorporate increased qualitative factors. The changes could change the nature of our credit disclosures and allocation of our allowance to loan categories compared to prior years.
The majority of gross loan charge-offs during 2010 were related to five borrowers totaling $1,064, or 73% of all charge-offs, with the largest charge-off of $448 related to a nonowner multi-use, multi-tenant commercial real estate development that remains in foreclosed assets at December, 2010 and is outlined in Table 17. During 2009, the majority of gross loan charge-offs were related to four borrowers totaling $1,187, or 73% of all charge-offs, with the largest charge off of $737 related to a out of state syndicated loan participation development project with remains in foreclosed assets at December 31, 2010 and is outlined in Table 17.
Table 15: Allocation of Allowance for Loan Losses
Nonperforming loans are defined as loans 90 days or more past due but still accruing, nonaccrual loans, including those defined as impaired under current accounting standards, and restructured loans. Loans are placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments. Previously accrued and uncollected interest on such loans is reversed, and future payments received are applied in full to reduce remaining loan principal. No income is accrued or recorded on future payments until the loan is returned to accrual status. Upon return to accrual status, the interest portion of past payments that were applied to reduce nonaccrual principal is taken back into income. The interest that would have been reported in 2010 if all such loans had been current throughout the year in accordance with their original terms was approximately $784 in comparison to $430 actually recorded in income. The interest that would have been reported in 2009 if all such loans had been current throughout the year in accordance with their original terms was approximately $851 in comparison to $557 actually recorded in income. The interest that would have been reported in 2008 if all such loans had been current throughout the year in accordance with their original terms was approximately $548 in comparison to $399 actually recorded in income.
Troubled debt restructured loans (“TDR”) are also included in nonperforming loans. Restructured loans involve the granting of concessions to the borrower involving the modification of terms of the loan, such as changes in payment schedule or interest rate, or capitalization of unpaid real estate taxes or unpaid interest that the lender would not normally grant. The majority of restructured loans represent conversion of amortizing commercial loans to interest only loans for a temporary period to increase the problem borrower’s cash flow. The remaining restructured loans granted a lower interest rate to borrowers for a temporary period to increase borrower operating cash flow. Such loans are subject to management review and ongoing monitoring and are made in cases where the borrower’s delinquency is considered short-term from circumstances the borrower is believed able to overcome or which would reduce our estimated total credit loss on the relationship. Nonaccrual loans (including nonaccrual restructured loans) remain classified as nonperforming loans until the uncertainty surrounding the credit is eliminated. Therefore, some borrowers continue to make substantially all required payments while maintained on non-accrual status.
Substantially all of our residential mortgage loans originated for and held in our loan portfolio were based on conventional and long standing underwriting criteria and are secured by first mortgages on homes in our local markets. We were not an originator of higher risk loans such as option ARM products, high loan-to-value ratio mortgages, interest only loans, subprime loans, or loans with initial teaser rates that can have a greater risk of non-collection than other loans. At December 31, 2010, approximately $1.2 million of loans receivable were 1 - 4 family home equity or junior lien mortgage loans in which the maximum commitment amount of the line of credit plus existing senior liens is greater than 100% of the underlying real estate value, or were a loan in a 3rd mortgage position or lower, compared to $2 million at December 31, 2009. Such loans were not originated as part of a program to add higher yielding loans to our portfolio but were loans made on a case by case basis and individually underwritten with the borrower customized to their need. The average credit score for borrowers represented by our entire in-house 1 to 4 family mortgage portfolio, including closed and open ended mortgage loans, was greater than 728 at December 31, 2010 and 2009. We do not maintain a formal residential mortgage modification program for delinquent residential mortgage borrowers. During 2009, we increased the inherent credit loss provision on open ended home equity lines of credit from .10% to .50% to reflect the risk of future credit losses on such junior lien mortgages from current economic conditions. This change added approximately $93 to the allowance for loan losses during 2009.
Table 16 presents nonperforming loans and assets by category for the five years ended December 31, 2010.
Table 16: Nonperforming Loans and Foreclosed Assets
2010 compared to 2009
The provision for loan losses was $1,795 in 2010 compared to $3,700 in 2009. Non-performing loans relative to total loans declined slightly and was 2.60% at December 31, 2010 compared to 2.99% at December 31, 2009. However, foreclosed assets increased from $3,776 at December 31, 2009 to $4,967 at December 31, 2010. Therefore, total nonperforming assets were $16,389, or 2.64% of total assets at December 31, 2010 compared to $17,074, or 2.81% of total assets at December 31, 2008. During 2010, the decline in local economic conditions stabilized but at low levels, which impacted borrower ability to repay according to the loan terms. At December 31, 2010, year-end, the unemployment rate was 7.0% in Wisconsin and 7.1% in Marathon County (the home of the majority of our borrowers and down from 8.9% at December 31, 2009) compared to a rate of 9.1% for the United States. The Marathon County unemployment rate ranked 29th out of Wisconsin’s 72 counties for December 2010 (from lowest to highest unemployment rate).
A significant portion of the allowance for loan losses at December 31, 2010 and 2009 was related to specifically identified impaired loans at year-end. If impaired loans and related specific reserves (if any) were disregarded, the allowance for loan losses to unimpaired loans would have been 1.47% at December 31, 2010 and 1.30% at December 31, 2009 as we continued to increase inherent losses on the loan portfolio during 2010 reflecting the uncertainty of ongoing customer credit stress and high delinquency ratios. At December 31, 2010, our internal grading system identified 24 separate loan relationships totaling approximately $4.8 million against which $2.0 million in specific loan loss reserves were recorded.
During 2011, we expect restructured loans to increase as we work with problem borrowers to minimize the level of potential future charge-offs and maximize cumulative total principal repayment. In addition, regulatory pressures and a change in generally accepted accounting principles regarding identification of restructured loans are likely to increase loans disclosed as troubled debt restructurings. Although some restructured loans could continue on accrual status, this designation would increase total nonperforming loans and could increase the provision for loan losses.
Approximately 46% of total nonperforming assets were represented by the following aggregate credits or foreclosed properties greater than $500 at December 31, 2010:
Table 17: Largest Nonperforming Assets at December 31, 2010 ($000s)
During the December 2009 quarter, $3.3 million of foreclosed properties originally related to a $5.8 million land development loan were sold at auction at a loss of $452 excluding a previously expensed $125 auction marketing fee. The remaining $2,477 foreclosed asset was further written down $427 to an estimated fair value of $2,050 at December 31, 2009. During 2010, one of the four remaining individual properties was sold and the entire $283 sale proceeds were applied to reduce cost basis of the remaining properties. As shown in Table 17, three properties remain with cost basis of $1,767 at December 31, 2010. During 2010, the northern Wisconsin area where these properties are located saw some vacation property transactions in excess of $1 million, such as would be required for this foreclosed property. We actively market these remaining properties for sale but cannot predict the final timing or resolution of this foreclosed asset.
At December 31, 2009, we held a $3,446 loan secured by commercial real estate collateral located in Weston, Wisconsin, and marketable equity investments shown in Table 17 on which we completed foreclosure during 2010 and charged off $448 of loan principal. Later in 2010, we recorded a further partial write-down of $250 for a remaining cost of $1,450. Current cost basis represents approximately 40% of the original construction cost incurred by the borrower during 2007. We actively market this property for sale but at this time are unable to determine the final timing or resolution of this foreclosed asset.
During 2010, we entered into a restructuring agreement with a local developer and owner of multi-family apartment complexes to extend the amortization period on existing debt to increase cash flow available to the developer to meet real estate tax and other obligations. The $1,177 commercial real estate loans reflected in Table 17 are maintained on accrual status and no reduction in stated interest rate was made in the modification. We expect the borrower to continue to meet required payments under the restructured terms which will be reevaluated during 2011.
During 2009, our borrower in the building supplies industry ceased payments on a $961 loan secured by construction inventory and accounts receivable in part due to uncollected large accounts receivable due to a dispute between our customer and the account payer. Due to poor collateral position, we reserved $700 against the loan relationship at December 31, 2009 which was maintained at December 31, 2010 as shown in Table 17. During 2010, we collected $138 in payments which were applied to principal. We expect to receive principal repayments of at least $123 during the upcoming year but are unable to determine the final resolution of this problem loan at this time.
During 2007, we entered into a syndicated construction loan agreement sold by Bankers’ Bank Madison, Wisconsin, for construction of vacation condos and an adjacent water park near Hollister, Missouri. The construction loan was intended to be repaid by the proceeds from a municipal tax incremental financing debt issue by the local municipality. When the credit markets for such financing dried up, the project was unable to continue and land development work ceased. The loan participants obtained the property in foreclosure during 2009. The original fair value estimate of the completed project was approximately $24 million. At the time of foreclosure, we valued our asset using a new liquidation value appraisal based on our approximately 7% ownership of the project resulting in a cost basis of $792 at December 31, 2010 and 2009 as shown in Table 17. Certain subcontractor liens related to work on this property are in dispute and subject to litigation before the loan syndicate may obtain clear title to the property. During 2010, we paid $51 in bonding and legal costs related to these claims. A victory in Appeals Court on these claims would result in repayment of these costs. At this time, we are unable to determine the final resolution of this property and expect to hold this asset during all of 2011.
During 2010, we restructured the loan terms on $754 of loan principal as shown in Table 17 to lower the interest rate on existing debt with a borrower in the cabinetry contracting industry to increase cash flow during a large decline in customer sales. We expect our customer to remain current under the loan modification provisions but recorded a $75 specific reserve to reflect the loss on restructured terms. We expect to maintain and classify this nonperforming loan during all of 2011.
During 2009, we restructured a $613 loan secured by an owner occupied restaurant to increase borrower cash flow and allow the business to continue operating. During 2010, the borrower’s residential mortgage loan was also classified as a nonperforming loan which increased net nonperforming principal by $93 to $706 as shown in Table 17. The borrower remains current on the restructured payments but continues be maintained on nonaccrual status at December 31, 2010. Our real estate collateral on the relationship has a fair value that approximates the net book value of the loan after the specific reserve of $100 at December 31, 2010. We expect to maintain and classify this nonperforming loan during all of 2011.
2009 compared to 2008
The provision for loan losses was $3,700 in 2009 compared to $885 in 2008. Non-performing loans relative to total loans continued to increase and was 2.99% at December 31, 2009 compared to 2.64% at December 31, 2008. In addition, foreclosed assets increased from $521 at December 31, 2008 to $3,776 at December 31, 2009. Therefore, total nonperforming assets were $17,074, or 2.81% of total assets at December 31, 2009 compared to $11,859, or 2.08% of total assets at December 31, 2008. Non-performing loans increased primarily from declining general and local economic conditions which impacted borrower ability to repay according to the loan terms. At year-end, the unemployment rate was 8.3% in Wisconsin and 8.9% in Marathon County (the home of the majority of our borrowers) compared to a rate of 9.7% for the United States. The Marathon County unemployment rate ranked 39th out of Wisconsin’s 72 counties for December 2009.
A significant portion of the allowance for loan losses at December 31, 2009 and 2008 was related to specifically identified impaired loans at year-end. If impaired loans and related specific reserves (if any) were disregarded, the allowance for loan losses to unimpaired loans would have been 1.30% at December 31, 2009 and 1.18% at December 31, 2008 as we increased inherent losses on the loan portfolio during 2009 reflecting the ongoing stress and rising delinquency ratios. At December 31, 2009, our internal grading system identified 22 separate loan relationships totaling approximately $10.8 million against which $2.5 million in specific loan loss reserves were recorded.
Approximately 58% of total nonperforming assets were represented by the following aggregate credits or foreclosed properties greater than $500 at December 31, 2009:
Table 18: Largest Nonperforming Assets at December 31, 2009 ($000s)
At December 31, 2009, we held a $3,446 loan secured by commercial real estate collateral and marketable equity investments shown in Table 18 on which we foreclosed during 2010 and incurred a charge off of $448.
During the December 2009 quarter, $3.3 million of foreclosed properties originally related to a $5.8 million land development loan were sold at auction at a loss of $452 excluding a previously expensed $125 auction marketing fee. The remaining $2,477 foreclosed asset was further written down $427 to its estimated fair value of $2,050 at December 31, 2009 as shown in Table 18. All other bank wide foreclosure holding costs and net sales losses were $126 during 2009 compared to $6 during 2008 excluding this $1,004 loss on an individual foreclosed asset in 2009. The remaining foreclosure property is actively marketed and one of the remaining four properties in this development was sold during 2010.
During 2010, we foreclosed on the commercial real estate associated with the $1,053 nonperforming loan listed in Table 18 and incurred a charge off of $148 during 2010. We continue to work with the borrower and maintain a $65 loan receivable to allow the enterprise to continue on a scaled down basis
The $1,045 loan on trucking equipment shown in Table 18 was a purchased participation loan in which payments were made as scheduled. The loan was classified as nonaccrual to accelerate repayment of principal as all payments received are applied against principal. During 2010, we were fully repaid on our participation balance and no credit losses were recorded.
Our $961 loan secured by construction inventory and accounts receivable shown in Table 18 had ceased payments during 2009 in part due to uncollected large accounts receivable due to a dispute between our customer and the account payor. Due to poor collateral position, we reserved $700 against the loan relationship at December 31, 2009. We received principal repayments of $138 during 2010.
During 2007, we entered into a syndicated construction loan agreement sold by Bankers’ Bank Madison, Wisconsin, for construction of vacation condos and an adjacent water park near Hollister, Missouri. The construction loan was intended to be repaid by the proceeds from a municipal tax incremental financing debt issue by the local municipality. When the credit markets for such financing dried up, the project was unable to continue and land development work ceased. The loan participants obtained the property in foreclosure during 2009. The original fair value estimate of the completed project was approximately $24 million. At the time of foreclosure, we valued our asset using a new liquidation value appraisal based on our approximately 7% ownership of the project. No principal repayments were received during 2010.
The $613 loan secured by an owner occupied restaurant shown in Table 18 was restructured during 2009 with the borrower current under the new loan terms to allow the business to continue operating. Our commercial real estate collateral on the relationship had a fair value that approximated the net book value of the loan after the specific reserve of $100 at December 31, 2009. During 2010, the gross principal considered nonperforming for this borrower increased $93, net of pay downs, from classification of the borrower’s residential mortgage debt as nonperforming.
2008 compared to 2007
The provision for loan losses was $885 in 2008 compared to $480 in 2007. Non-performing loans relative to total loans and total assets increased dramatically in 2008 compared to 2007 primarily from the addition to nonaccrual assets of a $5.5 million credit relationship. However, decline in general economic conditions also caused consistent increases in nonaccrual loans each quarter. Commercial loan portfolio growth, the addition of the large problem loan, and downgrades in credit quality in the existing portfolio caused us to increase the provision for loan losses during 2008 compared to 2007. The allowance for loan losses increased to 1.28% of total loans, which was the largest allowance as a percentage of total loans at fiscal year-end since December 31, 1996 when the allowance was 1.39% of gross loans. The allowance for loan losses as a percentage of nonperforming loans was 48.7% at December 31, 2008, compared to 127.7%, at December 31, 2007 due to recognition as nonperforming of a single $5.5 million credit during 2008. Excluding this credit and its specifically assigned reserves, the allowance for loan losses as a percentage of nonperforming loans would have been 91.5% at December 31, 2008.
Noninterest Income
Table 19 presents a common size income statement showing the changing mix of income and expense relative to traditional loan and deposit product net interest income (before tax adjustment) for the five years ending December 31, 2010. This analysis highlights the reliance on, or diversification of, noninterest or fee income to net interest income.
Table 19: Summary of Earnings as a Percent of Net Interest Income
Table 20 presents a breakdown of the components of noninterest income during the three years ended December 31, 2010.
Table 20: Noninterest Income
2010 compared to 2009
During 2010, total noninterest income declined $213, or 3.8%, to $5,363 compared to $5,576 during 2009. Excluding nonrecurring net gains (losses) on security sales, 2010 noninterest income increased $328, or 6.5% compared to 2009. Although 2010 mortgage banking income declined $378 as more borrowers refinanced their residential mortgages when rates fell significantly during 2009 compared to 2010, several other types of income experienced significant increases. Service charge income increased $338, or 23.3%, from higher overdraft income charges, and investment and insurance sales commissions increased $221, or 57.0%, from higher gross sales activity. Prior to new regulation which lowered overdraft activity following August 2010, the bank had rolled out an updated courtesy overdraft product early in 2010 which increased year over year overdraft income and service fee income despite the regulatory change. Lastly, interchange income from credit and debit cards increased $115, or 18.7% during 2010 compared to 2009.
Many of the increases in 2010 were in areas expected to be impacted by continued regulatory changes during 2011 including overdraft fees and card interchange income. Merchant and debit card fee interchange income continued to increase in 2010 due to increased Rewards Checking NOW balances which require substantial debit card use to earn the premium interest rate on the account. In addition, residential mortgage refinance activity is expected to slow significantly as long-term mortgages have risen to levels higher than rates already in the serviced loan portfolio from previous customer refinancing activity. Therefore, we expect mortgage banking income to significantly decline during 2011 compared to 2010 and 2009 levels. We are unable to estimate the timing and extent of these cumulative changes, but expect total noninterest income will decline during 2011 compared to 2010.
New consumer banking regulations promulgated by the Federal Reserve concerning customer overdraft programs went into effect during August 2010. The new regulation prevents banks from assessing an overdraft fee related to a transaction conducted at a point of sale such as those using a debit card unless the consumer has specifically “opted into” the program. Since the effective date of the regulation, we have experienced an approximately 18% reduction in gross overdraft activity compared to activity prior to the regulatory change.
Prior to 2009, bank owned life insurance was purchased on certain employees in connection with officer compensation programs which increased income from cash surrender value of life insurance during the three years ended December 31, 2010. However, limited further investments in this asset class are expected and we expect 2011 income on life insurance cash surrender value to remain similar to that seen during 2010.
2009 compared to 2008
Noninterest income excluding gain (loss) on sale of securities increased 21% during 2009 from a record year of mortgage banking income totaling $1,850 (up 78% over 2008) as customers refinanced their long-term fixed rate residential mortgages. Residential loan principal sold to the secondary market during 2009 was approximately 2.3 times and 3.9 times the levels seen during 2008 and 2007, respectively. This activity was promoted by historically low long-term mortgage rates which moved higher by the end of 2009.
During 2009, total noninterest income was $5,576 compared to $3,184 during 2008, an increase of $2,392, or 75.1%. The most significant components of the change include a gain on sale of securities of $521 as well as increased 2009 mortgage banking
income of $810 in addition to a loss on FNMA stock of $991 incurred during 2008. Excluding these special items, noninterest income would have increased $70, or 2.2% during 2009.
United States Treasury programs and open market mortgage related asset purchases by the Federal Reserve during 2009 dramatically lowered long-term residential mortgage rates, contributing to a wave of mortgage refinancing during 2009. Our mortgage banking income was $1,850 during 2009 compared to $1,040, an increase of $810. During 2009, our mortgage loan portfolio serviced for others increased 28% reaching $237.8 million at December 31, 2009. The components of mortgage banking income may be found in Item 8, Note 6 of the Notes to Consolidated Financial Statements.
Merchant and debit card fee interchange income continued to increase in 2009 due to increased Reward Checking NOW balances which require substantial debit card use to earn the premium interest rate on the account. Prior to 2009, bank owned life insurance was purchased on certain employees in connection with officer compensation programs which increased income from cash surrender value of life insurance during 2009 and 2008.
Noninterest Expense
Table 21 outlines the components of noninterest expenses for the three years ending December 31, 2010.
Table 21: Noninterest Expense
* Net interest income (net margin) is calculated on a tax equivalent basis using a tax rate of 34%.
2010 compared to 2009
During 2010, total noninterest expenses were $15,925 compared to $14,829 in 2009, an increase of $1,096, or 7.4%. The majority of the increase was in the form of higher salaries and employee benefits which increased $1,015, or 13.6% during 2010. Base wages represented $215 of the increase, growing 3.6% over 2009 with increased overtime pay representing $59 of the increase related to the June 2010 quarter core processing system conversion. Excluding overtime pay, base wages increased 2.6% during 2010. Other factors included fewer deferred direct loan origination costs of $190, increased health and dental insurance plan expense of $59, and higher year-end incentive and discretionary profit sharing plan allocations of $404, up 62%, based on exceeding 2010 net income targets.
FDIC insurance expense declined $204, or 20.6% during 2010 compared to 2009 due to the prior year including a special FDIC insurance assessment totaling $264. Prior to the special assessment, 2010 FDIC insurance expense increased $60, or 8.3%. Offsetting the 2010 decline in FDIC expense was an increase in data processing and other office operations expense of $217, or 22.7%, due to a change in core processing computer system during June 2010 from an internally maintained system to an outsourced system. Following the June 2010 conversion date, the system vendor provided a contractual reduction in monthly service fees that will expire during 2011. Following expiration of the reduction period, vendor servicing fees will increase significantly. The new system, while increasing data processing costs, is expected to provide significant operating efficiencies and capacity for customer and product growth compared to the prior system maintained in house since 1997.
During 2011, wages and benefits are expected to increase minimally with average base pay increases of 2.7% granted January 1, 2011. During 2010, employee costs were driven higher by incentives earned as net income exceeded the target. Depending on net income growth, such increased incentives may not recur in 2011, potentially reducing employee costs. Health and dental insurance costs are incurred under a self insured plan subject to a maximum stop loss. Refer to Note 15 of the Notes to Consolidated Financial Statements for more information. We expect 2011 health and dental costs to increase in a manner similar to that seen during 2010 and 2009.
Prior to 2010, we used an in house data processing system to record customer activity and manage internal accounting needs. Such costs were recorded as elements of depreciation expense, reflected as occupancy expense, and software maintenance charges, which were reflected as data processing costs. During June 2010, we entered into a contract to employ a third party to process customer and internal data on an outsourced basis. During the initial implementation period, monthly service bureau fees were reduced to recognize other transactional costs borne by us. However, during 2011, we will begin to pay the normal contractual fees for data processing and expect data processing expense could increase 30% to 35% higher during 2011 compared to 2010. Offsetting a portion of this increase will be a reduction in depreciation expense previously recognized on the in-house system, reducing occupancy expenses during 2011.
Foreclosed asset expense will remain high during 2011 as the inventory of foreclosed properties grows and we continue to have holding costs on both existing and new properties. In addition, other expenses related to legal fees associated with collection and foreclosure of loans receivable are expected to increase. Lastly, we recorded partial write-downs of foreclosed asset basis of $405 and $477 during 2010 and 2009, respectively, and continued partial write-downs prior to property sale would increase loss on foreclosed assets.
Changes to FDIC insurance assessment methods as part of the Dodd-Frank legislation will assess premiums based on total assets less Tier 1 capital beginning in 2011 compared to assessing based on total insured deposits as in years past. Industry wide, this change is expected to increase the burden of FDIC insurance premiums on the nation’s largest institutions. Therefore, we expect our FDIC insurance expense to decrease modestly during 2011 compared to 2010. However, due to deposit growth and potential increases in the FDIC assessment rate, FDIC insurance expense is unpredictable and could be greater in future years than seen during 2010. Although not expected during 2011, accelerated or unexpected levels of bank failures within the industry could cause the FDIC to increase premiums or collect special assessments to make up insurance fund shortfalls.
During 2010, we incurred a $110 loss related to debit card fraud, net of insurance proceeds, that resulted from a coordinated external fraud targeting us and our debit card customers. Even excluding this individual loss, debit card losses of $57 were significantly higher than seen during 2009. We expect fraud losses to continue to be elevated, though not to the extent seen during 2010 when the targeted fraud attack is included. Along with debit card losses, deposit losses increased from $96 during 2009 to $180 during 2010 as we increased the benefit limit of our courtesy overdraft program. The increased deposit losses on the courtesy overdraft program during 2010 were approximately 22% of the increased 2010 overdraft fee income.
2009 compared to 2008
Noninterest expenses totaled $14,829 during 2009 quarter compared to $12,566 during 2008, an increase of $2,263, or 18.0%. During 2009, loss on foreclosed assets increased $1,124 compared to 2008 to a total of $1,130 from a $1,004 loss on a large land development foreclosure partially sold at auction and $126 in foreclosure costs related to all other properties.
In addition, the FDIC increased regular quarterly insurance premiums and charged a onetime special assessment during 2009 to recapitalize the FDIC insurance fund in light of ongoing and expected bank failures. During 2009, our FDIC insurance expense was $986 compared to $284 during 2008, an increase of $702. During December 2009, we prepaid $2.6 million to the FDIC
representing estimated insurance premiums during 2010 through 2012 as required by the FDIC. This prepayment will be amortized as FDIC insurance expense during the next three years.
Salaries and employee benefits expense increased $608, or 8.9% during 2009 primarily from base wage increases and a slightly larger employee base (together representing $379 of increased expense). Incentive and profit sharing payments related to loan fees, deposit growth, mortgage banking, and return on equity performance to banking peer group increased $163, or 33% during 2009 compared to 2008. An increase in health insurance expense of $54, or 6.5%, during 2009 compared to 2008 made up the remainder of increased salaries and benefits expense.
Income Taxes
The effective tax rate was 29.5% in 2010 compared to 22.1% in 2009 and 20.3% in 2008. The 2010 effective rate increased as the percentage of tax-exempt income from securities and bank owned life insurance declined relative to total pre-tax income. While tax-exempt interest on securities and bank-owned life insurance reduced tax expense by $666 and $697 during 2010 and 2009, respectively, this reduction was 25% of tax expense excluding these items in 2010 compared to 44% of tax expense excluding these items in 2009. Refer to Item 8, Note 16 of the Notes to Consolidated Financial Statements for additional tax information. Due to declining average reinvestment rates on tax-exempt municipal securities, we expect the effective tax rate to increase slightly during 2011 compared to 2010.
The 2009 effective tax rate increased over 2008 from a change in State of Wisconsin income tax law to a combined reporting model. This change subjected investment income earned on investment securities held by PSB Investments, Inc., Peoples State Bank’s investment subsidiary, to state income taxes. Previously, income on these investments was not subject to Wisconsin income taxes. This change in taxation method increased our provision for income taxes by $162 during 2009. The 2009 effective tax rate would have been 18.0% without the state tax regulation change. The 2008 effective tax rate continued its decline from prior years as tax-exempt income such as interest on tax exempt municipal securities and increase in cash surrender value of life insurance made up a larger portion of pre-tax income.
Critical Accounting Policies
Allowance for Loan Losses
Current accounting standards call for the allowance for loan losses to include both specific losses on identified impaired problem loans and “inherent” losses on existing loan pools not yet considered problem loans. Determination of the allowance for loan losses at period-end is based primarily on subjective factors and management assessment of risk in the existing portfolio. Actual results, if significantly different from those using estimates at period-end, could have a material impact on the results of operations. For example, losses incurred on loans not previously identified as carrying significant loss potential would increase the provision for loan losses expense equal to the amount of the loan principal charged off.
Loans receivable, for the purpose of estimating the allowance for loan losses, are separated into four primary categories - residential real estate loan pool, consumer installment loan pool, specifically identified impaired problem commercial loans, and pools of non-problem commercial purpose loans subcategorized by credit risk assessment. We make the following estimates and perform the following procedures when setting the allowance for loan losses at period-end:
1.
We categorize existing loan principal into either commercial purpose loans, a pool of residential real estate loans, or a pool of consumer installment loans.
2.
Commercial purpose loans are subcategorized into credit risk “grades” based on an internal determination of risk established during credit analysis and updated no less than annually. Determination of risk grades takes into account several factors including collateral, cash flow, borrower’s industry environment, financial statement strength, and other factors. We use six risk grades for performing commercial purpose loans ranging from grade 1 (best) to grade 6 including separate risk grades for “watch” and “special mention” loans.
3.
Identified impaired problem loans are classified into the lowest quality risk grade (grade 7) and individually reviewed to determine specific reserves required for each relationship depending on the specific collateral and timing of cash flows to be received. The allowance for loan losses provided for these problem loans is based substantially on management’s estimates related the value of collateral, timing of cash flows to be received from the borrower or sale of the collateral, and likelihood of the specific borrower’s ability to repay all amounts due without foreclosure of collateral. Management updates the cash flow analysis of problem loan relationships quarterly.
4.
Other commercial loans not considered to be problem loans are assigned an estimated loan loss allowance based on historical “inherent” losses for loans of similar credit risk. These allowances range from .25% of principal to 2% of principal depending on the four assigned credit risk grades for non-problem performing commercial loans. Performing loans placed on the “watch” list and the “special mention” list are assigned “inherent” losses of 5% and 10% of principal, respectively. An inaccurate assignment of credit risk grade to a loan relationship could significantly change the actual levels of allowances required for that loan, and therefore our assignment of the credit risk grade is a significant estimate. We review actual long-term losses in comparison to the inherent losses assigned by credit risk grade and update allowance percentages as needed.
5.
Similar to nonproblem commercial purpose loans, inherent losses are assigned to the residential real estate loan pool. However, since residential real estate loan risk characteristics are very similar from borrower to borrower, a flat percentage loss of principal is applied to real estate loans rather than breaking the pool into subcategories of credit risk. The percentage applied is based primarily on historical losses on similar residential loan pools. An inaccurate estimate of inherent losses related to the real estate loan pool could significantly increase the actual levels of allowances required. Performing loans are assigned “inherent” losses ranging from .10% to .50% of principal, including open ended home equity lines of credit.
6.
Similar to the residential real estate loan pool, performing consumer installment loans are assigned an estimated loss based on a percentage of principal outstanding ranging from 1.73% to 5.00% of principal, including credit card loans. The percentage applied is based primarily on historical losses on similar consumer installment loan pools. An inaccurate estimate of inherent losses related to the consumer installment loan pool could significantly increase the actual levels of allowances required.
After calculating the estimate of required allowances for loan losses using the steps above, an analysis of the level of problem and past due loans is made relative to the aggregate allowance for loan losses recorded. If past due and problem loans rise significantly, additional unallocated reserves may be recorded to account for this additional risk of loss before it is recognized by the change in commercial credit risk grades, or the increase in the historical inherent loss percentage assigned to the real estate and consumer installment loan pools in the allowance for loan losses calculation. As of December 31, 2010 and 2009, no unallocated loan loss allowances were recorded.
Estimates of inherent losses on nonproblem loans are a significant accounting estimate due to the many economic and subjective factors involved in estimating future losses from existing negative factors on unidentified future problem loans currently making payments. If the actual inherent losses on performing loans evaluated using inherent loss estimates were 25% greater than those currently used to calculate reserve needs, the 2010 provision for loan losses would have been approximately $1.4 million greater, reducing net income $874 after income taxes.
Mortgage Servicing Rights
As required by current accounting standards, we record a mortgage servicing right asset (“MSR”) when we continue to service borrower payments and perform maintenance activities in exchange for an annual servicing fee of .25% of average serviced mortgage principal on loans in which the principal has been sold to the FHLB or other secondary market investors. Our initial value of servicing rights is calculated on an individual loan level basis and uses public financial market information for many of the significant estimates. In the period in which the principal is sold to the secondary market investors, we increase the gain on sale of the loan by the value of the initial MSR. If the actual value was less than we recorded, such as if the estimated future servicing period or average serviced principal was less than estimated, the gain recorded on origination of the MSR would be overstated. Recognition of impairment of excess mortgage servicing rights would decrease income, causing our accounting for mortgage servicing rights to be a critical accounting policy. For example, if the actual value of initial MSR on 2010 secondary market sales were 25% less than that recorded, gain on sale of loans (a component of mortgage banking income) during 2010 would have declined approximately $138 before income taxes. In addition, if the actual value of the entire December 31, 2010 MSR were 25% less than recorded, net servicing revenue (a component of mortgage banking income) would have declined approximately $275 before income taxes.
We make the following estimates and perform the following procedures when accounting for MSRs:
1.
Serviced loans are stratified by risk of prepayment criteria. Currently, strata are first based on the year in which the loan was originated, then on term, and then on the range of interest rates within that term.
2.
We use a discount approach to generate the initial value for the OMSR. The calculation takes the average of the current dealer consensus on prepayment speeds as reported by Andrew Davidson & Company or the prepayment speed implied in the mortgage backed security prices for newly created loans along with other assumptions to generate an estimate of future cash flows. The present value of estimated cash flows equals the fair value of the OMSR. We capitalize the lower of fair value or cost of the OMSR.
Refer to Note 22 of the Notes to Consolidated Financial Statements for significant fair value and cost estimates other than the estimate of public dealer consensus of prepayment speeds.
Changes in these estimates and assumptions would change the initial value recorded for OMSRs and change the gain on sale of mortgage loans recorded in the income statement.
3.
Amortization of the OMSR is calculated based on actual payment activity on a per loan basis. Because all loans are handled individually, curtailments decrease MSRs as well as regularly scheduled payments. The loan servicing value is amortized on a level yield basis.
4.
Significant declines in current market mortgage interest rates decrease the fair value of existing MSRs due to the increase in anticipated prepayments above the original assumed speed. Accounting standards require that impairment testing be performed and that MSRs be recorded at the lower of fair value or amortized cost. We perform quarterly impairment testing on our MSRs. Actual prepayment speeds (based on our actual customer activity on a loan level basis) are compared to the assumed prepayment speed on the date of the last quarterly impairment testing (or the origination prepayment speed if a new loan). The fair value assumptions other than prepayment speed are combined with the new estimated prepayment speed to create a new fair value. An impairment allowance is recorded for any shortfall between the new fair value and the original cost after adjusting for past amortization and curtailments.
LIQUIDITY
Similar to 2009, the majority of the $14,239 in asset growth seen during 2010 was funded by an increase in retail and local deposits of $16,890 (up 4.4%). Operating cash flow and increased local deposits paid down wholesale deposits and FHLB advances by $11,089 (8.2%). During 2009, local deposits increased $18,584 (5.1%) and brokered certificates increased $12,346 (19.0%) to fund net loan growth of $22,355 and repayment $6,841 of FHLB advances. During 2008, local deposits increased $11,646, or 3.3%, while wholesale funding increased $21,373, or 15.9%.
Wholesale funding includes FHLB advances, brokered certificates of deposits, wholesale repurchase agreements, and federal funds purchased. These sources of wholesale funding are limited by the wholesale lender’s ability to raise individual depositor funds, our regulatory capital classification, our ability to generate positive earnings performance, our sources of collateral acceptable to the wholesale lender, by our internal policy limitations on aggregate exposure to use of such funds, and in the case of the FHLB, our level of FHLB capital stock relative to our aggregate amount of FHLB advances. Table 22 summarizes the sources and uses of cash for the three years ending December 31, 2010.
Table 22: Summary Sources and Uses of Cash and Cash Equivalents
Deposits
Core retail deposits are our largest source of funds. We consider core retail deposits to include noninterest-bearing demand deposits, interest bearing demand and savings deposits, money market demand deposits, and retail time deposits less than $100. Core retail deposits represented 55.7% and 54.4% of total assets as of December 31, 2010 and 2009, respectively. In addition to core certificates of deposit, funding from local certificates with balances greater than $100 made up 8.4% and 8.5% of total assets at December 31, 2010, and 2009, respectively. Despite being held by local customers, these large certificates are not considered core funds as the balances may be temporary and subject to placement with any financial institution offering the highest interest rate bid. Our retail deposit growth is continuously influenced by competitive pressure from other financial institutions, as well as other investment opportunities available to customers. Table 23 outlines the average distribution of deposits during the three years ending December 31, 2010.
Table 23: Average Deposits Distribution
We hold retail and local time deposits collected under the “Certificate of Deposit Account Registry System” (CDARS), a nation-wide program in which network banks work together to obtain greater FDIC insurance on deposits through sharing of banking charters. Such deposits are typically greater than $100 in balance and average balances of CDARS deposits were $21,409 during 2010, $14,795 during 2009, and $11,776 during 2008. The increase in 2010 CDARS was from local municipalities seeking 100% FDIC insurance protection on their large deposits. The increase during 2009 and 2008 was due in part to certain existing and new large deposit balance customers seeking to have a greater portion of their deposits fully FDIC insured due to substantial uncertainty by consumers surrounding the health of the banking industry beginning in 2008. This concern among depositors over the industry waned during 2009 lessoning their desire for FDIC insurance on large deposits. For regulatory purposes, these deposits are considered brokered deposits and disclosed as such on quarterly regulatory filings. However, for internal and external reporting other than for Call Report purposes, these deposits are considered to be retail deposits since the terms of the account are set directly between us and our local customer on a retail basis. Accordingly, these deposits are included as “Retail time deposits $100 and over” in the Tables in this section. Total CDARS deposits totaled $19,618 and $12,113 at December 31, 2010 and 2009, respectively.
Under the TARP legislation passed by the federal government during 2008, we did not opt out of the Transaction Account Guarantee (“TAG”) provisions of the Temporary Liquidity Guarantee Program (“TLGP”). Therefore, in exchange for our payment of a fee to the FDIC, we provided our customers with unlimited FDIC insurance on their noninterest bearing transaction accounts (including certain transactional accounts carrying interest rates of .25% or less) through December 31, 2010. Additional FDIC insurance fees to participate in the TAG Program were approximately $22 and $24 during 2010 and 2009, respectively. In accordance with the provisions of Dodd-Frank, all banks are required to continue in the TAG program providing unlimited FDIC insurance on noninterest bearing deposits in excess of $250 through December 31, 2012.
Table 24 provides a breakdown of deposit categories as of December 31, 2010 and 2009.
Table 24: Period-End Deposit Composition
Table 25 provides a summary of changes in key deposit categories during 2010 and 2009.
Table 25: Change in Deposit Composition
Table 26 outlines maturities of time deposits of $100 or more, including broker and retail time deposits as of December 31, 2010 and 2009.
Table 26: Maturity Distribution of Certificates of Deposit of $100 or More
2010 compared to 2009
Local core deposits increased $16,186, up 4.9%, at December 31, 2010 compared December 31, 2009. An increase in commercial money market funds of $13,258, or 42.5%, led the increase in deposits. The increase of $9,989, or 24.9%, in Rewards Checking balances supported a decline in core certificates of deposit of $8,523, or 14.3% during the year.
Commercial money market balances increased in part from a significant new account opened by a related party during the December 2010 quarter which increased money market deposits by $7,167 at December 31, 2010. These funds are considered seasonal and expected to decline during 2011. In addition, we do not expect such significant commercial money market deposit growth during 2011.
Rewards Checking as been the primary driver of increased deposit growth since its introduction in June 2007. Since the quarter ended June 30, 2007, Rewards Checking has supplied approximately 64% of our net core deposit growth through December 31,
2010. Rewards Checking operates as a traditional interest bearing checking account but pays a premium interest rate and reimbursement of foreign ATM fees if the customer meets certain account usage requirements. In general, the account requires customers to use their debit card at least 10 times per month, deposit their employer paycheck via ACH, and receive their periodic checking account statement via email from our home banking website. The premium rewards annual percentage yield (“APY”) paid was 2.29% and 3.01% at December 31, 2010 and 2009, respectively. The Rewards Checking interest rate is adjustable at our discretion, but is intended to provide the highest potential retail deposit rate product available to customers. The debit card usage requirement substantially increased the amount of debit card interchange income as described previously under the section titled “Noninterest income”.
The incremental “all-in” cost of Rewards Checking deposits is less than wholesale funding alternatives and is believed to be a long-term cost effective source of funds in addition to providing PSB with a competitive advantage in the retail banking environment and greater control over the repricing of local deposits in a rising rate environment. Rewards Checking balances were $50,187 and $40,198 at December 31, 2010, and 2009, respectively. The average interest cost of Rewards Checking balances (excluding debit card interchange fees, savings from delivery of electronic periodic statements and software costs of maintaining the program) was 2.10% in 2010 compared to 2.80% in 2009. After accelerated growth in Rewards Checking balances since its introduction in June 2007, balance growth is expected to slow during 2011 compared to 2010 as this new type of product begins to mature in our current markets and the Rewards rate becomes less attractive to customers in an extended very low rate environment.
Changes to debit card interchange income contained in Dodd-Frank and proposed by the Federal Reserve are anticipated to have a dramatic impact to the profitability of Rewards Checking. Under rules currently proposed by the Federal Reserve, our customer’s debit card activity could become a loss leader after years of providing additional income with which to pay higher than market deposit rates since the product’s introduction. We are currently evaluating other product options attractive to our customers that meet market needs and minimize our operating expenses and servicing costs in light of reduced interchange income. These products could replace Rewards Checking or be priced in a manner more attractive than Rewards Checking in light of the potential decrease to debit card interchange income. Because Rewards Checking deposit growth has been the significant driver of local deposit growth, a change to the account structure could reduce Rewards Checking deposits.
Government deposits grew significantly during 2009 from introduction of an unsecured high yield money market account but declined $2,890, or 6.6%, to $40,807 at December 31, 2010 compared to December 31, 2009. As loan growth slowed significantly during 2010, we reduced the high yield rate paid on the government money market account which led to the decrease in balances. However, at December 31, 2010, we continue to maintain a large of amount of total deposits with a small number of municipalities and commercial customers. If a new overnight repurchase agreement account opened in 2010 were also included, we held $49.8 million of total deposits and overnight repurchase amounts form the ten largest customers, making up approximately 12% of our total local deposits and overnight repurchase agreements at December 31, 2010. Many of the balances at year-end were seasonal deposits and expected to be withdrawn during the first several months of 2011. In light of the seasonal nature of many large accounts at year-end and expected low organic loan growth during 2011, we expect small increases to local deposit growth in our existing markets during 2011.
2009 compared to 2008
Local core deposits other than certificates increased substantially during 2009, up $39,417, or 17.1% at December 31, 2009 compared to December 31, 2008. The primary drivers of these increased deposits were Rewards Checking NOW growth of $17,120, local government and municipal deposit growth of $10,060, private banking NOW deposit growth of $6,001, and noninterest bearing commercial deposit growth of $3,312. While growth in Rewards Checking and municipal deposits were driven by new account types, the increase in private banking NOW deposits and commercial noninterest bearing deposits was not due to new account types introduced during 2009.
The majority of growth in Rewards Checking was from new customers, who represented approximately 71% of the dollar growth during 2009. Rewards Checking balances were $40,198 and $23,078 at December 31, 2009, and 2008, respectively. The average interest cost of Rewards Checking balances (excluding debit card interchange fee income, savings from delivery of electronic periodic statements and software costs of maintaining the program) was 2.80% in 2009 compared to 3.62% in 2008.
Governmental deposits grew during 2009 primarily from introduction of a new high yield money market account paid on uncollateralized funds. Some municipalities, looking to maintain their investment yields in a declining short-term investment yield market, invested funds in our high yield money market account greater than $100 for which we did not need to provide collateralization of deposits. Because the high yield rate was substantially greater than our rate in the collateralized government NOW account, some funds moved from the NOW to the money market account. However, the account did provide sales opportunities to new municipality customers who added to our deposit base. In the future, as short-term investment yields rise past the high yield money market rate, we expect customers to move out of that account and back into the government NOW account to again obtain collateralization of their deposits. At December 31, 2009, $25,400 of government funds were maintained in the high yield money market account.
Wholesale Funding Sources and Available Liquidity
Our asset-liability management process provides a unified approach to management of liquidity, capital, and interest rate risk, as well as providing adequate funds to support the borrowing requirements and deposit flow of our customers. We view liquidity as the ability to raise cash at a reasonable cost or with a minimum of loss and as a measure of balance sheet flexibility to react to marketplace, regulatory, and competitive changes.
We use primary short-term and long-term funding sources other than retail deposits including federal funds purchased from other correspondent banks, repurchase agreements from security pledging, advances from the FHLB, use of wholesale time deposits, and advances taken from the Federal Reserve’s Discount Window. Table 28 outlines the available and unused portion of these funding sources (based on collateral and/or company policy limitations) as of December 31, 2010 and 2009. Currently unused but available funding sources along with a significant amount of overnight liquid funds at December 31, 2010 are considered sufficient to fund anticipated 2011 asset growth.
We maintain formal policies to address liquidity contingency needs and to manage a liquidity crisis. Table 27 provides a summary of how the wholesale funding sources normally available to us would be impacted by various operating conditions.
Table 27: Environmental Impacts on Availability of Wholesale Funding Sources:
* May be available but subject to restrictions
Table 28 summarizes the availability of various wholesale funding sources at December 31, 2010 and 2009.
Table 28: Available but Unused Funding Sources other than Retail Deposits:
2010 compared to 2009
The following discussion examines each of the available but unused funding sources listed in Table 28 above and the factors that may directly or indirectly influence the timing or the amount ultimately available to us.
Overnight federal funds purchased
Our aggregate federal funds purchase availability of $25,500 is from three correspondent banks. The most significant portion of the total is $12,500 from our primary correspondent bank, Bankers’ Bank located in Madison, Wisconsin. We make regular use of the Bankers’ Bank line as part of our normal daily cash settlement procedures, but rarely have used the lines offered by the other two correspondent banks. Federal funds must be repaid each day and borrowings may be renewed for up to 14 consecutive business days. To unilaterally draw on the existing federal funds line, we need to maintain a “composite ratio” as defined by Bankers’ Bank of 40% or less. Bankers’ Bank defines the composite ratio to be nonperforming assets divided by capital including the allowance for loan losses calculated at our subsidiary bank level. Due to existence of the composite ratio, an increase in nonperforming loans could impact availability of the line or subject us to further review. In addition, a rising composite ratio could cause our other two correspondent banks to reconsider their federal funds line with us since they do not also serve as our primary correspondent bank. At December 31, 2010, our subsidiary bank’s composite ratio was approximately 24% and less than the 40% benchmark used by Bankers’ Bank.
Federal Reserve discount window advances
We have a $100,000 line of credit with the Federal Reserve Discount Window supported by both commercial and commercial real estate collateral provided to the Federal Reserve under their Borrower in Custody (“BIC”) program. During 2010, the annualized interest rate applicable to Discount Window advances was .75%. Under the BIC program, we provide a monthly listing of detailed loan information on the loans provided as collateral. We are subject to annual review and certification by the Federal Reserve to retain participation in the program. The Discount Window represents the primary source of liquidity on a daily basis following our federal funds purchased lines of credit discussed above. We were limited to a maximum advance of $94,980 at December 31, 2010 based on the BIC loan collateral pledged. In general, Discount Window advances must be repaid or renewed each day. No Discount Window advances were used during 2010 or 2009.
Only performing loans are permitted as collateral under the BIC and each individual loan is subject to a haircut to collateral value based on the Federal Reserve’s review of the listing each month. In general, 55% to 60% of the loan principal offered as collateral is able to support Discount Window advances. Similar to the federal funds purchased lines of credit, an increase in nonperforming loans would decrease the amount of collateral available for Discount Window advances.
Federal Home Loan Bank (FHLB) advances under blanket mortgage lien and other FHLB advances
We maintain a line of credit availability with the FHLB based on a pledge of 1 to 4 family mortgage loan collateral, both first and secondary lien positions. We may borrow on the line to the lesser of the blanket mortgage lien collateral provided, or 20 times our existing FHLB capital stock investment. Based on the our existing $3,250 capital stock investment, total FHLB advances in excess of $65,000 require us to purchase additional FHLB stock equal to 5% of the advance amount. At December 31, 2010, we could have drawn an FHLB advance up to $7,566 of the $15,056 available without the purchase of FHLB stock. Further advances of the remaining $7,490 available would have required us to purchase additional FHLB stock totaling $375. After several years of no dividends, the FHLB declared a nominal annualized cash dividend of .10% during the December 2010 quarter. We do not expect significant increases in the FHLB dividend during 2011. Therefore, additional FHLB advances carry additional cost relative to other wholesale borrowing alternatives due to the requirement to hold non-earning FHLB stock.
Similar to the Discount Window, only performing residential mortgage loans may be pledged to the FHLB under the blanket lien. In addition, we are subject to a haircut of approximately 36% on first mortgage collateral and 60% on secondary lien collateral at December 31, 2010. The increase to a 60% haircut on secondary line collateral compared to the 40% haircut at December 31, 2009 reduced our borrowing capacity by approximately $7 million during 2010. The FHLB also conducts annual audits of collateral identification and submission procedures and adjusts the collateral haircuts higher in response to negative exam findings. The FHLB also assigns a credit risk grade to each member based on a quarterly review of the member’s regulatory CALL report. Our current credit risk is within the normal range for a healthy member bank. Negative financial performance trends such as reduced capital levels, increased nonperforming assets, net losses, and other factors can increase a member’s credit risk grade. Higher risk grades can require a member to provide detailed loan collateral listings (rather than a blanket lien), physical collateral, and other restrictions on the maximum line usage. FHLB advances are available on a daily basis and along with Discount Window advances represent a primary source of liquidity following our federal funds purchased lines of credit.
FHLB advances carry substantial penalties for early prepayment that are generally not recovered from the lower interest rates in refinancing. The amount of early prepayment penalty is a function of the difference between the current borrowing rate, and the rate currently available for refinancing. Effective in 2011, the FHLB has announced rules to ease the pledging of commercial related collateral for advances. We currently do not pledge commercial loan collateral to the FHLB.
Repurchase agreements and FHLB advances collateralized by investment securities
Wholesale repurchase agreements may be available from a correspondent bank counterparty for both overnight and longer terms. Such arrangements typically call for the agreement to be collateralized by us at 110% of the repurchase principal. In the current market, repurchase counterparty providers are extremely limited and would likely require a minimum $10 million transaction. Repurchase agreements could require up to several business days to receive funding. Due to the lack of availability of
counterparties offering the product, wholesale repurchase agreements are not a reliable source of liquidity. At December 31, 2010, $13.5 million of our repurchase agreements are wholesale agreements with correspondent banks and $18.0 million are overnight repurchase agreements with local customers utilizing our treasury management services.
In addition to availability of FHLB advances under the blanket mortgage lien, we also have the ability to pledge investment securities as collateral against FHLB advances. Advances secured by investments are also subject to the FHLB stock ownership requirement as described previously. Due to the need to purchase additional FHLB member stock, FHLB advances secured by investments are not considered a primary source of liquidity. At December 31, 2010, $17,177 of additional FHLB advances were available based on pledging of securities if an additional $859 of member capital stock were purchased.
Wholesale market deposits
Due to the strength of our capital position, balance sheet, and ongoing earnings, we enjoy the lowest possible costs when purchasing wholesale certificates of deposit on the brokered market. We have an internal policy that limits use of brokered deposits to 20% of total assets , which gave availability of $57,388 at December 31, 2010. Brokered certificates were 10.8% of assets at December 31, 2010 and 12.7% of assets at December 31, 2009. Due to a limited number of providers of repurchase agreement funding as well as our desire to retain unencumbered securities for liquidity purposes and adverse impacts from holding additional FHLB capital stock, brokered certificate of deposit funding is expected to increase during 2011 to the extent loan growth is not funded with local deposit growth.
Participants in the brokered certificate market must be considered “well capitalized” under current regulatory capital standards to acquire brokered deposits without approval of their primary federal regulator. We regularly acquire brokered deposits from three market providers and maintain relationships with other providers to obtain required funds at the lowest possible cost. Ten business days are typically required between the request for brokered funding and settlement. Therefore, brokered deposits are a reliable, but not daily, source of liquidity. Brokered deposits represent our largest source of wholesale funding and we would see significant negative impacts if capital levels or earnings were to decline to levels not considered to be well capitalized. In addition to the requirement to be considered well-capitalized, banks under regulatory consent orders are not permitted to participate in the brokered deposit market without approval of their primary federal regulator even if they maintain a well-capitalized capital classification.
Holding company unsecured line of credit
We maintain a $1,000 line of credit with a correspondent bank as a contingency liquidity source. No amounts were drawn on the line at December 31, 2010 or 2009. Although our bank subsidiary has in the past provided the holding company’s liquidity needs through semi-annual upstream dividends of profits, losses or other negative performance trends could prevent the bank form providing these dividends as cash flow. Because our bank holding company has approximately $892 of financing obligations per year as well as approximately $150 of other expenses (before tax benefits), the holding company line of credit is a critical source of potential liquidity.
We are subject to financial covenants associated with the line which during 2010 required our bank subsidiary to:
·
Be considered “well capitalized” at all times.
·
Maintain nonperforming assets as a percentage of equity plus the allowance for loan losses to less than 30%.
·
Maintain loan loss reserves no less than 55% of nonperforming loans.
·
Maintain total risk based capital ratio of at least 11.75%
At December 31, 2010, we were not in violation of any of the line of credit covenants. A violation of any covenant could prevent us from utilizing the unused balance of the line of credit. Refer to Item 8, Note 10 of the Notes to Financial Statements for more information. We expect to renew the line of credit upon its maturity on February 28, 2011.
If liquidity needs persist after exhausting all available funds from the sources described above, we would consider more drastic methods to raise funds including, but not limited to, sale of investment securities at a loss, cessation of lending to new or existing customers, sale of branch real estate in a sale-leaseback transaction, surrender of bank owned life insurance to obtain the cash surrender value net of taxes due, packaging and sale of residential mortgage loan pools held in our portfolio, sale of foreclosed assets at a loss, and sale of mortgage servicing rights. Such actions could generate undesirable sale losses or income tax impacts. While sale of additional common stock or issuance of other types of capital could provide additional liquidity, the ability to find significant buyers of such capital issues during a liquidity crisis would be difficult making such a source of funding unlikely or unreliable if the liquidity crisis was caused by our deteriorating financial condition.
2009 compared to 2008
At December 31, 2009, overnight federal funds purchased totaling $24,500 were available through three correspondent banks. During 2009, a correspondent bank providing a secondary federal funds purchased line reduced our funds availability from $10,000 to $7,000. This change lowered our total federal funds purchased lines from $27,500 to $24,500. During 2009, the only federal funds line used was our $12,500 line from our primary correspondent bank as part of our regular daily cash management system.
During 2009, we were granted permission by the Federal Reserve to participate in their Borrower in Custody (“BIC”) program that allows us to pledge performing commercial and commercial real estate loans against overnight Discount Window advances. During 2009, the annualized interest rate due on Discount Window advances was .50%, although this rate was increased to .75% by the Federal Reserve on February 18, 2010. The Federal Reserve intends for Discount Window advances to be used for emergency liquidity purposes and raised the interest rate to discourage banks from using the line for normal day to day operations. We may draw up to $100 million on our Discount Window line of credit, but were limited to a maximum advance of $74,261 at December 31, 2009 based on the BIC loan collateral pledged. At December 31, 2009, we could borrow on the Discount Window approximately 50% of the principal amount of loans pledged under the BIC program. No Discount Window advances were used during 2009.
During 2009, the FHLB made available the pledging of certain municipal investment securities against advances, which could increase our maximum advance liquidity with the FHLB, although this increase is not reflected in Table 27 due to specific limitations on the municipal securities eligible to be pledged. Although up to an additional $20,929 of FHLB advances could be obtained on existing mortgage collateral, due to our desire to maintain our current investment in FHLB capital stock of $3,250, the amount of unused but available FHLB advances at December 31, 2009 before additional capital stock would be required is $6,841.
Securities not pledged to the Federal Reserve for the Discount Window or pledged to the FHLB for advances are available for pledging against repurchase agreements. During 2009, borrower costs related to repurchase agreements increased compared to other wholesale funding alternatives and the number of correspondent banks providing such financing declined. As an alternative to pledging securities against repurchase agreements, such securities could also be pledged against FHLB advances, as noted previously, subject to the purchase of additional FHLB capital stock for aggregate advances in excess of $65,000.
Due to the strength of our capital position, balance sheet, and ongoing earnings, we enjoy the lowest possible costs when purchasing wholesale certificates of deposit on the brokered market. We have an internal policy that limits use of brokered certificates to 20% of total assets, which gave availability of $44,176 at December 31, 2009. Brokered certificates were 12.7% of assets at December 31, 2009 and 11.4% of assets at December 31, 2008.
Our parent company, PSB Holdings, Inc. maintained a $1,000 line of credit with a correspondent bank as contingency liquidity at the holding company level. The line of credit remained unused during 2009.
Liquidity Measurements and Contingency Plan
Our liquidity management and contingency plan calls for quarterly measurement of key funding, capital, problem loan, and liquidity contingency ratios at our banking subsidiary level. The measurements are compared to various risk levels that direct management to further responses to declining liquidity measurements as outlined below:
Risk Level 1 is defined as circumstances that create the potential for elevated liquidity risk, thus requiring an assessment of possible funding deficiencies. Normal business operations, plans and strategies are not anticipated to be immediately impacted.
Risk Level 2 is defined as circumstances that point to an increased potential for disruptions in the Bank’s funding plans, needs and/or resources. Assessment of the probability of a liquidity crisis is more urgent, and identification and prioritization of pre-emptive alternatives and actions may be both warranted and time sensitive.
Risk Level 3 is defined as circumstances that create a likely funding problem, or are symptomatic of circumstances that are highly correlated with impending funding problems; and, therefore, are expected to require some level of immediate action depending upon the situation.
These risk parameters and other qualitative and environmental factors are considered to determine whether a “Stress Level” response is required. Identification of a risk trigger does not automatically call for a stress level response. The following summarizes our response plans to various degrees of liquidity stress:
Stress Level A - Management provides a written summary evaluating the warning indicators and why it is deemed unlikely that there will be a resulting liquidity challenge.
Stress Level B - Management provides an assessment of the probability of a liquidity crisis and completes a sources and uses of funds report to estimate the impact on pro forma liquidity. Liquidity stress tests will be reviewed to ensure the scenarios being simulated are sufficiently robust and that there is adequate funding to satisfy potential demands for cash. Various pre-emptive actions will be considered and acted on as needed.
Stress Level C - Management has determined a funding crisis is likely and documents detailed assessments of the current liquidity situation and future liquidity needs. The Board approved action plan is carried out with vigor and may call for one or all of the following steps, among others, to mitigate the liquidity concern: sale of loans, intensify local deposit gathering programs, transferring unencumbered securities and loans to the Federal Reserve for Discount Window borrowings, curtail all lending except for specifically approved loans, reduce or suspend stock dividends, and investigate opportunities to raise new capital.
As of December 31, 2010, two capital risk triggers were exceeded based on a measurement added during 2010. At December, 31, 2010, commercial and industrial loans were 215% of capital and commercial real estate loans were 327% of capital, exceeding their “Risk Level 1” trigger points of 200% and 300%, respectively. Due to our concentration on commercial related lending to local borrowers and relatively low levels of capital, we consistently exceed this trigger. However, we have historically experienced net loan charge-offs on commercial related lending less than similar sized banks and do not consider this mix of loans to signify an undercapitalized position. No liquidity stress level was considered to exist at December 31, 2010.
As of December 31, 2009, no Risk Level 1 liquidity triggers were exceeded other than the projection of elevated wholesale funding needs during the March 2010 quarter due to seasonal run-off of local government deposit funds. Projection of elevated funding needs was considered a Risk Level 1 trigger. We did not incur difficulty replacing run-off of these seasonal funds with wholesale funds due to continued strong regulatory capital levels and existence of a large position of liquid federal funds sold at December 31, 2009. No liquidity stress level was considered to exist at December 31, 2009.
As part of our formal quarterly asset-liability management projections, we also measure basic surplus as the amount of existing net liquid assets (after deducting short-term liabilities and coverage for anticipated deposit funding outflows during the next 30 days) divided by total assets. The basic surplus calculation does not consider unused but available correspondent bank federal funds purchased, as those funds are subject to availability based on the correspondent bank’s own liquidity needs and therefore are not guaranteed contractual funds. However, basic surplus does include unused but available FHLB advances under the open line of credit supported by a blanket lien on mortgage collateral. Basic surplus does not include available brokered certificate of deposit funding as those funds generally may not be obtained within one business day following the request for funding. Our policy is to maintain a basic surplus of at least 5%. Basic surplus was 8.7% and 5.6% at December 31, 2010 and 2009, respectively.
CAPITAL RESOURCES
We are required to maintain minimum levels of capital to be considered well-capitalized under current banking regulation. Refer to Item 8, Note 19 of the Notes to Consolidated Financial Statements for these requirements and our current capital position relative to these requirements. The Dodd-Frank Act calls for higher regulatory minimums to be considered well capitalized. Although we expect the new capital guidelines to be published in 2011, no written guidance has yet been provided on how much the minimum levels will be raised. In addition, regulatory limitations on fee income and higher compliance burdens are expected to spur a wave of bank consolidation and merger and acquisition activity in the coming years. Acquisition of another bank or bank location for growth would likely pressure our regulatory capital ratios lower and increase the potential for a new common or preferred stock capital issue which could dilute existing stockholders.
The primary increase in stockholders’ equity during the three years ended December 31, 2010 has been retained net income not distributed to stockholders via cash dividends or share buybacks on the open market. Failure to remain well-capitalized would prevent us from obtaining future wholesale broker time deposits which have been an important source of funding during the past several years. Refer to Item 8, Statement of Changes in Stockholder’s Equity in the Consolidated Financial Statements for detailed activity in the capital accounts. Average tangible common capital to total assets was 7.43% during 2010 and 7.27% during 2009. Table 29 presents a reconciliation of stockholders’ equity as presented in the consolidated balance sheets for the three years ended December 31, 2010 to regulatory capital.
Table 29: Capital Ratios
Capital increased $4,420, or 10.5%, during 2010 from retained net income of $3,626 and an increase in unrealized gain on securities available for sale of $767. We pay a regular semi-annual cash dividend as described in Item 5 of this Annual Report on Form 10-K. Prior to 2008, we maintained an informal, annual, ongoing share repurchase program of up to 1% of outstanding shares per year as described in Item 5 of this Annual Report on Form 10-K. Due to the difficulty and related cost of raising new capital to support asset growth at this time, we temporarily suspended the buyback program during 2008 and no shares were repurchased during the three years ended December 31, 2010. We do not expect to buyback a significant number of shares under the program during 2011.
Capital increased $3,467 during 2009 from net income, unrealized gains in the securities available for sale portfolio and vesting of unrestricted stock before payment of dividends totaling $1,096. Capital increased $4,338 during 2008 from net income, unrealized gains in the securities available for sale portfolio and vesting of unrestricted stock grants before payment of dividends totaling $1,054.
During 2008 and 2007, asset growth (primarily commercial related lending) outpaced our retained earnings growth, decreasing the average stockholders’ equity ratio and lowering the total risk-adjusted capital ratio from 11.91% at December 31, 2006 to 10.63% at December 31, 2008. To retain “well capitalized” status under banking regulation, the total risk adjusted capital ratio must be greater than 10%. During 2008, we applied to the U.S. Treasury Department to issue them 14,000 shares of senior preferred stock with a stated value of $1,000 per share under the TARP Capital Purchase Program (“CPP”). To facilitate issuance of preferred stock, our shareholders approved the authorization of 30,000 shares of preferred stock at no-par value at a special meeting on December 12, 2008. We received approval of our application to sell preferred stock to the U.S. Treasury during 2009. However, we declined participation in the program following our approval due to concern participation in the program would be negatively perceived by customers and stakeholders as a “bailout”. To meet this regulatory capital need, during 2009, we issued 8% Senior Subordinated Notes of $7,000 to supplement our regulatory risk based total capital. Refer to
Item 8, Note 11 in the Notes to Consolidated Financial Statements for detailed information on the Senior Subordinated Notes issue.
We have issued trust preferred securities represented by junior subordinated debentures on the Consolidated Balance Sheets which may provide up to 25% of our total Tier 1 regulatory capital. Refer to Item 8, Note 12 in the Notes to Consolidated Financial Statements for detailed information on the trust preferred security issue. The Dodd-Frank Act no longer permits us to issue new trust preferred securities as Tier 1 capital as in prior years, although our existing $7.5 million trust preferred capital securities are grandfathered as Tier 1 capital.
Senior Subordinated Notes and Junior Subordinated Debentures represent approximately 23% of our total regulatory capital. Unlike our common stock, these capital obligations require regular quarterly interest payments that may not be eliminated if our financial condition were to deteriorate (although the interest payments on junior subordinated notes could be deferred for up to five years before considered a default of the debt). Therefore, we expect any future capital needs during the next several years beyond retained earnings from operations to be met via issuance of our authorized common or preferred stock, although no current plans for issuance of common or preferred stock exist.
In December 2010, the U.S. Treasury introduced a new small bank capital program known as the “Small Business Lending Fund” established by the Small Business Jobs Act with funding up to $30 billion in an effort to spur small business lending. Under the program, only available to well performing banks less than $10 billion in assets such as us, banks may issue Preferred Stock to the U.S. Treasury with a variable dividend rate that could later be fixed as low as 1% depending on the level of small business lending growth during the first 10 quarters following issuance of the preferred stock. The preferred stock dividend later resets to 9% on the 4 ½ year anniversary of the preferred stock issue until repaid. We are evaluating whether such temporarily low cost capital could be used to spur lending and income growth and are investigating other costs and limitations associated with the government plan.
We are considered well-capitalized under regulatory capital rules with total risk adjusted capital of 14.27% at December 31, 2010 compared to 12.49% at December 31, 2009. Current regulations require a minimum total risk adjusted capital ratio of 10.00% to be considered well-capitalized. During 2010, total risk weighted assets declined from recognition of certain five or more family real estate mortgage loans as subject to 50% risk weighting, rather than the 100% risk weighting assigned in prior years. In addition, we were relieved of a guarantee liability on customer debt to a correspondent bank during 2010 which further reduced risk weighted assets and increased the total risk adjusted capital ratio. These changes, along with retained 2010 net income, increased total regulatory capital significantly higher than 2009.
We maintain an incentive stock option plan approved by stockholders during 2001 and a restricted stock plan as described in Item 8, Note 18 of the Notes to Consolidated Financial Statements. The total expense recognized under both plans was $43, $25, and $10 during 2010, 2009, and 2008, respectively.
OFF-BALANCE-SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS
Off Balance Sheet Arrangements
We service residential mortgage loans originated by our lenders and sold to the FHLB and FNMA. As a FHLB Mortgage Partnership Finance (“MPF”) loan servicer, we provide a credit enhancement guarantee to reimburse the FHLB for foreclosure losses in excess of 1% of the original loan principal sold to the FHLB prior to November 2008. Refer to Item 8, Notes 4, 6, and 17 of the Notes to Consolidated Financial Statements for information on the FHLB MPF program. These first mortgage loans are underwritten using standardized criteria we consider to be conservative on residential properties in our local communities. We believe loans serviced for the FHLB will realize minimal foreclosure losses in the future and that we will experience no loan losses related to charge-offs in excess of the FHLB 1% First Loss Account. The north central Wisconsin residential real estate market is experiencing similar home value declines as the state of Wisconsin as a whole, which are moderate when compared to other states in the country. The average residential first mortgage originated by us under the FHLB program which required a credit enhancement was approximately $154 in 2008 and $140 during 2007, the last two years of the program.
Under bank regulatory capital rules, this FHLB recourse obligation to the FHLB is risk-weighted for the purposes of the total capital to risk-weighted assets capital calculation. Total risk-based capital required to be held for the recourse obligations under the FHLB MPF programs for capital adequacy purposes was $1,859 at December 31, 2010, and $1,901 at December 31, 2009, and 2008. During October 2008, we ceased origination and sale of loans to the FHLB that required a credit enhancement and no additional risk-based capital will be required to support such loans. More information on all loans serviced for other investors, including FHLB and FNMA, is outlined in Table 30.
Other significant off-balance sheet financial instruments include the various loan commitments outlined in Item 8, Note 17 of the Notes to Consolidated Financial Statements. These lending commitments are a traditional and customary part of lending operations and many of the commitments are expected to expire without being drawn upon.
Residential Mortgage Loan Servicing
We service $260,097 and $237,764 of residential real estate loans which have been sold to the FHLB and FNMA at December 31, 2010 and 2009, respectively. Loans sold to FHLB and FNMA are not reflected on our Consolidated Balance Sheets. An annualized servicing fee equal to .25% of outstanding principal is retained from payments collected from the customer as compensation for servicing the loan for the FHLB and FNMA.
For loans originated and sold to the FHLB prior to November 2008, we are also paid an annualized “credit enhancement” fee of .07% to .10% of outstanding serviced principal in addition to the .25% collected for servicing the loan for the FHLB impacting $70,209, or 27%, of loans serviced for the FHLB at December 31, 2010 compared to $102,659, or 44%, at December 31, 2009. See also “Off Balance Sheet Arrangements” in Item 8, Note 17 and “Loans” in Note 4 of the Notes to Consolidated Financial Statements. Mortgage loan servicing and credit enhancement fees have been an important source of mortgage banking income. Because no further loans are sold to the FHLB with our credit enhancement, we expect credit enhancement fees to decline in future years as this serviced principal is repaid. Credit enhancements fees were $29 in 2010, $105 in 2009, and $158 in 2008. Refer to Item 8, Note 6 of the Notes to Consolidated Financial Statements for a breakdown of mortgage banking revenue. We recognize a mortgage servicing right asset due to the substantial volume of loans serviced for the FHLB and FNMA. Refer to Note 1 of the Notes to Consolidated Financial Statements for a summary of our mortgage servicing right accounting policies.
Losses incurred by the FHLB on loans in the MPF 100 program and the MPF 125 program are absorbed by the FHLB in their First Loss Account. If cumulative losses were to exceed the First Loss Account, we would reimburse the FHLB for any excess losses up to the extent of our Credit Enhancement Guarantee. Ten years after the original pool master commitment date, the First Loss Account and the Credit Enhancement Guarantee are reset to current levels based on loans remaining in the pool. These factors are further reset every subsequent five years until the pool is repaid. During 2010, the MPF 100 program reached its ten year anniversary and the First Loss Account and Credit Enhancement Guarantee associated with that program were reset to the new level shown in Table 30. The next First Loss Account reset date for any individual master commitment containing our Credit Enhancement Guarantee is scheduled for August 18, 2013.
Due to historical strength of mortgage borrowers in our markets and relative stability of collateral home values, and the original 1% of principal First Loss Account provided by the FHLB, we believe the possibility of losses under guarantees to the FHLB to be remote. Since inception of our pools containing guarantees to the FHLB in 2000, only $0.2 million of $425 million of loans originated with guarantees have incurred a principal loss, all of which has been borne by the FHLB within their First Loss Account. Accordingly, no provision for a recourse liability has been made for this recourse obligation on loans currently serviced by us. Loans originated and sold to the FHLB under their XTRA program do not require credit enhancement and PSB has no risk of principal loss on such loans properly underwritten and sold.
All loans sold to FHLB or FNMA in which we retain the loan servicing are subject to underwriting representations and warranties made by us as the originator and we are subject to annual underwriting audits from both entities. Our representations and warranties would allow FHLB or FNMA to require us to repurchase inadequately originated loans for any number of underwriting violations. We have originated loans to these secondary market providers since 2000 and have never been required to repurchase a loan for underwriting or servicing violations and do not expect to be required to repurchase loans in the near term.
Table 30 summarizes the various programs and investors for which we serviced loans as of December 31, 2010 and 2009.
Table 30: Residential Mortgage Loan Servicing for Others
During 2010 and 2009, we experienced large amounts of growth in our serviced mortgage loan portfolio totaling $22,333, up 9.4% during 2010 and $51,859, up 28% during 2009, as borrowers refinanced loans during a period of historically low interest rates. We do not expect such serviced loan growth to continue during 2011.
Contractual Obligations
We are party to various contractual obligations requiring use of funds as part of our normal operations. Table 31 outlines the principal amounts and timing of these obligations, excluding amounts due for interest, if applicable. Nonmaturity deposits and overnight federal funds purchased and overnight repurchase obligations are not included in Table 31 because they are not classified as long-term obligations. Most of these obligations shown in the Table, including FHLB advances and time deposits, are routinely refinanced into a similar replacement obligation without requiring any substantial outflow of cash. However, renewal of these obligations is dependent on our ability to offer competitive market equivalent interest rates or availability of collateral for pledging such as retained mortgage loans or securities as in the case of advances from the FHLB. Our funds management policy includes a formal liquidity contingency plan to identify low cost and liquid funds available in the event of a liquidity crisis as outlined under the section labeled, “LIQUIDITY” in this Annual Report on Form 10-K.
Table 31: Long-Term Contractual Obligations at December 31, 2010
Item 7A.
Item 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
Item 8.
Item 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Registered Public Accounting Firm
Board of Directors
PSB Holdings, Inc.
Wausau, Wisconsin
We have audited the accompanying consolidated balance sheets of PSB Holdings, Inc. and Subsidiary (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included considerations of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PSB Holdings, Inc. and Subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States.
/s/ Wipfli LLP
Wipfli LLP
March 4, 2011
Wausau, Wisconsin
Consolidated Balance Sheets
December 31, 2010 and 2009
(dollars in thousands except per share data)
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
Years Ended December 31, 2010, 2009, and 2008
(dollars in thousands except per share data)
See accompanying notes to consolidated financial statements.
Consolidated Statements of Changes in Stockholders’ Equity
Years Ended December 31, 2010, 2009, and 2008
(dollars in thousands except per share data)
Consolidated Statements of Changes in Stockholders’ Equity (Continued)
Years Ended December 31, 2010, 2009, and 2008
(dollars in thousands except per share data)
See accompanying notes to consolidated financial statements.
Consolidated Statements of Cash Flows
Years Ended December 31, 2010, 2009, and 2008
(dollars in thousands except per share data)
Consolidated Statements of Cash Flows (Continued)
Years Ended December 31, 2010, 2009, and 2008
(dollars in thousands except per share data)
See accompanying notes to consolidated financial statements.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 1
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principal Business Activity
PSB Holdings, Inc. operates Peoples State Bank (the “Bank”), a full-service financial institution chartered as a Wisconsin commercial bank with eight locations in a primary service area including, but not limited to, Marathon, Oneida, and Vilas counties, Wisconsin. It provides a variety of banking products, including uninsured investment and insurance products, long-term fixed rate residential mortgages, and commercial treasury management services.
Principles of Consolidation
The consolidated financial statements include the accounts of PSB Holdings, Inc. and its subsidiary, Peoples State Bank. Peoples State Bank owns and operates a Nevada subsidiary, PSB Investments, Inc., to manage the Bank’s investment securities. All significant intercompany balances and transactions have been eliminated. The accounting and reporting policies of PSB conform to accounting principles generally accepted in the United States (GAAP) and to the general practices within the banking industry. Any reference to “PSB” refers to the consolidated or individual operations of PSB Holdings, Inc. and its subsidiary, Peoples State Bank.
Use of Estimates in Preparation of Financial Statements
The preparation of the consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Estimates that are susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing right assets, and the valuation of investment securities.
Cash Equivalents
For purposes of reporting cash flows in the consolidated financial statements, cash and cash equivalents include cash and due from banks, interest-bearing deposits and money market funds, and federal funds sold, all of which have original maturities of three months or less.
Securities
Securities are assigned an appropriate classification at the time of purchase in accordance with management’s intent. Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost. Amortization of the net unrealized gain on securities held to maturity that were transferred from securities available for sale is recognized in other comprehensive income using the interest method over the estimated lives of the securities. Amortization of premiums and accretion of discounts on purchased securities held to maturity is recognized in interest income using the interest method over the estimated lives of the securities.
Trading securities include those securities bought and held principally for the purpose of selling them in the near future. PSB has no trading securities.
Securities not classified as either securities held to maturity or trading securities are considered available for sale and reported at fair value determined from estimates of brokers or other sources. Unrealized gains and losses are excluded from earnings but are reported as other comprehensive income, net of income tax effects, in a separate component of stockholders’ equity. Amortization of premiums and accretion of discounts is recognized in interest income using the interest method over the estimated lives of the securities.
Gains and losses on the sale of securities are recorded on the trade date and determined using the specific-identification method.
Declines in fair value of securities that are deemed to be other than temporary, if applicable, are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers the length of time and the extent to which fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of PSB to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Loans Held for Sale
PSB sells substantially all long-term fixed-rate single-family mortgage loans it originates to the secondary market. The gain or loss associated with sales of single-family mortgage loans is recorded as a component of mortgage banking revenue.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. Gains and losses on the sale of loans held for sale are determined using the specific identification method using quoted market prices.
In sales of mortgage loans to the Federal Home Loan Bank (FHLB) prior to November 2008, PSB retained a secondary portion of the credit risk on the underlying loans in exchange for a credit enhancement fee. When applicable, PSB records a recourse liability to provide for potential credit losses. Because the loans involved in these transactions are similar to those in PSB’s loans held for investment, the review of the adequacy of the recourse liability is similar to the review of the adequacy of the allowance for loan losses (refer to “Allowance for Loan Losses”).
Loans
Loans that management has the intent to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest on loans is credited to income as earned. Interest income is not accrued on loans where management has determined collection of such interest is doubtful or those loans which are past due 90 days or more as to principal or interest payments. When a loan is placed on nonaccrual status, previously accrued but unpaid interest deemed uncollectible is reversed and charged against current income. After being placed on nonaccrual status, additional income is recorded only to the extent that payments are received and the collection of principal becomes reasonably assured. Interest income recognition on loans considered to be impaired is consistent with the recognition on all other loans.
Loan origination fees and certain direct loan origination costs are deferred and recognized as an adjustment of the related loan yield using the interest method.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes the collectibility of the principal is unlikely.
Management maintains the allowance for loan losses at a level to cover probable credit losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. In accordance with current accounting standards, the allowance is provided for losses that have been incurred based on events that have occurred as of the balance sheet date. The allowance is based on past events and current economic conditions and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions.
The allowance for loan losses includes specific allowances related to loans which have been judged to be impaired. A loan is impaired when, based on current information, it is probable that PSB will not collect all amounts due in accordance with the contractual terms of the loan agreement. Management has determined that commercial, financial, agricultural, and commercial real estate loans that have a nonaccrual status or have had their terms restructured meet this definition. Large groups of homogeneous loans, such as mortgage and consumer loans, are collectively evaluated for impairment. Specific allowances on impaired loans are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.
In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require PSB to make additions to the allowance for loan losses based on their judgments of collectibility resulting from information available to them at the time of their examination.
Foreclosed Assets
Real estate and other property acquired through, or in lieu of, loan foreclosure are initially recorded at fair value (after deducting estimated costs to sell) at the date of foreclosure, establishing a new cost basis. Costs related to development and improvement of property are capitalized, whereas costs related to holding property are expensed. After foreclosure, valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Revenue and expenses from operations and changes in any valuation allowance are included in loss on foreclosed assets.
Premises and Equipment
Premises and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed principally on the straight-line method and is based on the estimated useful lives of the assets varying primarily from 30 to 40 years on buildings, 5 to 10
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
years on furniture and equipment, and 3 years on computer hardware and software. Maintenance and repair costs are charged to expense as incurred. Gains or losses on disposition of property and equipment are reflected in income.
Mortgage Servicing Rights
PSB services the single-family mortgages it sells to the FHLB and Federal National Mortgage Association (FNMA). Servicing mortgage loans includes such functions as collecting monthly payments of principal and interest from borrowers, passing such payments through to third-party investors, maintaining escrow accounts for taxes and insurance, and making such payments when they are due. When necessary, servicing mortgage loans also includes functions related to the collection of delinquent principal and interest payments, loan foreclosure proceedings, and disposition of foreclosed real estate. PSB generally earns a servicing fee of 25 basis points on the outstanding loan balance for performing these services as well as fees and interest income from ancillary sources such as delinquency charges and payment float. Servicing fee income is recorded as a component of mortgage banking revenue, net of the amortization and charges described in the following paragraphs.
PSB records originated mortgage servicing rights (OMSR) as a component of mortgage banking income when the obligation to service such loans has been retained. The initial value recorded for OMSR is based on the fair values of the servicing fee adjusted for expected future costs to service the loans, as well as income and fees expected to be received from ancillary sources, as previously described. The carrying value of OMSR is amortized against service fee income in proportion to estimated gross servicing revenues, net of estimated costs of servicing, adjusted for expected prepayments. In addition to this periodic amortization, the carrying value of OMSR associated with loans that actually prepay is also charged against servicing fee income as amortization. During periods of falling long-term interest rates, prepayments would likely accelerate increasing amortization of existing OMSR against servicing fee income and impair the value of OMSR as described below.
The carrying value of OMSR recorded in PSB’s consolidated balance sheets (“mortgage servicing rights” or MSRs) is subject to impairment because of changes in loan prepayment expectations and in market discount rates used to value the future cash flows associated with such assets. In valuing MSRs, PSB stratifies the loans by year of origination, term of the loan, and range of interest rates within each term. If, based on a periodic evaluation, the estimated fair value of the MSRs related to a particular stratum is determined to be less than its carrying value, a valuation allowance is recorded against such stratum and against PSB’s loan servicing fee income, which is included as a component of mortgage banking revenue. If the periodic evaluation of impairment calls for a valuation allowance less than currently recorded, the decrease in the valuation allowance is recaptured, offsetting amortization from loan prepayments during the period and increasing mortgage banking revenue. The valuation allowance is calculated using the current outstanding principal balance of the related loans, long-term prepayment assumptions as provided by independent sources, a market-based discount rate, and other management assumptions related to future costs to service the loans, as well as ancillary sources of income.
Federal Home Loan Bank Stock
As a member of the FHLB system, PSB is required to hold stock in the FHLB based on the level of borrowings advanced to PSB. This stock is recorded at cost, which approximates fair value. The stock is evaluated for impairment on an annual basis. Transfer of the stock is substantially restricted.
Bank-Owned Life Insurance
PSB has purchased life insurance policies on certain officers. Bank-owned life insurance is recorded at its cash surrender value. Changes in cash surrender value are recorded in other income.
Retirement Plans
PSB maintains a defined contribution 401(k) profit sharing plan which covers substantially all full-time employees.
Income Taxes
Deferred income taxes have been provided under the liability method. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences are expected to reverse. Deferred tax expense is the result of changes in the deferred tax asset and liability and is a component of the provision for income taxes.
PSB may also recognize a liability for unrecognized tax benefits from uncertain tax positions. Unrecognized tax benefits represent the difference between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured in the financial statements. Interest and penalties related to unrecognized benefits are recorded as additional income tax expense.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Advertising and Promotional Costs
Costs relating to PSB’s advertising and promotion are generally expensed when paid.
Derivative Instruments and Hedging Activities
All derivative instruments are recorded at their fair values. If derivative instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in other comprehensive income and reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of hedges are reflected in income. The fair value of derivative instruments is not offset against cash collateral paid to secure those instruments but is reflected as gross amounts outstanding.
Rate Lock Commitments
PSB enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Rate lock commitments are recorded at fair value at period-end and classified as other assets on the consolidated balance sheets. Changes in the fair value of rate lock commitments during the period are reflected in the current period’s income statement as mortgage banking income. The fair value of rate lock commitments includes the estimated gain on sale of the loan to the secondary market agency plus the estimated value of originated mortgage servicing rights on loans expected to be closed.
Fair Values of Financial Instruments
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on- and off-balance-sheet financial instruments do not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments.
Segment Information
PSB, through a branch network of its banking subsidiary, provides a full range of consumer and commercial banking services to individuals, businesses, and farms in north central Wisconsin. These services include demand, time, and savings deposits; safe deposit services; credit cards; notary services; night depository; money orders, traveler’s checks, and cashier’s checks; savings bonds; secured and unsecured consumer, commercial, and real estate loans; ATM processing; cash management; and wealth management. While PSB’s chief decision makers monitor the revenue streams of various PSB products and services, operations are managed and financial performance is evaluated on a companywide basis. Accordingly, all of PSB’s banking operations are considered by management to be aggregated in one reportable operating segment.
Stock-Based Compensation
PSB uses the fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is normally the vesting period.
Accumulated Other Comprehensive Income (Loss)
PSB’s accumulated other comprehensive income (loss) is composed of the unrealized gain (loss) on securities available for sale, net of tax, unrealized gain (loss) on interest rate swaps used for cash flow hedges after reclassification of settlements of the hedged item, net of tax, and unamortized unrealized gain on securities transferred to securities held to maturity from securities available for sale, net of tax, and is shown on the consolidated statements of changes in stockholders’ equity.
Current Accounting Changes
Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 810, Consolidation. New authoritative accounting guidance under ASC Topic 810 amended prior guidance to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity’s financial statements. The new authoritative accounting guidance under ASC Topic 810 was effective January 1, 2010, but had no significant impact to PSB’s financial statements.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
FASB ASC Topic 860, Transfers and Servicing. New authoritative accounting guidance under ASC Topic 860, Transfers and Servicing, amended prior accounting guidance to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative accounting guidance under ASC Topic 860 was effective for transactions occurring after December 31, 2009, and did not have a significant impact on PSB’s financial statements.
During 2008, the FASB issued new guidance requiring additional disclosures about transfer of financial assets and variable interest entities. PSB is not a sponsor of variable interest entities. However, these changes include additional disclosures associated with loan participations sold to other parties in which the risk and benefits of the underlying loan are not shared equally or on the same basis. Adoption of these changes to ASC Topic 860 on December 31, 2008, did not have a significant effect on PSB’s financial statements.
FASB ASC Topic 310, Receivables. New authoritative accounting guidance issued in July 2010 under ASC Topic 310, Receivables, requires extensive new disclosures surrounding the allowance for loan losses although it does not change any credit loss recognition or measurement rules. The new rules require disclosures to include a breakdown of allowance for loan loss activity by portfolio segment as well as problem loan disclosures by detailed class of loan. In addition, disclosures on internal credit grading metrics and information on impaired and nonaccrual loans are also required. The new period-end disclosures were effective for financial periods ending December 31, 2010, while disclosures of loan loss allowance activity are effective for the quarter ended March 31, 2011. Disclosures concerning restructured loans were deferred but expected to be effective for quarterly periods beginning June 30, 2011. Adoption of these new disclosures under ASC Topic 310 did not have a significant impact on PSB’s financial statements.
FASB ASC Topic 805, Business Combinations. On January 1, 2009, new authoritative accounting guidance under ASC Topic 805, Business Combinations, became applicable to PSB’s accounting for business combinations closing on or after January 1, 2009. ASC Topic 805 applies to all transactions and other events in which one entity obtains control over one or more other businesses. ASC Topic 805 requires an acquirer, upon initially obtaining control of another entity, to recognize the assets, liabilities, and any noncontrolling interest in the acquiree at fair value as of the acquisition date. Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt. ASC Topic 805 also requires acquirers to expense acquisition-related costs as incurred rather than allocating such costs to the assets acquired and liabilities assumed, as was previously the case under prior accounting guidance. Adoption of these accounting changes did not have a material impact to PSB’s financial statements.
FASB ASC Topic 815, Derivatives and Hedging. New authoritative accounting guidance under ASC Topic 815, Derivatives and Hedging, amends prior guidance to amend and expand the disclosure requirements for derivatives and hedging activities to provide greater transparency about (i) how and why an entity uses derivative instruments, (ii) how derivative instruments and related hedge items are accounted for under ASC Topic 815, and (iii) how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. To meet those objectives, the new authoritative accounting guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The new authoritative accounting guidance under ASC Topic 815 became effective for PSB on January 1, 2009, but did not have a significant impact on PSB’s financial statements.
FASB ASC Topic 260, Earnings Per Share. On January 1, 2009, PSB adopted new authoritative accounting guidance under FASB ASC Topic 260, Earnings Per Share, which provides that unvested share-based payment awards that contain nonforfeitable rights to dividends (whether paid or unpaid) such as awards to PSB employees granted under PSB’s restricted stock compensation program are considered participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. Adoption of this new accounting guidance lowered 2008 basic earnings per share by $.01 as prior periods’ earnings per share are adjusted retrospectively when shown comparatively with 2010 and 2009 earnings per share.
FASB ASC Topic 855, Subsequent Events. New authoritative accounting guidance under ASC Topic 855, Subsequent Events, establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued. ASC Topic 855 defines (i) the period after the balance sheet date during which a reporting entity’s management should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, (ii) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and (iii) the disclosures an entity should make about events or transactions that occurred after the balance sheet date. The new authoritative accounting guidance under ASC Topic 855 first became effective for PSB’s financial statements issued after June 30, 2009, and did not have a significant impact upon adoption.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
FASB ASC Topic 820, Fair Value Measurements and Disclosures. New authoritative disclosure guidance under Topic 820 was designed to increase transparency of fair value disclosures. Under the new guidance, transfers between fair value Levels 1 and 2 must be described and disclosed separately. In addition, the reconciliation of Level 3 fair value measurements should present activity separately rather than as one net number. Also, fair value measurement disclosures should include disclosures for each class of assets and liabilities, which class may be a subset of a line item in the consolidated balance sheet. Lastly, disclosures about valuation techniques and inputs used to measure fair value for both recurring and nonrecurring items are required for measurements that fall in either Level 2 or Level 3. The new disclosures were effective for interim periods beginning January 1, 2010, except for disclosures related to items in the reconciliation of Level 3 fair value measurements, which are effective for interim periods beginning January 1, 2011. The new disclosure did not have a significant impact on the presentation of PSB’s financial statements.
New authoritative accounting guidance under ASC Topic 820, Fair Value Measurements and Disclosures, affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction and clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. ASC Topic 820 requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. The new accounting guidance also expanded certain disclosure requirements. PSB adopted the new authoritative accounting guidance under ASC Topic 820 on June 30, 2009. Adoption of the new guidance did not significantly impact PSB’s financial statements.
ASC Topic 820 further provided guidance for measuring the fair value of a liability in circumstances in which a quoted price in an active market for the identical liability is not available. In such instances, a reporting entity is required to measure fair value utilizing a valuation technique that uses (i) the quoted price of the identical liability when traded as an asset, (ii) quoted prices for similar liabilities or similar liabilities when traded as assets, or (iii) another valuation technique that is consistent with the existing principles of ASC Topic 820, such as an income or market approach. The new authoritative accounting guidance also clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. This new authoritative accounting guidance under ASC Topic 820 was adopted on October 1, 2009, and did not have a significant impact on PSB’s financial statements.
New authoritative accounting guidance under ASC Topic 820, Fair Value Measurements and Disclosures, defined fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at period-end and established a three-level hierarchy for fair value measurement. It also clarified the method to estimate fair value for financial assets exchanged in a market that is not active as well as expanded disclosure about instruments measured at fair value and how changes in fair value have impacted net income. PSB adopted these changes to ASC Topic 820 during 2008 which had no material impact on its financial statements.
FASB ASC Topic 825 Financial Instruments. New authoritative accounting guidance under ASC Topic 825, Financial Instruments, requires an entity to provide disclosures about the fair value of financial instruments in interim financial information (rather than providing only with annual financial statements) and amends prior guidance to require those disclosures in summarized financial information at interim reporting periods. The new interim disclosures required under Topic 825 were first included in the June 30, 2009, financial statements. Adoption of this new disclosure did not have a significant impact on PSB’s financial statements.
During 2007, the FASB issued new guidance which allowed PSB to choose to measure many financial instruments at fair value that are not currently required to be measured at fair value. This election established new presentation and disclosure requirements in the event such fair value election was made. PSB did not elect to measure any financial instruments at fair value in connection with adoption of these changes to ASC Topic 825 on January 1, 2008.
FASB ASC Topic 320, Investments - Debt and Equity Securities. New authoritative accounting guidance under ASC Topic 320, Investments - Debt and Equity Securities, (i) changes existing guidance for determining whether an impairment is other than temporary to debt securities and (ii) replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert (a) it does not have the intent to sell the security and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. Under ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. PSB adopted the provisions of the new authoritative accounting guidance under ASC Topic 320 on June 30, 2009. Adoption of the new guidance did not significantly impact PSB’s financial statements.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
FASB ASC Topic 715, Compensation - Retirement Benefits. During 2006 and 2007, the FASB issued new guidance to clarify that deferred compensation or postretirement or postemployment benefits should be accounted for separately from the related investments in split-dollar bank-owned life insurance (BOLI). The benefits of the life insurance investment should be calculated based on the substantive agreement and the benefit plan costs accrued for over the requisite service period. Adoption of this new guidance to ASC Topic 715 on January 1, 2008, did not have a material effect on PSB’s financial condition or results of operations.
Reclassifications
Certain prior year balances have been reclassified to conform to the current year presentation.
Subsequent Events
Management has reviewed PSB’s operations for potential disclosure of information or financial statement
impacts related to events occurring after December 31, 2010, but prior to the release of these financial statements. Based on the results of this review, no subsequent event disclosures are required as of the release date.
NOTE 2
CASH AND CASH EQUIVALENTS
PSB is required to maintain a certain reserve balance, in cash or on deposit with the Federal Reserve Bank, based upon a percentage of transactional deposits. The total required reserve balance was approximately $25 at December 31, 2010 and 2009.
PSB is also required to provide collateral on interest rate swap agreements with counterparties. The total required collateral on deposit with counterparties was $350 at December 31, 2010 and $0 at December 31, 2009.
In the normal course of business, PSB maintains cash and due from bank balances with correspondent banks, some of which are participating in the Federal Deposit Insurance Corporation’s (FDIC) Transaction Account Guarantee Program. Consequently, the majority of account balances with correspondent banks, except the FHLB and U.S. Bank, were guaranteed at December 31, 2010. PSB also maintains cash balances in money market mutual funds. Such balances are not insured. Uninsured cash and cash equivalent balances totaled $45 and $731 at December 31, 2010 and 2009, respectively.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 3
SECURITIES
The amortized cost and estimated fair value of investment securities are as follows:
Fair values of securities are estimated based on financial models or prices paid for similar securities. It is possible future interest rates could change considerably resulting in a material change in the estimated fair value.
Nonrated trust preferred securities at December 31, 2010 and 2009 consist of separate obligations issued by three holding companies headquartered in Wisconsin.
Nonrated senior subordinated notes at December 31, 2010, consist of one obligation issued by a Wisconsin state chartered bank.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The following table indicates the number of months securities that are considered to be temporarily impaired have been in an unrealized loss position at December 31:
At December 31, 2010, 177 debt and equity securities had unrealized losses with aggregate depreciation of 2.95% from the amortized cost basis. These unrealized losses relate principally to an increase in interest rates relative to interest rates in effect at the time of purchase or reclassification from available for sale to held to maturity classification and are not due to changes in the financial condition of the issuers. However, the unrealized loss on nonrated trust preferred securities is due to an increase in credit spreads for risk on such investments demanded in the market, but not specific to the securities held by PSB. In analyzing an issuer’s financial condition, management considers whether the securities are issued by a government body or agency, whether a rating agency has downgraded the securities, industry analysts’ reports, and internal review of issuer financial statements. Since management does not intend to sell and has the ability to hold debt securities until maturity (or the foreseeable future for securities available for sale), no declines are deemed to be other than temporary.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The amortized cost and estimated fair value of debt securities and nonrated trust preferred securities and senior subordinated notes at December 31, 2010, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Securities with a fair value of $60,111, and $51,189 at December 31, 2010 and 2009, respectively, were pledged to secure public deposits, other borrowings, and for other purposes required by law.
There was no sale of securities during 2010. During 2010, PSB realized a loss of $20 ($12 after tax benefits) on recognition of other than temporary impairment to the amortized cost basis of its remaining investment in FNMA preferred stock. During 2009, proceeds from the sale of securities totaled $10,146 with a gross gain of $531 ($322 after-tax effects) and a gross loss of $10 ($6 after-tax effects). There was no sale of securities during 2008. During 2008, PSB realized a loss of $991 ($600 after-tax benefits) on recognition of other than temporary impairment to the historical cost basis of its investment in FNMA preferred stock.
During 2010, PSB transferred all of its municipal, trust preferred, and senior subordinated note securities from the available-for-sale classification to the held-to-maturity classification to better reflect its intent and practice to hold these long-term debt securities until maturity. Fair value of the securities was $54,130 at the time of the transfer, which included a $2,552 unrealized gain over the existing amortized cost basis. The unrealized gain will be amortized against the new cost basis (equal to transfer date fair value) over the remaining life of the securities. Scheduled amortization of the transfer date unrealized gain is as follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 4
LOANS
The composition of loans at December 31 categorized by the type of the loan is as follows:
PSB originates and holds adjustable rate residential mortgage loans and commercial purpose loans with variable rates of interest. The rate of interest on some of these loans is capped over the life of the loan. At December 31, 2010 and 2009, PSB held $9,450 and $16,931, respectively, of variable rate loans with interest rate caps. At December 31, 2010, none of the loans had reached the interest rate cap.
PSB, in the ordinary course of business, grants loans to its executive officers and directors, including their families and firms in which they are principal owners. All loans to executive officers and directors are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others and, in the opinion of management, did not involve more than the normal risk of collectibility or present other unfavorable features. Activity in such loans is summarized below:
At December 31, 2010 and 2009, PSB had total loans receivable of approximately $5,295 and $4,633, respectively, from one related party.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The following is a summary of information pertaining to impaired loans and nonperforming loans:
No additional funds are committed to be advanced in connection with impaired loans.
Total loans receivable (including nonaccrual impaired loans) maintained on nonaccrual status as of December 31, 2010 and 2009 were $9,039 and $13,298, respectively. There were no loans past due 90 days or more but still accruing income at December 31, 2010 and 2009.
An analysis of the allowance for loan losses for the three years ended December 31 follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The allowance for loan losses for the year ended December 31, 2010, follows:
The commercial credit exposure based on internally assigned credit grade at December 31, 2010, follows:
The consumer credit exposure based on payment activity at December 31, 2010, follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The payment age analysis of loans receivable disbursed at December 31, 2010, follows:
The impaired loans at December 31, 2010, follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The loans on nonaccrual status at December 31, 2010, follows:
Under a secondary market loan servicing program with the FHLB, PSB in exchange for a monthly fee provides a credit enhancement guarantee to reimburse the FHLB for foreclosure losses in excess of 1% of original loan principal sold to the FHLB. At December 31, 2010, PSB serviced payments on $70,209 of first lien residential loan principal under these terms for the FHLB. At December 31, 2010, the maximum PSB obligation for such guarantees would be approximately $1,945 if total foreclosure losses on the entire pool of loans exceed approximately $2,004. Management believes the likelihood of a reimbursement for loss payable to the FHLB beyond the monthly credit enhancement fee is remote. PSB recognizes the credit enhancement fee as mortgage banking income when received in cash and does not maintain any recourse liability for possible losses.
At December 31, 2010, PSB had originated and sold $5,288 of commercial and commercial real estate loans to other participating financial institutions to accommodate customer credit needs and maintain compliance with internal and external large borrower limits. Likewise, at December 31, 2010, PSB had purchased $13,305 of commercial and commercial real estate loans originated by other Wisconsin-based financial institutions as part of informal reciprocal relationships that allow the originating bank to meet the needs of their large credit customers. PSB does not charge servicing fees to the participating institutions on these traditional loan participations sold by PSB, and no servicing right asset or liability has been recognized on these relationships. Any credit losses incurred on purchased or sold participation loans upon liquidation are shared pro-rata among the participants based on principal owned.
NOTE 5
FORECLOSED ASSETS
A summary of activity in foreclosed assets for the period ended December 31 is as follows:
Net gain and loss from the sale of foreclosed assets as well as the provision to expense for the partial write-down of foreclosed assets prior to sale are recorded as loss on foreclosed assets. Loss on foreclosed assets also includes periodic holding costs
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
related to foreclosed assets. The total loss on foreclosed assets was $849, $1,130, and $6 during the years ended 2010, 2009, and 2008, respectively.
NOTE 6
MORTGAGE SERVICING RIGHTS
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of residential mortgage loans serviced for FHLB and FNMA were $260,097 and $237,764 at December 31, 2010 and 2009, respectively. The following is a summary of changes in the balance of MSRs:
The table below summarizes the components of PSB’s mortgage banking income for the three years ended December 31.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 7
PREMISES AND EQUIPMENT
The composition of premises and equipment at December 31 follows:
Depreciation and amortization charged to operating expenses amounted to $827 in 2010, $801 in 2009, and $907 in 2008.
Lease Commitments
PSB leases various pieces of equipment under cancelable leases and office space for one branch location under a noncancelable lease. The noncancelable branch location lease expires in May 2012. The lease is classified as operating. Future minimum payments under the noncancelable lease total $54 during 2011 and $23 during 2012.
Rental expense for all operating leases was $67, $67, and $66, for the years ended December 31, 2010, 2009, and 2008, respectively.
NOTE 8
DEPOSITS
The distribution of deposits at December 31 is as follows:
The scheduled maturities of time deposits at December 31, 2010, are summarized as follows:
Time deposits with individual balances of $100 and over totaled $118,207 and $118,344 at December 31, 2010 and 2009, respectively.
Deposits from PSB directors, executive officers, and related parties at December 31, 2010 and 2009 totaled $11,638 and $2,918, respectively.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 9
FEDERAL HOME LOAN BANK ADVANCES
FHLB advances at December 31 consist of the following:
The puttable fixed rate advance outstanding at December 31, 2010, maturing in 2019, is puttable at the one-time option of the FHLB during 2012.
FHLB advances are subject to a prepayment penalty if they are repaid prior to maturity. PSB may draw upon an FHLB open line of credit up to approximately 65% of unencumbered one- to four-family residential first mortgage loans and 40% of residential junior mortgage loans pledged as collateral out of its portfolio. The FHLB advances are also secured by $3,250 of FHLB stock owned by PSB at December 31, 2010. PSB may draw both short-term and long-term advances on a maximum line of credit totaling approximately $74,435 based on pledged performing residential real estate mortgage collateral totaling $129,928 as of December 31, 2010. At December 31, 2010, PSB’s available and unused portion of this line of credit totaled approximately $15,056. PSB also has, under a current agreement with the FHLB, an ability to borrow up to $17,177 by pledging securities.
FHLB advances drawn by PSB totaling greater than $65,000 would require PSB to purchase additional shares of FHLB capital stock. As of December 31, 2010, FHLB capital stock does not pay dividends, and transfer of the stock is substantially restricted.
NOTE 10
OTHER BORROWINGS
Other borrowings consist of the following obligations at December 31 as follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
PSB pledges various securities available for sale as collateral for repurchase agreements. The fair value of securities pledged for repurchase agreements totaled $36,639 and $32,894 at December 31, 2010 and 2009, respectively.
The following information relates to securities sold under repurchase agreements for the years ended December 31:
The wholesale structured repurchase agreements are with JP Morgan Chase Bank N.A. and carry fixed rates. The repurchase agreements may be put back by the issuer to PSB on a quarterly basis. The following information relates to the terms of wholesale structured repurchase agreements issued at December 31, 2010:
PSB has an agreement with the Federal Reserve to participate in their “Borrower in Custody” program in which performing commercial and commercial real estate loans may be pledged against short-term Discount Window advances. At December 31, 2010, the maximum amount of available advances from the Discount Window totaled $100,000, subject to available collateral pledged under the Borrower in Custody program or pledge of qualifying investment securities. At December 31, 2010, PSB had pledged $170,244 of commercial purpose loans in the program, which permitted Discount Window advances up to $94,980 against this collateral. No investment securities were pledged against the line at December 31, 2010. There were no Discount Window advances outstanding at December 31, 2010 or 2009.
PSB maintains a line of credit at the parent holding company level with U.S. Bank for advances up to $1,000 which expires on February 28, 2011. The line carries a variable rate of interest based on changes in the one-month London Interbank Offered Rate (LIBOR) subject to a nonusage fee. As of December 31, 2010 and 2009, no advances were outstanding on the line of credit.
NOTE 11
SENIOR SUBORDINATED NOTES
During 2009, PSB issued $7,000 of Senior Subordinated Notes (the “Notes”) on a private placement basis. The Notes carry a fixed interest rate of 8.00% paid quarterly and mature on July 1, 2019. At its option, PSB may prepay the Notes in whole or in part beginning July 1, 2012. Under current banking regulatory capital rules, for the first five years of the issue, PSB may reclassify the Notes as Tier 2 equity capital. Beginning in the sixth year, the amount eligible to be classified as regulatory capital declines 20% per year until the Note’s final maturity. Total interest expense on the Notes was $567 during 2010 and $341 during 2009.
NOTE 12
JUNIOR SUBORDINATED DEBENTURES
PSB has issued $7,732 of junior subordinated debentures to PSB Holdings Statutory Trust I (the “Trust”) in connection with an issue of trust preferred securities during 2005. The subordinated debentures mature in 2035 and carried a fixed rate of interest of 5.82% during the five-year period ending September 2010. Following the fixed rate period, the debentures pay a variable rate of interest based on changes in the three-month LIBOR plus 1.70%, adjusted quarterly. During 2010, PSB entered into a cash flow hedge to fix the payments of interest (excluding the credit spread) on the debentures for a seven-year period ending September 2017 at a rate of 2.72%. Including the credit spread, the net interest due on the notes until September 2017 will be equal to a fixed rate of 4.42%. Total interest expense on the junior subordinated debentures was $420 in 2010 and $454 in 2009 and 2008. The subordinated debentures may be called by PSB in part or in full on a quarterly basis.
PSB has fully and unconditionally guaranteed all the obligations of the Trust. The guarantee covers the quarterly distributions and payments on liquidation or redemption of the trust preferred securities to the extent of the funds held by the Trust. The trust preferred securities qualify as Tier 1 capital for regulatory capital purposes.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 13
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
PSB is exposed to certain risks relating to its ongoing business operations. The primary risk managed by using derivative instruments is interest rate risk. Interest rate swaps are entered into to manage interest rate risk associated with PSB's variable rate junior subordinated debentures. Accounting standards require PSB to recognize all derivative instruments as either assets or liabilities at fair value in the balance sheet. PSB designates its interest rate swap associated with the junior subordinated debentures as a cash flow hedge of variable-rate debt.
For derivative financial instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative instrument representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
PSB is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. PSB controls the credit risk of its financial contracts through credit approvals, limits, and monitoring procedures, and does not expect any counterparties to fail their obligations. PSB enters into agreements only with primary dealers. These derivative instruments are negotiated over-the-counter (OTC) contracts. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amounts, exercise prices, and maturity.
No interest rate swaps were outstanding as of December 31, 2009. As of December 31, 2010, PSB had the following outstanding interest rate swap that was entered into to hedge variable-rate debt:
This agreement provides for PSB to receive payments at a variable rate determined by the three-month LIBOR in exchange for making payments at a fixed rate. Actual maturities may differ from scheduled maturities due to call options and/or early termination provisions. No interest rate swap agreements were terminated prior to maturity in 2010 or 2009. Risk management results for the year ended December 31, 2010, related to the balance sheet hedging of variable rate debt indicates that the hedge was 100% effective, and no component of the derivative instrument’s gain or loss was excluded from the assessment of hedge effectiveness.
At December 31, 2010, the fair value of the interest rate swap of $25 was recorded in other liabilities. Net unrealized losses on the derivative instrument recognized in other comprehensive income during the year ended December 31, 2010, totaled $48, net of tax. The net amount of other comprehensive loss reclassified into interest expense during the year ended December 31, 2010 was $33, net of tax.
As of December 31, 2010, approximately $175 of losses reported in other comprehensive income related to the interest rate swap are expected to be reclassified into interest expense as a yield adjustment of the hedged borrowings during the 12-month period ending December 31, 2011. The interest rate swap agreements are secured by cash and cash equivalents of $350 at December 31, 2010.
NOTE 14
RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS
PSB has established a 401(k) profit sharing plan for its employees. Beginning in 2008, PSB matches 100% of employees’ salary deferrals up to the first 1% of pay deferred and 50% of salary deferrals of the next 5% of pay deferrals, for a maximum match of 3.5% of salary. Prior to 2008, PSB matched 50% of employees’ salary deferrals up to the first 6% of pay deferred. PSB also may declare a discretionary profit sharing contribution. The expense recognized for contributions to the plan for the years ended December 31, 2010, 2009, and 2008 was $446, $274, and $356, respectively.
PSB maintains deferred compensation agreements with certain executives and directors. PSB matches 20% of the amount of employees' salary deferrals up to the first 15% of pay deferred. PSB directors may elect to defer earned directors’ fees into a separate deferred directors’ fees plan. No PSB match is made on deferred directors’ fees. Beginning in 2008, cumulative deferred balances earn a crediting rate generally equal to 100% of PSB’s return on average equity subject to a maximum crediting rate of 15% per year. Prior to 2008, the crediting rate was equal to 50% of PSB’s return on equity. The agreements provide for benefits to be paid in a lump sum at retirement or in monthly installments for a period up to 15 years following each participant’s normal retirement date. PSB is accruing this liability over the participant’s remaining periods of service. The liability
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
outstanding under the agreements was $1,948 and $1,604 at December 31, 2010 and 2009, respectively. The amount charged to operations was $215, $127, and $160, for 2010, 2009, and 2008, respectively.
PSB maintains an unfunded, postretirement health care benefit plan for certain currently retired bank officers and their spouses. Benefits were earned by these participants prior to their retirement and prior to curtailments of the plan during 2003 and 2005. Under the plan, PSB pays 30% to 50% of health insurance premiums depending on years of service at retirement. Plan benefits for these retired officers continue until the officer’s death. No current employees are eligible for benefits under this plan. At December 31, 2010, there were four retirees receiving benefits. The liability for future postretirement health care benefits was $108 and $114 at December 31, 2010 and 2009, respectively. Postretirement health care benefit plan (income) expense was $0, ($14), and ($12), in 2010, 2009, and 2008, respectively.
NOTE 15
SELF-FUNDED HEALTH INSURANCE PLAN
PSB has established an employee medical benefit plan to self-insure claims up to $55 per year for each individual with no stop-loss per year for participants in the aggregate. Coverages will continue at the same level in 2011. PSB and its covered employees contribute to the fund to pay the claims and stop-loss premiums. Medical benefit plan costs are expensed as incurred. The liability recognized for claims incurred but not yet paid was $78 and $123 as of December 31, 2010 and 2009, respectively. Health and dental insurance expense recorded in 2010, 2009, and 2008, was $941, $882, and $828, respectively.
NOTE 16
INCOME TAXES
The components of the provision for income taxes are as follows:
A summary of the source of differences between income taxes at the federal statutory rate and the provision for income taxes for the years ended December 31, follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of PSB’s assets and liabilities. The major components of the net deferred tax assets are as follows:
Prior to 2009, [Missing Graphic Reference]PSB paid state income taxes on individual, unconsolidated net earnings. At December 31, 2010, net operating loss carryforwards of the parent company of approximately $2.8 million existed to offset future state taxable income. These net operating losses will begin to expire in 2012. A valuation allowance has been recognized to adjust deferred tax assets to the amount of net operating losses expected to be utilized to offset future income. If realized, the tax benefit for this item will reduce current tax expense for that period. There was no change in the valuation allowance during 2010 and 2009.
At December 31, 2010, federal tax returns remained open for Internal Revenue Service (IRS) review for tax years after 2006, while state tax returns remain open for review by state taxing authorities for tax years after 2005. There were no federal or state income tax audits being conducted at December 31, 2010.
NOTE 17
COMMITMENTS, CONTINGENCIES, AND CREDIT RISK
Financial Instruments With Off-Balance-Sheet Credit Risk
PSB is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheets.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
PSB’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. PSB uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. These commitments at December 31 are as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. PSB evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
Letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which PSB deems necessary. The commitments are generally structured to allow for 100% collateralization on all letters of credit.
Unfunded commitments under home equity lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit are secured by residential mortgages not to exceed the collateral property fair market value upon origination and may or may not contain a specific maturity date.
Credit card commitments are commitments on credit cards issued by PSB and serviced by Elan Financial Services (a subsidiary of U.S. Bancorp). These commitments are unsecured.
PSB participates in the FHLB Mortgage Partnership Finance Program (the “Program”). In addition to entering into forward commitments to sell mortgage loans to various secondary market agency providers, PSB enters into firm commitments to deliver loans to the FHLB through the Program. Under the Program, loans are funded by the FHLB, and PSB receives an agency fee reported as a component of gain on sale of loans. PSB had approximately $6,026 in firm commitments outstanding to deliver loans through the Program at December 31, 2010 from rate lock commitments made with customers. Once delivered to the Program, until November 2008, PSB provided a contractually agreed-upon credit enhancement with the commitment to perform servicing of the loans. Under the credit enhancement, PSB is liable for losses on loans delivered to the Program after application of any mortgage insurance and a contractually agreed-upon credit enhancement provided by the Program subject to an agreed-upon maximum. PSB received a fee for this credit enhancement. PSB does not anticipate that any credit losses will be incurred in excess of anticipated credit enhancement fees. PSB no longer delivers loans to the FHLB or other secondary market agency providers that required a credit enhancement guarantee.
Guarantee Credit Risk
PSB had guaranteed repayment of a certain customer’s interest rate swaps and letter of credit to a correspondent bank in exchange for an underwriting fee and a first mortgage lien on commercial real estate which was extinguished during 2010. The total principal amount guaranteed by PSB totaled $0 and $5,924 at December 31, 2010 and 2009, respectively. The guarantee liability was carried at estimated fair market value and totaled $93 at December 31, 2009. Income recognized on the guarantee totaled $93 during 2010, $40 during 2009, and $41 during 2008.
Concentration of Credit Risk
PSB grants residential mortgage, commercial, and consumer loans predominantly in Marathon, Oneida, and Vilas counties, Wisconsin. There are no significant concentrations of credit to any one debtor or industry group. Management believes the diversity of the local economy prevents significant losses during economic downturns.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Contingencies
In the normal course of business, PSB is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the consolidated financial statements.
NOTE 18
STOCK BASED COMPENSATION
Under the terms of an incentive stock option plan adopted during 2001, shares of unissued common stock are reserved for options to officers and key employees of PSB at prices not less than the fair market value of the shares at the date of the grant. Options may be exercised anytime after the option grant’s six-month anniversary. These options expire ten years after the grant date, and all currently unexercised options will expire between December 2011 and April 2012. As of December 31, 2010, all 3,645 options outstanding were eligible to be exercised at exercise prices ranging from $15.80 to $16.83 per share. The following table summarizes information regarding stock options outstanding at December 31, 2010, and activity during the three years ended December 31, 2010, 2009, and 2008.
No common stock options were issued, and no expense was recorded in the three years ended December 31, 2010. As of December 31, 2010, no additional shares of common stock remain reserved for future option grants to officers and key employees under the option plan approved by the shareholders.
PSB granted shares of restricted stock to certain employees having a market value of $75, $150, and $100 during 2010, 2009, and 2008, respectively. The restricted shares vest to employees based on continued PSB service over a six-year period and are recognized as compensation expense over the vesting period. Cash dividends are paid on unvested shares at the same time and amount as paid to PSB common shareholders. Cash dividends paid on unvested restricted stock shares are charged to retained earnings as significantly all restricted shares are expected to vest to employees. As of December 31, 2010, 18,530 shares of restricted stock remained unvested. Unvested shares are subject to forfeiture upon employee termination.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The following table summarizes information regarding unvested restricted stock and shares outstanding during the three years ended December 31, 2010, 2009, and 2008.
During 2010, total compensation expense of $43 (before tax benefits of $17) was recorded from amortization of restricted shares expected to vest. During 2009, total compensation expense of $25 (before tax benefits of $10) was recorded from amortization of restricted shares expected to vest. During 2008, total compensation expense of $10 (before tax benefits of $4) was recorded from amortization of restricted shares expected to vest. Future projected compensation expense (before tax benefits) assuming all restricted shares eventually vest to employees would be as follows:
NOTE 19
CAPITAL REQUIREMENTS
PSB and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory-and possibly additional discretionary-actions by regulators that, if undertaken, could have a direct material effect on PSB’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, PSB and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require PSB and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2010, PSB and the Bank meet all capital adequacy requirements.
As of December 31, 2010, the most recent notification from the FDIC categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
PSB’s and the Bank’s actual and regulatory capital amounts and ratios are as follows:
NOTE 20
EARNINGS PER SHARE
Basic and diluted earnings per share data are based on the weighted-average number of common shares outstanding during each period. Unvested but issued restricted stock shares are considered to be outstanding for purposes of calculating the weighted average number of shares outstanding to determine basic and diluted earnings per share and net book value per share.
Diluted earnings per share are further adjusted for potential common shares that were dilutive and outstanding during the period. Potential common shares consist of stock options outstanding under incentive plans. The dilutive effect of potential common shares is computed using the treasury stock method. All stock options are assumed to be 100% vested for purposes of the diluted earnings per share computations. The computation of earnings per share for the years ended December 31 are as follows:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 21
RESTRICTIONS ON RETAINED EARNINGS
The Bank is restricted by banking regulations from making dividend distributions above prescribed amounts and is limited in making loans and advances to PSB. At December 31, 2010, management believes that maintaining the regulatory framework of the Bank at the well-capitalized level will effectively restrict potential dividends from the Bank to an amount less than $17,545. Furthermore, any Bank dividend distributions to PSB above customary levels are subject to approval by the FDIC, the Bank’s primary federal regulator.
NOTE 22
FAIR VALUE MEASUREMENTS
Certain assets and liabilities are recorded or disclosed at fair value to provide financial statement users additional insight into PSB’s quality of earnings. Under current accounting guidance, PSB groups assets and liabilities which are recorded at fair value in three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). All transfers between levels are recognized as occurring at the end of the reporting period.
Following is a brief description of each level of the fair value hierarchy:
Level 1 - Fair value measurement is based on quoted prices for identical assets or liabilities in active markets.
Level 2 - Fair value measurement is based on (1) quoted prices for similar assets or liabilities in active markets; (2) quoted prices for identical or similar assets or liabilities in markets that are not active; or (3) valuation models and methodologies for which all significant assumptions are or can be corroborated by observable market data.
Level 3 - Fair value measurement is based on valuation models and methodologies that incorporate at least one significant assumption that cannot be corroborated by observable market data. Level 3 measurements reflect PSB’s estimates about assumptions market participants would use in measuring fair value of the asset or liability.
Some assets and liabilities, such as securities available for sale and interest rate swaps, are measured at fair value on a recurring basis under GAAP. Other assets and liabilities, such as impaired loans, foreclosed assets, mortgage servicing rights, mortgage rate lock commitments, and guarantee liabilities are measured at fair value on a nonrecurring basis.
Following is a description of the valuation methodology used for each asset and liability measured at fair value on a recurring or nonrecurring basis, as well as the classification of the asset or liability within the fair value hierarchy.
Securities available for sale - Securities available for sale may be classified as Level 1, Level 2, or Level 3 measurements within the fair value hierarchy. Level 1 securities include equity securities traded on a national exchange. The fair value measurement of a Level 1 security is based on the quoted price of the security. Level 2 securities include U.S. government and agency securities, obligations of states and political subdivisions, corporate debt securities, and mortgage-related securities. The fair value measurement of a Level 2 security is obtained from an independent pricing service and is based on recent sales of similar securities and other observable market data and represents a market approach to fair value.
At December 31, 2010, Level 3 securities include common stock investments in Bankers’ Bank Wisconsin and FNMA preferred stock that are not traded on an active market. Amortized historical cost of the common stock is assumed to approximate fair value of these investments. At December 31, 2009, Level 3 securities included trust preferred securities and senior subordinated notes issued by Wisconsin headquartered banks that were not traded in an active market. The fair value measurement of a Level 3 security is based on a discounted cash flow model that incorporates assumptions market participants would use to measure the fair value of the security which represents an income approach to fair value.
Loans - Loans are not measured at fair value on a recurring basis. However, loans considered to be impaired (see Note 4) may be measured at fair value on a nonrecurring basis. The fair value measurement of an impaired loan that is collateral dependent is based on the fair value of the underlying collateral. All other impaired loan fair value measurements are based on the present value of expected future cash flows discounted at the applicable effective interest rate and, thus, are not fair value measurements. Fair value measurements of underlying collateral that utilize observable market data, such as independent appraisals reflecting recent comparable sales, are considered Level 2 measurements. Other fair value measurements that incorporate internal collateral appraisals or estimated assumptions market participants would use to measure fair value, such as discounted cash flow measurements, are considered Level 3 measurements and represent an income approach to fair value.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Foreclosed assets - Real estate and other property acquired through, or in lieu of, loan foreclosure are not measured at fair value on a recurring basis. Initially, foreclosed assets are recorded at fair value less estimated costs to sell at the date of foreclosure. Valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Fair value measurements are based on current formal or informal appraisals of property value compared to recent comparable sales of similar property. Independent appraisals reflecting comparable sales are considered Level 2 measurements, while internal assessments of appraised value based on current market activity are considered Level 3 measurements and represent an income approach to fair value.
Mortgage servicing rights - Mortgage servicing rights are not measured at fair value on a recurring basis. However, mortgage servicing rights that are impaired are measured at fair value on a nonrecurring basis. Serviced loan pools are stratified by year of origination and term of the loan, and a valuation model is used to calculate the present value of expected future cash flows for each stratum. When the carrying value of a stratum exceeds its fair value, the stratum is measured at fair value. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, custodial earnings rate, ancillary income, default rates and losses, and prepayment speeds. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value. As a result, the fair value measurement of mortgage servicing rights is considered a Level 3 measurement and represents an income approach to fair value. Significant unobservable inputs at December 31, 2010, used to measure fair value included:
Mortgage rate lock commitments - The fair value of mortgage rate lock commitments is not measured on a recurring basis. Fair value is based on current secondary market pricing for delivery of similar loans and the value of originated mortgage servicing rights on loans expected to be delivered. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value. As a result, the fair value measurement of mortgage rate lock commitments is considered a Level 3 measurement and represent an income approach to fair value. Significant unobservable inputs at December 31, 2010, used to measure fair value included:
·
Estimated failure to close on 10% of period-end rate lock commitments
·
Estimated combined cash gain on sale of principal and originated mortgage servicing rate equal to 1% of mortgage rate lock loan principal
Interest rate swap agreements - Fair values for interest rate swap agreements are based on the amounts required to settle the contracts based on valuations provided by third-party dealers in the contracts.
Guarantee liability - Guarantees by PSB of customer payment obligations to a third party are measured at fair value using Level 3 inputs on a nonrecurring basis. Fair value measurements include fair value of interest rate swaps covered by the guarantee, transaction fees received for offering the guarantee, and the credit risk and performance of the customer for which the guarantee is given. Because recognition of initial transaction fees adjusted by amortization of such fees over the period of the guarantee is used to estimate fair value, these measurements represent a cost approach to fair value. There was no guarantee liability outstanding at December 31, 2010.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Information regarding the fair value of assets measured at fair value on a recurring basis as of December 31:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
The following reconciles the beginning and ending balances of assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended December 31:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Information regarding the fair value of assets and liabilities measured at fair value on a nonrecurring basis as of December 31 follows.
At December 31, 2010, loans with a carrying amount of $2,643 were considered impaired and were written down to their estimated fair value of $1,147, net of a valuation allowance of $1,496. At December 31, 2009, loans with a carrying amount of $9,452 were considered impaired and were written down to their estimated fair value of $7,464, net of a valuation allowance of $1,988. Changes in the valuation allowances are reflected through earnings as a component of the provision for loan losses.
At December 31, 2010, mortgage servicing rights with a carrying amount of $1,303 were considered impaired and were written down to their estimated fair value of $1,100, resulting in an impairment allowance of $203. At December 31, 2009, mortgage servicing rights with a carrying amount of $1,229 were considered impaired and were written down to their estimated fair value of $1,147, resulting in an impairment allowance of $82. Changes in the impairment allowances are reflected through earnings as a component of mortgage banking income.
PSB estimates fair value of all financial instruments regardless of whether such instruments are measured at fair value. The following methods and assumptions were used by PSB to estimate fair value of financial instruments not previously discussed.
Cash and cash equivalents - Fair value approximates the carrying value.
Securities held to maturity - Fair value of securities held to maturity is based on dealer quotations on similar securities at near period-end, which is considered a Level 2 measurement.
Bank certificates of deposit - Fair value of fixed rate certificates of deposit is estimated by discounting future cash flows using current rates at which similar certificates could be purchased.
Loans - Fair value of variable rate loans that reprice frequently are based on carrying values. Loans with an active sale market, such as one- to four-family residential mortgage loans, estimate fair value based on sales of loans with similar structure and credit quality. Fair value of other loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings. Fair value of impaired and other nonperforming loans are estimated using discounted expected future cash flows or the fair value of underlying collateral, if applicable.
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Loans held for sale - Loans held for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value. The fair value measurement of a loan held for sale is based on current secondary market prices for similar loans, which is considered a Level 2 measurement.
Federal Home Loan Bank stock - Fair value is the redeemable (carrying) value based on the redemption provisions of the Federal Home Loan Bank.
Accrued interest receivable and payable - Fair value approximates the carrying value.
Cash value of life insurance - Fair value is based on reported values of the assets by the issuer which are redeemable to the insured.
Deposits - Fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, by definition, is the amount payable on demand on the reporting date. Fair value of fixed rate time deposits is estimated using discounted cash flows applying interest rates currently offered on issue of similar time deposits.
FHLB advances and other borrowings - Fair value of fixed rate, fixed term borrowings is estimated by discounting future cash flows using the current rates at which similar borrowings would be made. Fair value of borrowings with variable rates or maturing within 90 days approximates the carrying value of these borrowings.
Senior subordinated notes and junior subordinated debentures - Fair value of fixed rate, fixed term notes and debentures are estimated by discounting future cash flows using the current rates at which similar borrowings would be made.
The carrying amounts and fair values of PSB’s financial instruments consisted of the following at December 31:
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 23
CONDENSED PARENT COMPANY ONLY FINANCIAL STATEMENTS
The following are condensed balance sheets as of December 31, 2010 and 2009, and condensed statements of income and cash flows for the years ended December 31, 2010, 2009, and 2008, for PSB Holdings, Inc.
Balance Sheets
December 31, 2010 and 2009
Statements of Income
Years Ended December 31, 2010, 2009, and 2008
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
Statements of Cash Flows
Years Ended December 31, 2010, 2009, and 2008
Notes to Consolidated Financial Statements (dollars in thousands except per share data)
NOTE 24
SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
*
Basic and diluted earnings per share may not foot to the total for the year ended December 31 due to rounding.
Item 9.
Item 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
Not applicable.
Item 9A(T).
Item 9A(T). CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
As required by SEC rules, PSB’s management evaluated the effectiveness, as of December 31, 2010, of PSB’s disclosure controls and procedures. PSB’s Chief Executive Officer and Chief Financial Officer participated in the evaluation. Based on this evaluation, the PSB’s Chief Executive Officer and Chief Financial Officer concluded that PSB’s disclosure controls and procedures were effective as of December 31, 2010.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting. As such term is defined in Rule 13a-15(f) of the Securities Exchange Act of 1934, internal control over financial reporting is a process designed by, or under the supervision of, the principal executive and principal financial officers, or persons performing similar functions, and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. Internal control over financial reporting includes those policies and procedures that:
·
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of PSB;
·
provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of PSB are being made only in accordance with authorizations of management and the directors of PSB; and
·
provide reasonable assurance regarding prevention of unauthorized acquisition, use, or disposition of PSB’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies of procedures may deteriorate. This annual report does not include an attestation report of PSB’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by PSB’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report. Management’s report in internal control over financial reporting should be read with these limitations in mind.
Management conducted an evaluation of the effectiveness of the PSB’s internal control over financial reporting based on the criteria in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation under the criteria in Internal Control - Integrated Framework , management concluded that internal control over financial reporting was effective as of December 31, 2010.
Changes in Internal Controls
No change occurred during the fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, PSB’s internal control over financial reporting.
Item 9B.
Item 9B.
OTHER INFORMATION.
Not applicable.
PART III
Item 10.
Item 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information relating to directors of PSB is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in PSB’s proxy statement dated March 15, 2011, relating to the 2011 annual meeting of stockholders (the “2011 Proxy Statement”) under the subcaption “Proposal No. 1 - Election of Directors - Election of Directors.”
PSB’s executive officers include Peter W. Knitt, age 52, President and Chief Executive Officer of PSB and Peoples State Bank since July 2006 and previously Senior Vice President of Peoples State Bank, and Scott M. Cattanach, age 42, Treasurer of PSB and Secretary of PSB since January 2007, and Senior Vice President and Chief Financial Officer of Peoples State Bank.
Information required under Rule 405 of Regulation S-K is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2011 Proxy Statement under the subcaption “Beneficial Ownership of Common Stock - Section 16(a) Beneficial Ownership Reporting Compliance.”
Code of Ethics
PSB has adopted a Code of Ethics Policy for all directors, officers, and employees and a Code of Compliance and Reporting Requirements for Senior Management and Senior Financial Officers which covers PSB’s Chief Executive Officer, Treasurer (the chief financial and accounting officer), each Vice President, and the Secretary. The Code of Compliance and Reporting Requirements for Senior Management and Senior Financial Officers has been posted on PSB’s website at www.psbholdingsinc.com. In the event PSB amends or waives any provision of the Code of Compliance and Reporting Requirements for Senior Management and Senior Financial Officers, PSB intends to disclose such amendment or waiver at the website address where the code may also be found.
Audit Committee
The Board of Directors has appointed an Audit Committee in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Mr. Polzer (Chairman), Mr. Crooks, Mr. Fish, and Mr. Gullickson serve on the Audit Committee (PSB is not a “listed issuer” as defined in SEC Rule 10A-3).
Financial Expert
The SEC has adopted rules which require PSB to disclose whether one of the members of the Audit Committee qualifies under SEC rules as an “audit committee financial expert.” Based on its review of the SEC rules, the Board does not believe that any member of the Audit Committee listed above can be classified as an “audit committee financial expert.”
In order to qualify as an “audit committee financial expert,” a member of the Audit Committee must, for all practical purposes, have the attributes and career experience of a person who has been actively involved in the preparation, auditing, or evaluation of public company financial statements. PSB’s size and geographic location make it difficult to recruit directors who have these specific qualifications. While it may be possible to recruit a director having these specific qualifications, the Board believes that each of its members should have a familiarity with PSB’s market area and an understanding of PSB’s customer base, in addition to meeting the other general criteria described in the 2011 Proxy Statement under “Election of Directors - Nominations - Qualifications,” and that it is not in the best interest of PSB to nominate a director who does not possess these characteristics. Moreover, the Committee has the authority under its charter to retain or dismiss the independent auditor and to hire such other experts or legal counsel as it deems appropriate in order to fulfill its duties, and it therefore believes that it has access to required financial expertise. The Board will consider any potential candidates who meet its current general qualification criteria and those of an “audit committee financial expert,” but, for the time being, the Board believes that the current members of the Committee, working with the independent auditor, are qualified to perform the duties required in the Committee’s charter.
Item 11.
Item 11.
EXECUTIVE COMPENSATION.
Information relating to director compensation is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2011 Proxy Statement under the subcaption “Proposal No. 1 - Election of Directors - Director Compensation for 2010.”
Information relating to the compensation of executive officers is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2010 Proxy Statement under the caption “Executive Officer Compensation.”
Item 12.
Item 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
Information relating to security ownership of certain beneficial owners and management is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2010 Proxy Statement beginning under the caption “Beneficial Ownership of Common Stock.”
The following table sets forth, as of December 31, 2010, information with respect to the sole compensation plan under which PSB’s common stock is authorized for issuance:
Item 13.
Item 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information relating to certain relationships and related transactions with directors and officers, and the independence of our directors is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2011 Proxy Statement under the subcaption “Corporate Governance - The Board - Certain Relationships and Related Transactions” and “Corporate Governance - The Board - Director Independence” and “Proposal No. 1 - Election of Directors - Director Compensation for 2010.”
Item 14.
Item 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES.
Information relating to the fees and services of PSB’s principal accountant is incorporated into this Annual Report on Form 10-K by this reference to the disclosure in the 2011 Proxy Statement under the subcaptions “Audit Committee Report and Related Matters - Independent Auditor and Fees,” and “Audit Committee Report and Related Matters - Audit Committee Pre-Approval Policies.”
PART IV
Item 15.
Item 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a)
Documents filed as part of this report.
(1)
The following consolidated financial statements of PSB and the Independent Auditors’ Report thereon are filed as part of this report:
(i)
Consolidated Balance Sheets as of December 31, 2010 and 2009
(ii)
Consolidated Statements of Income for the years ended December 31, 2010, 2009, and 2008
(iii)
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2010, 2009, and 2008
(iv)
Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009, and 2008
(v)
Notes to Consolidated Financial Statements
(2)
No financial statement schedules are required by Item 15(b).
(3)
The following exhibits required by Item 601 of Regulation S-K are filed as part of this report.
Exhibit
Number Description
3.1
Second Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to Current Report on Form 8-K dated December 16, 2008)
3.2
Bylaws (incorporated by reference to Exhibit 3.1 to Current Report on Form 8-K dated February 21, 2006)
4.1
Indenture dated June 28, 2005 between PSB Holdings, Inc. as issuer, and Wilmington Trust Company, as trustee, including the form of Junior Subordinated Debenture as Exhibit A thereto (incorporated by reference to Exhibit 1.1 to Current Report on Form 8-K dated June 28, 2005)
4.2
Guarantee Agreement dated June 28, 2005 between PSB Holdings, Inc., as guarantor, and Wilmington Trust Company, as guarantee trustee (incorporated by reference to Exhibit 1.2 to Current Report on Form 8-K dated June 28, 2005)
4.3
Amended and Restated Declaration of Trust dated June 28, 2005 among PSB Holdings, Inc., as sponsor, Wilmington Trust Company, as Institutional and Delaware Trustees, and the Administrators named therein, including the form of trust preferred securities (incorporated by reference to Exhibit 1.3 to Current Report on Form 8-K dated June 28, 2005)
10.1
Bonus Plan of Directors of Peoples State Bank (incorporated by reference to Exhibit 10.1 to Annual Report on Form 10-K for the fiscal year ended December 31, 2002)*
10.2
Non-Qualified Retirement Plan for Directors of Peoples State Bank (incorporated by reference to Exhibit 10.2 to Annual Report on Form 10-K for the fiscal year ended December 31, 2001)*
10.3
2001 Stock Option Plan as amended March 15, 2005 (incorporated by reference to Exhibit 10.3 to Quarterly Report on Form 10-Q for the period ended March 31, 2005)*
10.4
Peoples State Bank Focus Rewards Plan for Executive Officers (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated January 25, 2010)*
10.5
Restricted Stock Plan (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K dated November 27, 2007)*
10.6
Amendment to Restricted Stock Plan (incorporated by reference to Exhibit 10.4 to Current Report on Form 8-K dated June 17, 2008)*
10.7
Amended and Restated Employment Agreement dated June 17, 2008, between Peoples State Bank and Scott M. Cattanach (incorporated by reference to Exhibit 10.3 to Current Report on Form 8-K dated June 17, 2008)*
10.8
Amendment to Amended and Restated Employment Agreement between Peoples State Bank and Scott M. Cattanach (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K dated December 23, 2009)*
10.9
Directors Deferred Compensation Plan as amended October 17, 2007 (incorporated by reference to Exhibit 10.1 to Quarterly Report on Form 10-Q for the period ended September 30, 2007)*
10.10
Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated November 27, 2007)*
10.11
2005 Directors Deferred Compensation Plan (incorporated by reference to Exhibit 10.2 to Quarterly Report on Form 10-Q for the quarter ended September 30, 2007)*
10.12
Peoples State Bank Survivor Income Plan (incorporated by reference to Exhibit 10.11 to Annual Report on Form 10-K for the year ended December 31, 2004)*
10.13
Executive Officer Post Retirement Benefit Plan (incorporated by reference to Exhibit 10.4 to Quarterly Report on Form 10-Q for the quarter ended March 31, 2005)*
10.14
Amended and Restated Employment Agreement dated June 17, 2008, between Peoples State Bank and Peter W. Knitt (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated June 17, 2008)*
10.15
Amendment to Amended and Restated Employment Agreement between Peoples State Bank and Peter W. Knitt (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated December 23, 2009)*
10.16
Executive Deferred Compensation Agreement with Peter W. Knitt dated December 31, 2007 (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated November 27, 2007)*
10.17
Amendment to Executive Deferred Compensation Agreement with Peter W. Knitt dated June 17, 2008 (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated November 27, 2007)*
10.18
Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated November 27, 2007)*
21.1
Subsidiaries of PSB (incorporated by reference to Exhibit 21.1 to PSB’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000)
23.1
Consent of Wipfli LLP
31.1
Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2
Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32.1
Certifications of CEO and CFO under Section 906 of Sarbanes-Oxley Act of 2002
*Denotes Executive Compensation Plans and Arrangements.
(b)
Exhibits.
See Item 15(a)(3).
(c)
Financial Schedules.
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on this 15th day of March, 2011.
EXHIBIT INDEX
to
FORM 10-K
of
PSB HOLDINGS, INC.
for the fiscal year ended December 31, 2010
Pursuant to Section 102(d) of Regulation S-T
(17 C.F.R. §232.102(d))
The following exhibits are filed as part of this report:
23.1
Consent of Wipfli LLP
31.1
Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2
Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32.1
Certifications under Section 906 of Sarbanes-Oxley Act of 2002