XNAS:PSBH PSB Holdings, Inc. Annual Report 10-K Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended June 30, 2012
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
 
Commission File Number: 000-50970
 
PSB Holdings, Inc.
(Name of Registrant as Specified in its Charter)
   
Federal
42-1597948
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification Number)
40 Main Street, Putnam, Connecticut
06260
(Address of Principal Executive Office)
(Zip Code)
 
(860) 928-6501
(Registrant’s Telephone Number including area code)
 
Securities Registered Under to Section 12(b) of the Act:
Common Stock, par value $0.10 per share
(Title of Class)
The NASDAQ Stock Market LLC
(Name of exchange on which registered)
 
Securities Registered Under Section 12(g) of the Exchange Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES  o  NO  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of 15(d) of the Act. YES  o  NO  x
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file reports), and (2) has been subject to such requirements for the past 90 days.
(1)  YES  x  NO  o
(2)  YES  x  NO  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x No o
 
Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
 
Large accelerated filer o
Accelerated filer  o
 
 
Non-accelerated filer  o
Smaller reporting company   x
 
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)  o  YES    x  NO
 
The aggregate value of the voting stock held by non-affiliates of the Registrant, computed by reference to the closing price of the Common Stock as of December 31, 2011 ($4.50) was $7.9 million.
 
As of August 31, 2012, there were 6,528,863 shares outstanding of the Registrant’s Common Stock, including 3,729,846 shares owned by Putnam Bancorp, MHC.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
 
1.
Proxy Statement for the 2012 Annual Meeting of Stockholders (Parts II and III)
 


 
 

 

PSB HOLDINGS, INC.
 
FORM 10-K
 
   
Page
PART I
        1
     
ITEM 1.
Business
        1
     
ITEM 1A.
Risk Factors
       32
     
ITEM 1B.
Unresolved Staff Comments
       38
     
ITEM 2.
Properties
        39
     
ITEM 3.
Legal Proceedings
        40
     
ITEM 4.
Mine Safety Disclosures
        40
   
PART II
        41
     
ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
        41
     
ITEM 6.
Selected Financial Data
       42
     
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
        43
     
ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
        51
     
ITEM 8.
Consolidated Financial Statements and Supplementary Data
        52
     
ITEM 9.
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
        114
     
ITEM 9A.
Controls and Procedures
        114
     
ITEM 9B.
Other Information
        115
   
PART III 
        115
     
ITEM 10.
Directors, Executive Officers and Corporate Governance
        115
     
ITEM 11.
Executive Compensation
        115
     
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
        115
     
ITEM 13.
Certain Relationships and Related Transactions, and Director Independence
        115
 
   
ITEM 14.
Principal Accountant Fees and Services
        115
   
PART IV 
        116
   
ITEM 15.
Exhibits and Financial Statement Schedules
        116
   
Signatures
        118
 
 
 

 
 
PART I
 
ITEM 1.
Business
 
Forward Looking Statements
 
This Annual Report on Form 10-K contains certain “forward-looking statements” which may be identified by the use of words such as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to our financial condition, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates and most other statements that are not historical in nature. These factors include, but are not limited to, general and local economic conditions, changes in interest rates, deposit flows, demand for mortgage and other loans, real estate values, competition, changes in accounting principles, policies, or guidelines, changes in legislation or regulation, and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing products and services.
 
PSB Holdings, Inc.
 
PSB Holdings, Inc. is the federally chartered stock holding company of Putnam Bank, and owns 100% of the common stock of Putnam Bank. PSB Holdings, Inc. also owns investment securities valued at $1.2 million as of June 30, 2012. We have not engaged in any significant business activity other than owning the common stock of Putnam Bank and investing in marketable securities. Our executive office is located at 40 Main Street, Putnam, Connecticut 06260, and our telephone number is (860) 928-6501. As of June 30, 2012, 57.1% of the outstanding stock of PSB Holdings, Inc. was owned by Putnam Bancorp, MHC.
 
Putnam Bancorp, MHC
 
Putnam Bancorp, MHC is a federally chartered mutual holding company. Putnam Bancorp, MHC has not engaged in any significant business activity other than owning the common stock of PSB Holdings, Inc. Putnam Bancorp, MHC owns 57.1% of the outstanding shares of common stock of PSB Holdings, Inc. So long as Putnam Bancorp, MHC exists, it is required to own a majority of the voting stock of PSB Holdings, Inc. As a result, stockholders other than Putnam Bancorp, MHC will not be able to exercise voting control over most matters put to a vote of stockholders and Putnam Bancorp, MHC, through its Board of Directors, will be able to exercise voting control over most matters put to a vote of stockholders.
 
Putnam Bancorp, MHC is headquartered at 40 Main Street in Putnam, Connecticut and its telephone number at that address is (860) 928-6501.
 
Putnam Bank
 
Putnam Bank was founded in 1862 as a state-chartered mutual savings bank. In October 2004, the Bank converted to a federally chartered stock savings bank in connection with the offering of common stock by PSB Holdings, Inc. The Bank is headquartered at 40 Main Street in Putnam, Connecticut and conducts substantially all of its business from eight full-service banking offices and one loan origination center. In addition, the Bank maintains a “Special Needs Limited Branch” and a “Limited Service (Mobile) Branch.” The telephone number at the Bank’s main office is (860) 928-6501.
 
Available Information
 
PSB Holdings, Inc. is a public company, and files interim, quarterly and annual reports with the Securities and Exchange Commission.  These respective reports are on file and a matter of public record with the Securities and Exchange Commission and may be obtained on the Securities and Exchange Commission’s website (http://www.sec.gov).
 
Our website address is www.putnambank.com.  Information on our website should not be considered a part of this annual report.
 
General
 
Our principal business consists of attracting deposits from the general public in Windham County and New London County, Connecticut and investing those deposits, together with funds generated from operations, primarily in one- to four-family residential mortgage loans and, to a lesser extent, commercial real estate loans (including multi-family real estate loans), commercial loans, construction mortgage loans and consumer loans, and in investment securities. Our revenues are derived principally from interest on loans and securities, and from loan origination and servicing fees. Our primary sources of funds are deposits and principal and interest payments on loans and securities.
 
 
1

 
 
Competition
 
We face intense competition within our market area both in making loans and attracting deposits. The Town of Putnam and the surrounding area have a high concentration of financial institutions, including large commercial banks, community banks and credit unions. Some of our competitors offer products and services that we currently do not offer, such as trust services and private banking. As of June 30, 2011, based on the FDIC’s annual Summary of Deposits Report (the most current data available), our market share of deposits represented 18.2% of deposits in Windham County and 1.6% in New London County.
 
Our competition for loans and deposits comes principally from commercial banks, savings institutions, mortgage banking firms and credit unions. We face additional competition for deposits from money market funds, brokerage firms, mutual funds and insurance companies. Our primary focus is to build and develop profitable customer relationships across all lines of business while maintaining our role as a community bank.
 
Market Area
 
We operate in a primarily rural market area that has a stable population and household base.  We currently operate out of eight offices, which are located in Windham County and New London County, Connecticut.  According to SNL Financial, LC., from 2010 to 2011, the population of Windham County increased by 0.2%, while London County reflected relatively no change (0.0%).  At the same time, the population of the state of Connecticut increased by 0.1%, while the United States increased at a slightly higher rate of 0.6%.  During the same period, the growth in number of households in Windham and New London Counties, as well as on a statewide  basis, paralleled the relative nationwide population growth rate.  In 2011, per capita income for Windham County was $26,678 and the median household income was $54,234.  In the same year, per capita income for New London County was $31,615 and the median household income was $60,209.  These compare to per capita income levels for the state of Connecticut and the United States of $35,026 and $26,391 and median household income levels of $65,386 and $50,227, respectively.
 
Windham County is located in the Northeastern corner of Connecticut and borders both Massachusetts (to the north) and Rhode Island (to the east).  New London County is to the south of Windham County, located in the Southeastern corner of Connecticut.  Putnam is approximately 45 miles from Hartford, Connecticut, 30 miles from Providence, Rhode Island, and 65 miles from Boston, Massachusetts.
 
Windham County has a diversified mix of industry groups and employment sectors, including services, wholesale/retail trade and government.  These three sectors comprise approximately 68% of the employment base in Windham County.  The same three sectors comprise an approximately higher 75% of the employment base in New London County; however, nearly 27% of the employment base is employed by the government sector.
 
Windham Countys June 2012 unemployment rate of 9.9% is higher than the New London County unemployment rate of 8.5%, which were both higher than the comparable Connecticut unemployment rate of 8.1%, and the national unemployment rate of 8.2%.  Notably, the unemployment rates for the United States, Connecticut, Windham County, and New London County for June 2012 have all decreased relative to their June 2011 unemployment rates of 9.1%, 8.9%, 10.6%, and 8.9%, respectively.  Our primary market area for deposits includes the communities in which we maintain our main office and our branch office locations.  Our primary lending area is broader than our primary deposit market area and includes all of Windham County, and parts of the adjacent Connecticut Counties of New London and Tolland, as well as the Rhode Island and Massachusetts communities adjacent to Windham County.

 
2

 
 
Lending Activities
 
 
Historically, our principal lending activity has been the origination of first mortgage loans for the purchase or refinancing of one- to four-family residential real estate. We retain most of the loans that we originate. However, we generally sell long-term fixed rate loans in the secondary market. When we sell loans, we generally retain the servicing rights for such loans. One- to four-family residential real estate mortgage loans (including home equity loans and lines of credit) represented $200.1 million, or 79.2%, of our loan portfolio at June 30, 2012. We also offer commercial real estate loans (including multi-family real estate loans), commercial loans, construction mortgage loans (primarily secured by single-family properties) and consumer loans. At June 30, 2012, commercial real estate loans totaled $45.0 million, or 17.8% of our loan portfolio, commercial loans totaled $3.5 million, or 1.4% of our loan portfolio, residential construction mortgage loans totaled $3.0 million, or 1.2% of our loan portfolio and consumer loans, consisting primarily of automobile loans and secured personal loans, totaled $898,000, or 0.4% of our loan portfolio.
 
Loan Portfolio Composition. The following table sets forth the composition of our loan portfolio at June 30, of each year indicated.
 
   
At June 30,
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
 
   
(Dollars in thousands)
 
Mortgage Loans:
                                                           
   Residential (1)
  $ 200,148       79.24 %   $ 193,084       74.96 %   $ 194,960       75.37 %   $ 200,680       74.57 %   $ 181,978       72.59 %
   Commercial real estate
    45,032       17.83       53,248       20.67       54,398       21.03       56,500       20.99       55,406       22.10  
   Residential construction
    3,044       1.20       2,824       1.10       1,338       0.52       1,887       0.70       3,223       1.29  
Commercial
    3,459       1.37       7,356       2.86       6,786       2.62       8,958       3.33       8,687       3.46  
Consumer and other
    898       0.36       1,070       0.41       1,177       0.46       1,097       0.41       1,394       0.56  
                                                                                 
Total loans
    252,581       100.00 %     257,582       100.00 %     258,659       100.00 %     269,122       100.00 %     250,688       100.00 %
                                                                                 
Unadvanced construction loans
    (1,559 )             (1,476 )             (1,521 )             (2,929 )             (6,522 )        
      251,022               256,106               257,138               266,193               244,166          
Net deferred loan costs
    463               191               285               324               320          
Allowance for loan losses
    (2,913 )             (3,072 )             (2,651 )             (2,200 )             (1,758 )        
                                                                                 
Loans, net
  $ 248,572             $ 253,225             $ 254,772             $ 264,317             $ 242,728          
                                                                                 
 
(1)          Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.

 
3

 
 
Loan Portfolio Maturities and Yields.  The following table summarizes the final maturities of the Company’s loan portfolio at June 30, 2012. This table does not reflect scheduled principal payments, unscheduled prepayments, or the ability of certain loans to reprice prior to maturity dates.  Demand loans, and loans having no stated repayment schedule, are reported as being due in one year or less.
 
   
Residential (1)
   
Commercial Real Estate
   
Residential Construction
   
Commercial
   
Consumer and Other
Loans
   
Total Loans
 
   
Amount
 
Weighted
Average
Rate
   
Amount
 
Weighted
Average
Rate
   
Amount
 
Weighted
Average
Rate
   
Amount
 
Weighted
Average
Rate
   
Amount
 
Weighted
Average
Rate
   
Amount
 
Weighted
Average
Rate
 
   
(Dollars in thousands)
 
Due During the Years
                                                           
Ending After June 30, 2012
                                                           
One year or less
  $ 1,660   5.41 %   $ 9,062   6.11 %   $ 1,930   4.36 %   $ 1,081   5.30 %   $ 286   5.17 %   $ 14,019   5.70 %
More than one to five years
    5,672   5.85 %     10,844   6.25 %     369   6.31 %     2,125   6.12 %     594   6.91 %     19,604   6.14 %
More than five years
    192,816   4.60 %     24,312   6.32 %     -   0.00 %     253   5.65 %     18   6.00 %     217,399   4.79 %
                                                                         
      Total
  $ 200,148   4.64 %   $ 44,218   6.26 %   $ 2,299   4.67 %   $ 3,459   5.83 %   $ 898   6.34 %   $ 251,022   4.95 %
 

(1)
Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.
 
 
4

 
 
The following table sets forth the scheduled repayments of fixed and adjustable rate loans at June 30, 2012 that are contractually due after June 30, 2013.
                   
   
Fixed
   
Adjustable
   
Total
 
   
(In thousands)
 
Mortgage loans:
                 
     Residential (1)
  $ 127,613     $ 70,875     $ 198,488  
     Commercial real estate
    11,444       23,712       35,156  
     Residential construction
    300       69       369  
Commercial
    1,390       988       2,378  
Consumer and other
    612       -       612  
                         
      Total
  $ 141,359     $ 95,644     $ 237,003  
 

(1)
Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.
 
At June 30, 2012, the total amount of loans that had fixed interest rates was $150.4 million, and the total amount of loans that had floating or adjustable interest rates was $100.6 million.
 
Residential Mortgage Loans. Our primary lending activity consists of the origination of one- to four-family residential mortgage loans that are primarily secured by properties located in Windham and New London Counties, Connecticut. At June 30, 2012, $200.1 million, or 79.2% of our loan portfolio, consisted of one- to four-family residential mortgage loans. At June 30, 2012, our residential mortgage loans included $11.3 million of home equity loans and $11.3 million of home equity lines of credit. Generally, one- to four-family residential mortgage loans are originated in amounts up to 80% of the lesser of the appraised value or purchase price of the property, with private mortgage insurance required on loans with a loan-to-value ratio in excess of 80%. We will not make loans with a loan-to-value ratio in excess of 100% for loans secured by single family homes. Fixed rate mortgage loans generally are originated for terms of 10 to 30 years. Generally, all fixed rate residential mortgage loans are underwritten according to Fannie Mae policies and procedures. Fixed rate residential mortgage loans with terms of more than 15 years are generally sold in the secondary market, although bi-weekly fixed rate mortgage loans with terms of more than 15 years are generally retained in our portfolio. Bi-weekly mortgage loans are loans that require payments to be made every two weeks. We will usually retain the servicing rights for all loans that we sell in the secondary market. We originated $39.3 million of fixed rate one- to four-family residential loans during the year ended June 30, 2012, of which $9.7 million were sold in the secondary market.
 
We also offer adjustable rate mortgage loans for one- to four-family properties, with an interest rate based on the one-year Constant Maturity Treasury Bill Index, which adjusts annually from the outset of the loan or which adjusts annually after a three-, five-, seven-, or ten-year initial fixed rate period. We originated $6.6 million of adjustable rate one- to four-family residential loans during the year ended June 30, 2012, of which $214,000 was sold in the secondary market. Our adjustable rate mortgage loans generally provide for maximum rate adjustments of 100 basis points per adjustment, with a lifetime maximum adjustment up to 6% above the initial rate, regardless of the initial rate. Our adjustable rate mortgage loans amortize over terms of up to 30 years.
 
Adjustable rate mortgage loans decrease the risk associated with changes in market interest rates by periodically repricing, but involve other risks because, as interest rates increase, the monthly or bi-weekly payments by the borrower increase, thus increasing the potential for default by the borrower. At the same time, the value of the underlying collateral may be adversely affected by higher interest rates. Upward adjustment of the contractual interest rate is also limited by the maximum periodic and lifetime interest rate adjustments permitted by our loan documents and, therefore, the effectiveness of adjustable rate mortgage loans may be limited during periods of rapidly rising interest rates. At June 30, 2012, $70.8 million, or 36.7%, of our one- to four-family residential loans had adjustable rates of interest.
 
In an effort to provide financing for moderate income home buyers, we offer Veterans Administration (VA), Federal Housing Administration (FHA), Connecticut Housing Finance Authority (CHFA) and Rural Development loans. These programs offer residential mortgage loans to qualified individuals. These loans are offered with fixed rates of interest and terms of up to 30 years. Such loans are secured by one- to four-family residential properties. All of these loans are originated using agency underwriting guidelines. VA, FHA and CHFA loans are closed in the name of Putnam Bank and are immediately sold on a servicing-released basis. All such loans are originated in amounts of up to 100% of the lower of the property’s appraised value or the sale price. Private mortgage insurance is required on all such loans.
 
 
5

 
 
All residential mortgage loans that we originate include “due-on-sale” clauses, which give us the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid. Regulations limit the amount that a savings association may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal of the property at the time the loan is originated. All borrowers are required to obtain title insurance. We also require homeowner’s insurance and fire and casualty insurance and, where circumstances warrant, flood insurance, on properties securing real estate loans. At June 30, 2012, our largest residential mortgage loan had a principal balance of $698,000 and was secured by a residence located in our primary market area. At June 30, 2012, this loan was performing in accordance with its original terms.
 
At June 30, 2012, home equity loans and lines of credit totaled $22.6 million, or 11.3% of our residential mortgage loans and 9.0% of total loans. Additionally, at June 30, 2012, the unadvanced amounts of home equity lines of credit totaled $10.1 million. The underwriting standards utilized for home equity loans and home equity lines of credit include a determination of the applicant’s credit history, an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan and the value of the collateral securing the loan. Home equity loans are offered with fixed rates of interest and with terms up to 15 years. The loan-to-value ratio for a home equity loan is generally limited to 80%. However, we offer special programs to borrowers, who satisfy certain underwriting criteria, with loan-to-value ratios of up to 100%. Our home equity lines of credit have adjustable rates of interest which are indexed to the prime rate, as reported in The Wall Street Journal. Interest rates on home equity lines of credit are generally limited to a maximum rate of 14.25%.
 
Commercial Real Estate Loans. We originate commercial real estate loans, including multi-family real estate loans.  These loans are generally secured by five unit or more apartment buildings, construction loans and loans on properties used for business purposes such as small office buildings, industrial facilities or retail facilities primarily located in our primary market area. We also offer real estate development loans to licensed contractors and builders for the construction and development of commercial real estate projects and one- to four-family residential properties. At June 30, 2012, commercial mortgage loans totaled $45.0 million, which amounted to 17.8% of total loans. Our commercial real estate underwriting policies provide that such real estate loans may be made in amounts of up to 80% of the appraised value of the property provided such loan complies with our current loans-to-one-borrower limit, which at June 30, 2012 was $5.9 million. Our commercial real estate loans may be made with terms of up to five years with 20 year amortization schedules and are offered with interest rates that are fixed or that adjust periodically and are generally indexed to the prime rate as reported in The Wall Street Journal or to Federal Home Loan Bank advance rates. In reaching a decision on whether to make a commercial real estate loan, we consider the net operating income of the property, the borrower’s expertise and credit history, and the profitability of the value of the underlying property. In addition, with respect to commercial real estate rental properties, we will also consider the term of the lease and the quality of the tenants. We generally require that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before debt service to debt service) of at least 1.25x. Environmental surveys are generally required for commercial real estate loans. Generally, multi-family and commercial real estate loans made to corporations, partnerships and other business entities require personal guarantees by the principals.
 
A commercial borrower’s financial information is monitored on an ongoing basis by requiring periodic financial statement updates, payment history reviews and periodic face-to-face meetings with the borrower. We require commercial borrowers to provide annually updated financial statements and federal tax returns. These requirements also apply to all guarantors on commercial loans. We also require borrowers with rental investment property to provide an annual report of income and expenses for the property, including a tenant list and copies of leases, as applicable. The largest commercial real estate loan in our portfolio at June 30, 2012 was a $2.7 million loan secured by property located in our primary market area.  At June 30, 2012, this loan was performing in accordance with its original terms.
 
Loans secured by commercial real estate, including multi-family properties, generally involve larger principal amounts and a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by commercial real estate, including multi-family properties, are often dependent on successful operation or management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy.
 
 
6

 
 
Residential Construction Loans. We originate construction loans to individuals for the construction and acquisition of personal residences. At June 30, 2012, construction mortgage loans totaled $3.0 million, or 1.2%, of total loans.  At June 30, 2012, the unadvanced portion of these construction loans totaled $745,000.
 
Our construction mortgage loans generally provide for the payment of interest only during the construction phase, which is usually nine months. At the end of the construction phase, the construction loan converts to a permanent mortgage loan. Construction loans can be made with a maximum loan-to-value ratio of 95%, provided that the borrower obtains private mortgage insurance on the loan if the loan balance exceeds 80% of the appraised value or sales price, whichever is less, of the secured property. At June 30, 2012, our largest outstanding residential construction mortgage loan commitment was for $417,000, $38,000 of which was outstanding. This loan was performing according to its original terms at June 30, 2012. Construction loans to individuals are generally made on the same terms as our one- to four-family mortgage loans.
 
Before making a commitment to fund a residential construction loan, we require an appraisal of the property by an independent licensed appraiser. We also review and inspect each property before disbursement of funds during the term of the construction loan. Loan proceeds are disbursed after inspection based on the percentage of completion method.
 
Construction financing is generally considered to involve a higher degree of credit risk than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the value of the property at completion of construction compared to the estimated cost (including interest) of construction and other assumptions. If the estimate of construction cost is inaccurate, we may be required to advance funds beyond the amount originally committed in order to protect the value of the property. Additionally, if the estimate of value is inaccurate, we may be confronted with a project, when completed, with a value that is insufficient to assure full payment.
 
Commercial Loans. At June 30, 2012, we had $3.5 million in commercial business loans which amounted to 1.4% of total loans. We make such commercial loans primarily in our market area to a variety of professionals, sole proprietorships and small businesses. Commercial lending products include term loans and revolving lines of credit. Such loans are generally used for longer-term working capital purposes such as purchasing equipment or furniture. Commercial loans are made with either adjustable or fixed rates of interest. Variable rates are based on the prime rate, as published in The Wall Street Journal, plus a margin. Fixed rate commercial loans are set at a margin above the comparable Federal Home Loan Bank advance rate.
 
When making commercial loans, we consider the financial statements of the borrower, our lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business and the value of the collateral.  Commercial loans are generally secured by a variety of collateral, primarily accounts receivable, inventory and equipment, and are supported by personal guarantees. Depending on the collateral used to secure the loans, commercial loans are made in amounts of up to 75% of the value of the collateral securing the loan. We generally do not make unsecured commercial loans.
 
Commercial loans generally have greater credit risk than residential mortgage loans. Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans generally are made on the basis of the borrower’s ability to repay the loan from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. Further, any collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. We seek to minimize these risks through our underwriting standards. At June 30, 2012, our largest commercial loan was a $299,000 loan secured by business assets located in our primary market area. This loan was performing according to its original terms at June 30, 2012.
 
Consumer and Other Loans. We offer a limited range of consumer loans, principally to Putnam Bank customers residing in our primary market area with acceptable credit ratings. Our consumer loans generally consist of loans on new and used automobiles, loans secured by deposit accounts and unsecured personal loans. Consumer loans totaled $898,000, or 0.4% of our total loan portfolio, at June 30, 2012.
 
Origination, Purchase, Sale and Servicing of Loans. Lending activities are conducted primarily by our loan personnel operating at our eight branch offices and one loan origination center. All loans originated by us are underwritten pursuant to our policies and procedures. We originate both adjustable rate and fixed rate loans. Our ability to originate fixed or adjustable rate loans is dependent upon the relative customer demand for such loans, which is affected by current and expected future levels of market interest rates.
 
 
7

 
 
Generally, we retain in our portfolio all bi-weekly loans and other loans that we originate, with the exception of longer-term, non-bi-weekly fixed rate one- to four-family mortgage loans. The one- to four-family loans that we currently originate for sale include mortgage loans which conform to the underwriting standards specified by Fannie Mae. We also sell all mortgage loans insured by CHFA, FHA, VA and Rural Development. Generally, all one- to four-family loans that we sell are sold pursuant to master commitments negotiated with Fannie Mae. Generally, we sell our loans without recourse. We generally retain the servicing rights on the mortgage loans sold to Fannie Mae, but sell all CHFA, VA, FHA and Rural Development loans on a servicing-released basis.
 
At June 30, 2012, Putnam Bank was servicing loans sold in the amount of $30.5 million. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults, making certain insurance and tax payments on behalf of the borrowers and generally administering the loans.
 
During the fiscal year ended June 30, 2012, we originated $48.7 million of fixed rate and adjustable rate one- to four-family loans, of which we retained $38.8 million. We recognize at the time of sale, the cash gain or loss on the sale of the loans based on the difference between the net cash proceeds received and the carrying value of the loans sold.
 
Loan Approval Procedures and Authority. The Board of Directors establishes the lending policies and loan approval limits of Putnam Bank. Loan officers generally have the authority to originate mortgage loans, consumer loans and commercial loans up to amounts established for each lending officer. Loans in amounts above the individual authorized limits require the approval of Putnam Bank’s Credit Committee. The Credit Committee is authorized to approve all one- to four family mortgage loans, commercial real estate loans, commercial loans and secured consumer loans in amounts up to $500,000.  All loans of $500,000 or greater must receive the approval of Putnam Bank’s Board of Directors.
 
The Board annually approves independent appraisers used by Putnam Bank. For larger loans, the Bank may require an environmental site assessment to be performed by an independent professional for all non-residential mortgage loans. It is Putnam Bank’s policy to require hazard insurance on all mortgage loans.
 
Loan Origination Fees and Other Income. In addition to interest earned on loans, Putnam Bank receives loan origination fees. Such fees and costs vary with the volume and type of loans and commitments made and purchased, principal repayments, and competitive conditions in the mortgage markets, which in turn respond to the demand and availability of money.
 
Loans to One Borrower. The maximum amount that we may lend to one borrower and the borrower’s related entities is generally limited, by regulation, to 15% of our stated capital and reserves. At June 30, 2012, our regulatory limit on loans to one borrower was $5.9 million. At that date, the largest aggregate amount loaned by Putnam Bank to one borrower was $3.2 million. The loans comprising this lending relationship were performing in accordance with their original terms as of June 30, 2012.                                                                                        
 
Delinquencies and Classified Assets
 
            Collection Procedures A computer-generated delinquency notice is mailed monthly to all delinquent borrowers, advising them of the amount of their delinquency. When a loan becomes 60 days delinquent, Putnam Bank sends a letter advising the borrower of the delinquency. The borrower is given 30 days to pay the delinquent payments or to contact Putnam Bank to make arrangements to bring the loan current over a longer period of time. If the borrower fails to bring the loan current in 30 days or to make arrangements to cure the delinquency over a longer period of time, the matter is referred to legal counsel and foreclosure proceedings are started. We may consider forbearance in cases of a temporary loss of income if a plan is presented by the borrower to cure the delinquency in a reasonable period of time after his or her income resumes.
 
Loans Past Due and Non-performing Assets.  Loans are reviewed on a regular basis.  Management determines that a loan is impaired or non-performing when it is probable at least a portion of the loan will not be collected in accordance with the original terms due to an irreversible deterioration in the financial condition of the borrower or the value of the underlying collateral.  When a loan is determined to be impaired, the measurement of the loan is based on present value of expected future cash flows, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. Non-accrual loans are loans in which collectability is questionable and therefore interest on such loans will no longer be recognized on an accrual basis. All loans that become 90 days or more delinquent are placed on non-accrual status.  When loans are placed on non-accrual status, unpaid accrued interest is fully reserved, and further income is recognized only to the extent received.    At June 30, 2012, the Company had non-performing loans of $8.4 million and a ratio of non-performing loans to total loans of 3.34%.
 
 
8

 
 
Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as other real estate owned (“OREO”) until such time as it is sold.  When real estate is acquired through foreclosure or by deed in lieu of foreclosure, it is recorded at its fair value, less estimated costs of disposal.  If the value of the property is less than the loan, less any related specific loan loss provisions, the difference is charged against the allowance for loan losses.  Any subsequent write-down of OREO is charged against earnings.  At June 30, 2012, the Company had OREO of $1.7 million.  Other real estate owned is included in non-performing assets.
 
A loan is classified as a troubled debt restructuring if the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. This usually includes a modification of loan terms, such as a reduction of the interest rate to below market terms, capitalizing past due interest or extending the maturity date and possibly a partial forgiveness of debt. Interest income on restructured loans is accrued after the borrower demonstrates the ability to pay under the restructured terms through a sustained period of repayment performance, which is generally six months.
 
At June 30, 2012, the Company had total non-performing assets of $10.1 million, and a ratio of total non-performing assets to total assets of 2.23%.  At June 30, 2012, the Company had total non-performing assets and troubled debt restructurings of $13.5 million, and a ratio of total non-performing assets and troubled debt restructurings to total assets of 2.99%.

 
9

 
 
Non-Performing Assets. The table below sets forth the amounts and categories of our non-performing assets at the dates indicated.  A loan classified in the table below as “non-accrual” does not necessarily mean that such loan is or has been delinquent. Once a loan is more than 90 days delinquent or the borrower or collateral securing the loan experiences an event that makes collectability suspect, the loan is placed on “non-accrual” status. Our policies require six months of continuous payments in order for the loan to be removed from non-accrual status.
 
   
At June 30,
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(Dollars in thousands)
 
                               
Non-accrual loans:
                             
Residential mortgage loans (1)
  $ 3,985     $ 1,752     $ 1,425     $ 1,277     $ -  
    Commercial real estate
    3,975       4,635       4,164       5,073       982  
    Residential construction
    424       -       -       -       -  
Commercial
    -       -       213       99       -  
Total
    8,384 (2)     6,387 (2)     5,802       6,449       982  
Accruing loans past due 90 days or more:
                                     
Residential mortgage loans (1)
    -       32       491       -       -  
    Commercial real estate
    -       -       -       -       470  
Total
    -       32       491       -       470  
Total non-performing loans
    8,384       6,419       6,293       6,449       1,452  
Other real estate owned
    1,683       1,074       1,561       1,211       -  
Other non-performing assets
    -       46       46       46       -  
Total non-performing assets
    10,067       7,539       7,900       7,706       1,452  
Troubled debt restructurings in compliance with restructured terms
    3,443       4,644       930       259       -  
Troubled debt restructurings and total non-performing assets
  $ 13,510     $ 12,183     $ 8,830     $ 7,965     $ 1,452  
Total non-performing loans to total loans
    3.34 %     2.51 %     2.45 %     2.42 %     0.59  
Total non-performing assets to total assets
    2.23 %     1.60 %     1.61 %     1.61 %     0.29 %
Total non-performing assets and troubled debt restructurings to total assets
    2.99 %     2.58 %     1.80 %     1.67 %     0.29 %
 

(1)
Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.
(2)
The gross interest income that would have been reported if the loans had performed in accordance with their original terms was $456,000 and $592,000 for the years ended June 30, 2012 and 2011, respectively. Actual income recognized in income was $201,000 and $202,000 for the years ended June 30, 2012 and 2011, respectively.
 
Total non-performing assets increased $2.6 million to $10.1 million at June 30, 2012 from $7.5 million at June 30, 2011. Non-performing assets as of June 30, 2012 consisted of $1.7 million in other real estate owned which reflects the repossession of a six-lot residential development project at a carrying value of $247,000, a single family home with a carrying value of $236,000, a commercial building at a carrying value of $166,000, five lots in a recreational park at a value of $338,000 and 202.5 acres of land carried at $696,000.  Also included in non-performing assets is $8.4 million in non-performing loans.  These loans consisted of 17 residential loans totaling $4.0 million, one residential construction loan totaling $424,000 and 25 commercial real estate loans totaling $4.0 million.  Non-performing assets as of June 30, 2011 consisted of $1.1 million in other real estate owned which reflects the repossession of a six-lot residential development project at a carrying value of $303,000, a single family home with a carrying value of $201,000, 34 acres of land carried at $110,000, a single family home at a carrying value of $142,000, one residential/commercial office space at a carrying value of $213,000 and a single family home with a carrying value of $105,000.  Also included in non-performing assets is $46,000 in Freddie Mac auction-rate trust preferred securities and $6.4 million in non-performing loans.  These loans consisted of ten residential loans totaling $1.8 million and 16 commercial real estate loans totaling $4.6 million.  Fourteen of these loans continue to be classified as non-performing as of June 30, 2012.
 
 
10

 
 
The Banks non-performing loans are a direct correlation to the weakened real estate climate.  Management is focused on working with borrowers and guarantors to resolve these trends by restructuring or liquidating assets when prudent. Many of our commercial relationships are secured by development loans, in particular condominiums which have experienced a significant reduction in demand. The Bank reviews the strength of the guarantors; requires face to face discussions and offers restructuring suggestions that provide the borrowers with short-term relief and exit strategies. Overall, we expect to see improvement as solutions are identified and executed. The Bank obtains a current appraisal on all real estate secured loans that are 180 days or more past due if the appraisal in our file is older than one year. If the determination is made that there is the potential for collateral shortfall, an allocated reserve will be assigned to the loan for the expected deficiency. It is the policy of the Bank to charge off or write down loans or other assets when, in the opinion of the Credit Committee and loan review, the ultimate amount recoverable is less than the book value, or the collection of the amount is expected to be unduly prolonged.  The level of non-performing assets is expected to fluctuate in response to changing economic and market conditions, and the relative sizes of the respective loan portfolios, along with management’s degree of success in resolving problem assets. Management takes a proactive approach with respect to the identification and resolution of problem loans.  In addition, in connection with a regularly scheduled Office of the Comptroller of the Currency (“OCC”) examination, the Holding Company and Bank developed and implemented a plan to reduce classified assets.  See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Comparisons of Operating Results for the Fiscal Years Ended June 30, 2012 and 2011.
 
 
11

 

 
The following table sets forth certain information with respect to our loan portfolio delinquencies at the dates indicated.
 
   
Loans Delinquent For
             
   
60-89 Days Past Due
   
90 Days and Over
   
Total
 
   
Number
   
Amount
   
Number
   
Amount
   
Number
   
Amount
 
   
(Dollars in thousands)
 
At June 30, 2012
                                   
    Residential (1)
    2     $ 162       5     $ 940       7     $ 1,102  
    Commercial real estate
    -       -       5       1,573       5       1,573  
    Residential construction
    -       -       1       424       1       424  
Total
    2     $ 162       11     $ 2,937       13     $ 3,099  
                                                 
At June 30, 2011
                                               
    Residential (1)
    2     $ 247       5     $ 1,126       7     $ 1,373  
    Commercial real estate
    4       488       8       3,324       12       3,812  
Total
    6     $ 735       13     $ 4,450       19     $ 5,185  
                                                 
At June 30, 2010
                                               
    Residential (1)
    6     $ 696       4     $ 491       10     $ 1,187  
Total
    6     $ 696       4     $ 491       10     $ 1,187  
                                                 
At June 30, 2009
                                               
    Residential (1)
    3     $ 581       -     $ -       3     $ 581  
    Commercial real estate
    4       2,024       -       -       4       2,024  
Total
    7     $ 2,605       -     $ -       7     $ 2,605  
                                                 
At June 30, 2008
                                               
    Commercial real estate
    6     $ 1,289       11     $ 2,859       17     $ 4,148  
    Commercial
    1       45       1       195       2       240  
Total
    7     $ 1,334       12     $ 3,054 (2)     19     $ 4,388  
 

(1)
Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.
(2)
The difference in loans delinquent 90 days and over and non-performing loans as of June 30, 2008 is primarily related to completion of underwriting for renewals and obtaining current financial information from borrowers, with these loans otherwise performing as agreed.

 
12

 
 
Classified Assets. The Office of the Comptroller of the Currency (“OCC”) regulations and the Bank’s internal policies require that management utilize an internal asset classification system to monitor and evaluate the credit risk inherent in its loan portfolio.  The bank currently classifies problem and potential problem assets as “substandard”, “doubtful”, “loss” or “special mention.”  An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, questionable, and there is a high probability of loss. Assets classified as “loss” are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.  In addition, assets that do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories but possess credit deficiencies or potential weaknesses are required to be designated “special mention.”
 
An insured institution is required to establish general allowances for loan losses in an amount deemed prudent by management for loans classified substandard or doubtful, as well as for other potential problem loans. General allowances represent loss allowances which have been established to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as “loss”, it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount. Our determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the OCC which can order the establishment of additional general or specific loss allowances.
 
On the basis of management’s review of its assets, at June 30, 2012 we had classified $14.0 million of our loans as substandard and $849,000 as doubtful. Of these loans, $7.8 million were considered non-performing and included in the table of non-performing assets.  At June 30, 2012, $2.7 million of our loans were designated as special mention, and none of our assets were classified as loss.
 
The loan portfolio is reviewed on a regular basis to determine whether any loans require classification in accordance with applicable regulations. Not all classified assets constitute non-performing assets.
 
Allowance for Loan Losses
 
Our allowance for loan losses is maintained at a level necessary to absorb loan losses that are both probable and reasonably estimable. Management, in determining the allowance for loan losses, considers the losses inherent in our loan portfolio and changes in the nature and volume of loan activities, along with the general economic and real estate market conditions. Starting with March 31, 2012, we changed the loan categories to match those used in the call report.  We utilize a two-tier approach: (1) identification and establishment of specific loss allowances on impaired loans; and (2) establishment of general valuation allowances on the remainder of our loan portfolio. Once a loan becomes delinquent or otherwise identified as impaired, we may establish a specific loan loss allowance based on a review of among other things, delinquency status, size of loans, type and market value of collateral and financial condition of the borrowers. General loan loss allowances are based upon a combination of factors including, but not limited to, actual loan loss experience, composition of the loan portfolio, current economic conditions and delinquency trends. The allowance is increased through provisions charged against current earnings and recoveries of previously charged-off loans. Loans that are determined to be uncollectible are charged against the allowance. While management uses available information to recognize probable and reasonably estimable loan losses, future loss provisions may be necessary based on changing economic conditions. Payments received on non-accrual commercial loans are applied first to principal. The allowance for loan losses as of June 30, 2012 was maintained at a level that represents management’s best estimate of losses inherent in the loan portfolio, and such losses were both probable and reasonably estimable.
 
In addition, the OCC, as an integral part of their examination process, periodically reviews our allowance for loan losses. This agency may require that we recognize additions to the allowance based on its judgment of information available to it at the time of its examination.
 
 
13

 
 
The following table sets forth activity in our allowance for loan losses for the years indicated.
 
   
Year Ended June 30,
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(Dollars in thousands)
 
                               
Balance at beginning of year
  $ 3,072     $ 2,651     $ 2,200     $ 1,758     $ 1,780  
Provision for loan losses
    1,152       915       1,049       967       51  
Charge offs:
                                       
    Residential (1)
    (364 )     (208 )     (50 )     (53 )     -  
    Commercial real estate
    (928 )     (62 )     (410 )     (400 )     -  
    Commercial
    -       (212 )     (49 )     -       (27 )
    Consumer and other
    (60 )     (72 )     (156 )     (118 )     (97 )
Total charge-offs
    (1,352 )     (554 )     (665 )     (571 )     (124 )
Recoveries:
                                       
    Residential (1)
    7       6       4       1       -  
    Commercial real estate
    -       -       -       -       10  
    Commercial
    11       18       25       5       4  
    Consumer and other
    23       36       38       40       37  
Total recoveries
    41       60       67       46       51  
Net charge-offs
    (1,311 )     (494 )     (598 )     (525 )     (73 )
Balance at end of year
  $ 2,913     $ 3,072     $ 2,651     $ 2,200     $ 1,758  
                                         
Ratios:
                                       
Allowance for loan losses to non-performing loans
at end of year
    34.74 %     47.86 %     42.13 %     34.11 %     121.07 %
Allowance for loan losses to total loans
outstanding at the end of the year
    1.16 %     1.20 %     1.03 %     0.83 %     0.72 %
Net charge-offs to average loans outstanding
    0.51 %     0.19 %     0.22 %     0.20 %     0.03 %
 

(1)           Residential mortgage loans include one- to four-family mortgage loans, home equity loans, and home equity lines of credit.
 
 
14

 
 
Allocation of Allowance for Loan Losses. The following table sets forth the allowance for loan losses allocated by loan category, the percent of the allowance for a category to the total allowance, and the percent of loans in each category to total loans at the dates indicated. The allowance for loan losses allocated to each loan category is not necessarily indicative of future losses in any particular category.
 
   
Amount
   
% of
Allowance to
Total
Allowance
   
% of Loans
in Category
to Total
Loans
 
   
(Dollars in thousands)
 
                   
At June 30, 2012
                 
Residential mortgages (1)
  $ 1,505       51.67 %     80.43 %
Commercial loans (2)
    1,364       46.82       19.21  
Consumer and other
    37       1.27       0.36  
Unallocated
    7       0.24       -  
Total allowance for loan losses
  $ 2,913       100.00 %     100.00 %
                         
At June 30, 2011
                       
Residential mortgages (1)
  $ 1,548       50.39 %     76.05 %
Commercial loans (2)
    1,426       46.42       23.53  
Consumer and other
    11       0.36       0.42  
Unallocated
    87       2.83       -  
Total allowance for loan losses
  $ 3,072       100.00 %     100.00 %
                         
At June 30, 2010
                       
Residential mortgages (1)
  $ 1,342       50.62 %     75.89 %
Commercial loans (2)
    1,198       45.19       23.65  
Consumer and other
    43       1.62       0.46  
Unallocated
    68       2.57       -  
Total allowance for loan losses
  $ 2,651       100.00 %     100.00 %
                         
At June 30, 2009
                       
Residential mortgages (1)
  $ 1,085       49.32 %     75.27 %
Commercial loans (2)
    1,016       46.18       24.32  
Consumer and other
    11       0.50       0.41  
Unallocated
    88       4.00       -  
Total allowance for loan losses
  $ 2,200       100.00 %     100.00 %
                         
At June 30, 2008
                       
Residential mortgages (1)
  $ 842       47.89 %     73.88 %
Commercial loans (2)
    845       48.07       25.56  
Consumer and other
    15       0.85       0.56  
Unallocated
    56       3.19       -  
Total allowance for loan losses
  $ 1,758       100.01 %     100.00 %
 

(1)
Residential mortgage loans include one- to four-family mortgage loans, residential construction loans, home equity loans, and home equity lines of credit.
(2)
Commercial loans include commercial real estate loans and commercial loans.
 
 
15

 
 
Each quarter, management evaluates the total balance of the allowance for loan losses based on several factors, some of which are not loan specific but are reflective of the inherent losses in the loan portfolio. This process includes, but is not limited to, a periodic review of loan collectability in light of historical experience, the nature and volume of loan activity, conditions that may affect the ability of the borrower to repay, underlying value of collateral, if applicable, and economic conditions in our immediate market area. First, we group loans by delinquency status. All loans 90 days or more delinquent are generally evaluated individually along with other impaired loans, based primarily on the present value of expected future cash flows or the value of the collateral securing the loan. Specific loss allowances are established as required by this analysis. All loans which are not individually evaluated are segregated by type, delinquency status or loan grade and a loss allowance is established by using loss experience data and management’s judgment concerning other matters it considers significant. The allowance is allocated to each category of loan based on the results of the above analysis. Small differences between the allocated balances and recorded allowances are reflected as unallocated to absorb losses resulting from the inherent imprecision involved in the loss analysis process.
 
This analysis process is inherently subjective, as it requires us to make estimates that are susceptible to revisions as more information becomes available. Although we believe that we have established the allowance at levels to absorb probable and estimable losses, future additions may be necessary if economic or other conditions in the future differ from the current environment.
 
Investment Activities
 
Putnam Bank’s Executive Committee is responsible for implementing Putnam Bank’s Investment Policy. The Investment Policy is reviewed annually and any changes to the policy are recommended to, and subject to, the approval of our Board of Directors. The Executive Committee is comprised of our Chairman, President, Executive Vice-President and one rotating director. Authority to make investments under the approved Investment Policy guidelines is delegated by the Executive Committee to appropriate officers. While general investment strategies are developed and authorized by the Asset/Liability Committee, the execution of specific actions rests with the Chief Executive Officer or Executive Vice-President who may act jointly or severally as Putnam Bank’s Investment Officer. The Investment Officer is responsible for ensuring that the guidelines and requirements included in the Investment Policy are followed and that all securities are considered prudent for investment. The Investment Officer is authorized to execute investment transactions (purchases and sales) up to $5 million per transaction without the prior approval of the Executive Committee and within the scope of the established investment policy. Each transaction in excess of established limits must receive prior approval of the Executive Committee.
 
In addition, Putnam Bank may utilize the services of an independent investment advisor to assist in managing the investment portfolio. The investment advisor is responsible for maintaining current information regarding securities dealers with whom they are conducting business on our behalf. A list of appropriate dealers is provided annually to the Board of Directors for approval and authorization prior to execution of trades. The investment advisor, through its assigned portfolio manager, must contact our President or Treasurer to review all investment recommendations and transactions and receive approval from the President or Treasurer prior to execution of any transaction that might be transacted on our behalf. Upon receipt of approval, the investment advisor, or its assigned portfolio manager, is authorized to conduct all investment business on our behalf.
 
Our Investment Policy requires that all securities transactions be conducted in a safe and sound manner. Investment decisions must be based upon a thorough analysis of each security instrument to determine its quality, inherent risks, fit within our overall asset/liability management objectives, effect on our risk-based capital measurement and prospects for yield and/or appreciation.
 
The investment policy is consistent with our overall business and asset/liability management strategy, which focuses on sustaining adequate levels of core earnings.  During the fiscal year ended June 30, 2012, the Company recognized other-than-temporary write-downs of $2.0 million on non-agency mortgage-backed securities.
 
U.S. Government and government-sponsored securities. At June 30, 2012, the Company’s U.S. Government and government-sponsored securities portfolio classified as available-for-sale totaled $459,000, or 0.3% of total securities. At June 30, 2012, the Company’s U.S. Government and government-sponsored securities portfolio classified as held-to-maturity totaled $9.2 million, or 6.0% of total securities.  While U.S. Government and government-sponsored securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes, as collateral for borrowings and prepayment protection.
 
Corporate Bonds. At June 30, 2012, the Company’s corporate bond portfolio totaled $4.7 million, or 3.1% of total securities, all of which was classified as available-for-sale. Although corporate bonds may offer higher yields than U.S. Treasury or agency securities of comparable duration, corporate bonds also have a higher risk of default due to possible adverse changes in the credit-worthiness of the issuer. In order to mitigate this risk, our investment policy requires that corporate debt obligations be rated investment grade or better by a nationally recognized rating agency. If the bond rating goes below investment grade, then the investment is placed on an investment “watch report” and is monitored by our Investment Officer. The investment is then reviewed quarterly by our Board of Directors where a determination is made to hold or dispose of the investment.
 
 
16

 
 
Mortgage-Backed Securities. The Company purchases mortgage-backed securities insured or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. We invest in mortgage-backed securities to achieve positive interest rate spreads with minimal administrative expense, and lower our credit risk as a result of the guarantees provided by Freddie Mac, Fannie Mae and Ginnie Mae. The Company also invests in collateralized mortgage obligations (CMOs or non-agency mortgage-backed securities), also insured or issued by Freddie Mac, Fannie Mae and Ginnie Mae, or private issuers such as Washington Mutual and Countrywide Home Loans. All private issuer CMOs were rated AAA at time of purchase.
 
Mortgage-backed securities are created by the pooling of mortgages and the issuance of a security with an interest rate that is less than the interest rate on the underlying mortgage. Mortgage-backed securities typically represent a participation interest in a pool of single-family or multi-family mortgages, although we focus our investments on mortgage-backed securities backed by one- to four-family mortgages. The issuers of such securities (generally U.S. government agencies and government-sponsored enterprises, including Fannie Mae, Freddie Mac and Ginnie Mae) pool and resell the participation interests in the form of securities to investors such as Putnam Bank, and guarantee the payment of principal and interest to investors. Mortgage-backed securities generally yield less than the loans that underlie such securities because of the cost of payment guarantees and credit enhancements. However, mortgage-backed securities are usually more liquid than individual mortgage loans and may be used to collateralize our specific liabilities and obligations.
 
CMOs are a type of non-agency mortgage-backed security issued by a special purpose entity that aggregates pools of mortgage-backed securities and creates different classes of CMO securities with varying maturities and amortization schedules as well as a residual interest, with each class, or “tranche”, possessing different risk characteristics. A particular tranche of CMOs may, therefore, carry prepayment risk that differs from that of both the underlying collateral and other tranches. CMO tranches are purchased by the Company in an attempt to moderate reinvestment risk associated with mortgage-backed securities resulting from unexpected prepayment activities.
 
At June 30, 2012, mortgage-backed securities and CMOs classified as available for sale totaled $32.5 million, or 21.3% of total securities.  At June 30, 2012, mortgage-backed securities and CMOs classified as held to maturity totaled $96.0 million, or 63.0% of total securities.  At June 30, 2012, 65.9% of the mortgage-backed securities were backed by adjustable rate loans and 34.1% were backed by fixed rate mortgage loans. The mortgage-backed securities portfolio had a weighted average yield of 3.59% at June 30, 2012.  Investments in mortgage-backed securities involve a risk that actual prepayments may differ from estimated prepayments over the life of the security, which may require adjustments to the amortization of any premium or accretion of any discount relating to such instruments thereby changing the net yield on such securities. There is also reinvestment risk associated with the cash flows from such securities or if such securities are redeemed by the issuer. In addition, the market value of such securities may be adversely affected by changes in interest rates.
 
Marketable Equity Securities. At June 30, 2012, our equity securities portfolio totaled $9.6 million, or 6.3% of total securities, all of which were classified as available for sale.  At June 30, 2012, the portfolio consisted of auction-rate trust preferred securities (“ARP”).  Auction-rate trust preferred securities are a floating rate preferred stock, on which the dividend rate generally resets every 90 days based on an auction process to reflect the yield demand for the instruments by potential purchasers.  At June 30, 2012, our investments in auction-rate trust preferred securities consisted of investments in three corporate issuers.  These securities were originally purchased by the Company because they represented highly liquid, tax-preferred investments secured, in most cases, by preferred stock issued by high quality, investment grade companies, generally other financial institutions (“collateral preferred shares”).  The ARP shares, or certificates, purchased by the Company are Class A certificates, which, among other rights, entitles the holder to priority claim on dividends paid into the trust holding the preferred shares.
 
In most cases, the trusts which issued the ARP certificates own various callable preferred shares of stock by a single entity.  In addition to the call dates for redemption established by the collateral preferred shares, each trust has a maturity date upon which the trust itself will terminate.  The value of the remaining collateral preferred shares is not guaranteed, and may be more or less than the stated par value of the collateral preferred shares, and is dependent on the market value of those collateral preferred shares on the date of the trust’s maturity.
 
 
17

 
 
The certificates issued by the trusts previously traded in an active, open auction market, with each individual trust establishing the frequency of its auctions, typically every 90 days (the “reset date”).  The results of an auction would be the exchange of certificates, at par, between participants entering or exiting the market, and resetting of the yield to be earned by holders of the Class A certificates as well as the holders of other classes of trust certificates.
 
Beginning in February 2008, auctions for these securities began to fail when investors declined to bid on the securities.  Five of the largest investment banks that made a market in these securities (Merrill Lynch, Citigroup, USB, AG and Morgan Stanley) declined to act as bidders of last resort, as they had in the past.  The auction failures did not result in the loss of any principal value to the certificate holders, but prevented many sellers from exiting, or redeeming, their certificates at the reset date.  These unsuccessful sellers were required to continue to hold the certificates until the next scheduled reset date.  To compensate these unsuccessful sellers, the failed auctions triggered a penalty-rate feature which provided that owners of the Class A certificates were entitled to a higher portion of the dividends, and thus a higher yield, on the Class A certificates.
 
During this time, the Company attempted to divest itself of the ARPs, but was prevented from doing so due to the continued failure of the auction market.  The Company continued to carry its investments at par value, despite the increased liquidity risk, because the credit strength of the issuers of the collateral preferred shares remained high, and the yield remained above-market.
 
The turmoil in the financial markets caused the value of the underlying collateral preferred shares to decline dramatically.  Market values for the ARPs from Merrill Lynch, the Company’s safekeeping agent, also declined, and the Company recorded a temporary impairment adjustment to the carrying value of the ARPs which are classified as available for sale.  A temporary impairment reduces the carrying value of the investment security with an offsetting reduction in the capital accounts of the Company.
 
The Company had difficulty identifying market prices of comparable instruments for ARPs due to the inactive market.  As a result, during the quarter ended June 30, 2009, the Company modified its methodology for determining the fair value of the ARPs classified as Level 3, and used the quoted market values of the underlying collateral preferred shares, adjusted for the higher yield earned by the Company through the Class A certificates compared with the nominal rate available to a direct owner of the collateral preferred shares.  The Company continued to record a temporary impairment adjustment on the ARPs, primarily due to the depressed market values of the underlying collateral preferred shares.
 
During 2009, the Company concluded that the market value of the underlying collateral preferred shares did not represent orderly transactions and adopted the use of a discounted cash flow model to determine if there was any other-than-temporary impairment of its investments in the ARPs.  The resulting discounted cash flow for each ARP classified as Level 3 showed no other-than-temporary impairment in the fair value of the securities.
 
On September 7, 2008, the U.S. Department of the Treasury placed Fannie Mae and Freddie Mac under conservatorship and assumed an equity position in these entities, which takes priority over both common and preferred stocks.  Putnam Bank owned $4,000,000 in Freddie Mac auction-rate preferred securities and recorded an other-than-temporary impairment loss totaling $3.95 million during the quarters ended September 30, 2008 and December 31, 2008.  The book value of this investment was $46,000 as of June 30, 2011.  The Company took possession of the underlying preferred shares of this investment and sold them during the current fiscal year.  A gain on sale of $235,000 was recognized.
 
The Company has the ability and intent to hold these securities for the time necessary to collect the expected cash flows.
 
 
18

 
 
The chart below includes information on the various issuers of Auction Rate Preferred securities owned by the Company:
 
Issuer
Goldman Sachs
 
Merrill Lynch
 
Bank of America
Par amount
 $3,000,000
 
 $5,000,000
 
 $2,000,000
Book Value
 $3,000,000
 
 $5,000,000
 
 $2,000,000
Purchase Date
12-12-07
 
09-04-07
 
11-20-07
Maturity Date
08-23-26
 
05-28-27
 
08-17-47
Next Reset Date
08-21-12
 
08-27-12
 
08-16-12
Reset Frequency
Quarterly
 
Quarterly
 
Quarterly
Failed Auction
Yes
 
Yes
 
Yes
Receiving Default Rates
Yes
 
Yes
 
Yes
Current Rate
4.592%
 
4.714%
 
4.677%
Dividends Current:
Yes
 
Yes
 
Yes
 
The Bank’s entire auction rate preferred securities holdings as of June 30, 2012 had failed auctions for the past fiscal year.
 
Securities Portfolio Composition. The following table sets forth the composition of our securities portfolio, excluding Federal Home Loan Bank stock, at the dates indicated,
 
   
At June 30,
 
   
2012
   
2011
   
2010
 
   
Carrying
   
Percent
   
Carrying
   
Percent
   
Carrying
   
Percent
 
   
Value
   
of total
   
Value
   
of total
   
Value
   
of total
 
   
(Dollars in thousands)
 
                                     
Securities, available for sale:                                    
U.S. Government and government-sponsored securities
  $ 459       0.3 %   $ 666       0.4 %   $ 6,101       3.6 %
Corporate bonds and other securities
    4,654       3.1 %     4,905       2.9 %     4,368       2.6 %
U.S. Government sponsored and guaranteed mortgage-backed securities 
    24,113       15.8 %     30,316       17.5 %     50,734       30.0 %
Non-agency mortgage-backed securities
    8,351       5.5 %     11,722       6.8 %     16,233       9.6 %
Equity securities
    9,636       6.3 %     10,400       6.0 %     8,457       5.0 %
Total securities, available for sale
    47,213       31.0 %     58,009       33.6 %     85,893       50.8 %
                                                 
Securities, held-to-maturity:                                                
U.S. Government and government-sponsored securities
    9,192       6.0 %     16,085       9.3 %     45,275       26.8 %
U.S. Government sponsored and guaranteed mortgage-backed securities
    96,003       63.0 %     98,656       57.1 %     37,974       22.4 %
Total securities, held-to-maturity
    105,195       69.0 %     114,741       66.4 %     83,249       49.2 %
                                                 
Total securities
  $ 152,408       100.0 %   $ 172,750       100.0 %   $ 169,142       100.0 %
 
At June 30, 2012, we had invested in $4.9 million in Merrill Lynch auction-rate securities and $8.4 million in non-agency mortgage-backed securities, and had no other investments in a single company or entity (other than the U.S. Government or an agency of the U.S. Government) that had an aggregate book value in excess of 10% of our equity.
 
 
19

 
 
Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio at June 30, 2012 are summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur. State agency and municipal obligations as well as common and preferred stock yields have not been adjusted to a tax-equivalent basis. Certain mortgage-backed securities have interest rates that are adjustable and will reprice annually within the various maturity ranges. These repricing schedules are not reflected in the table below. At June 30, 2012, mortgage-backed securities with adjustable rates totaled $84.8 million.
 
   
In One
Year or
Less
   
After One
Year
Through
Five Years
   
After Five
Years
Through
Ten Years
   
After Ten
Years
   
Total
 
   
(Dollars in thousands)
 
Securities available for sale:
                             
U.S. Government and government-sponsored securities
  $ 459     $ -     $ -     $ -     $ 459  
Corporate debt securities
    -       -       -       4,654       4,654  
U.S. Government sponsored and guaranteed mortgage-backed securities
    1       440       2,704       20,968       24,113  
Non-agency mortgage-backed securities
    -       -       -       8,351       8,351  
Total debt securities
    460       440       2,704       33,973       37,577  
Equity securities
    -       -       -       9,636       9,636  
                                         
Total securities available for sale
    460       440       2,704       43,609       47,213  
                                         
Securities held to maturity:
                                       
U.S. Government and government-sponsored securities
    -       5,996       3,196       -       9,192  
U.S. Government sponsored and guaranteed mortgage-backed securities
    -       -       6,767       89,236       96,003  
Total securities held to maturity
    -       5,996       9,963       89,236       105,195  
                                         
Total securities
  $ 460     $ 6,436     $ 12,667     $ 132,845     $ 152,408  
Weighted average yield
    5.27 %     1.90 %     2.64 %     3.04 %     2.96 %
 
Sources of Funds
 
General. Deposits have traditionally been our primary source of funds for use in lending and investment activities. In addition to deposits, funds are derived from scheduled loan payments, investment maturities, loan prepayments, retained earnings and income on earning assets. While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition. Borrowings from the Federal Home Loan Bank of Boston and brokered certificates of deposit may be used to compensate for reductions in deposits and to fund loan growth.
 
Deposits. A majority of our depositors are persons who work or reside in Windham County and New London County, Connecticut. We offer a selection of deposit instruments, including checking, savings, money market deposit accounts, negotiable order of withdrawal (NOW) accounts and fixed-term certificates of deposit. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate.
 
Interest rates paid, maturity terms, service fees and withdrawal penalties are established on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals. To attract and retain deposits, we rely upon personalized customer service, long-standing relationships and competitive interest rates.
 
The flow of deposits is influenced significantly by general economic conditions, changes in money market and other prevailing interest rates and competition. The variety of deposit accounts that we offer allows us to be competitive in obtaining funds and responding to changes in consumer demand. Based on historical experience, management believes our deposits are relatively stable. However, the ability to attract and maintain money market accounts and certificates of deposit, and the rates paid on these deposits, have been and will continue to be significantly affected by market conditions. At June 30, 2012, $134.5 million, or 39.3%, of our deposit accounts were certificates of deposit, of which $60.7 million had maturities of one year or less.

 
20

 
 
The following table sets forth the average distribution of total deposit accounts, by account type, for the years indicated.
 
   
At June 30,
 
   
2012
   
2011
   
2010
 
               
Weighted
               
Weighted
               
Weighted
 
   
Average
         
Average
   
Average
         
Average
   
Average
         
Average
 
   
Balance
   
Percent
   
Rate
   
Balance
   
Percent
   
Rate
   
Balance
   
Percent
   
Rate
 
   
(Dollars in thousands)
 
                                                       
Demand deposits
  $ 38,948       11.66 %     - %   $ 35,914       10.85 %     - %   $ 35,279       10.99 %     - %
NOW accounts
    91,767       27.46       0.67       90,186       27.25       0.81       80,526       25.08       1.11  
Regular savings
    51,063       15.28       0.21       48,004       14.50       0.34       46,447       14.46       0.35  
Money market accounts
    15,117       4.52       0.48       13,517       4.09       0.68       11,036       3.44       0.88  
Club accounts
    196       0.06       0.15       199       0.06       0.30       237       0.07       0.30  
      197,091       58.98       0.40       187,820       56.75       0.52       173,525       54.04       0.67  
Certificates of deposit
    137,054       41.02       1.96       143,158       43.25       2.34       147,599       45.96       2.58  
       Total
  $ 334,145       100.00 %     1.04 %   $ 330,978       100.00 %     1.31 %   $ 321,124       100.00 %     1.55 %
 
As of June 30, 2012, the aggregate amount of outstanding certificates of deposit in amounts greater than or equal to $100,000 was $62.4 million. The following table sets forth the maturity of those certificates as of June 30, 2012, in thousands.
 
Three months or less
  $ 15,363  
Over three through six months
    4,702  
Over six months through one year
    7,926  
Over one year through three years
    23,127  
Over three years
    11,272  
     Total
  $ 62,390  
 
 
21

 
 
 Borrowings. Our borrowings consist of advances from, and a line of credit with, the Federal Home Loan Bank of Boston (“FHLB”), and securities sold under agreements to repurchase.  At June 30, 2012, we had an available line of credit with the Federal Home Loan Bank of Boston in the amount of $2.4 million and access to additional Federal Home Loan Bank advances of up to $58.2 million. At June 30, 2012, retail securities sold under agreements to repurchase were $3.7 million.  The following table sets forth information concerning balances and interest rates on our borrowings at the dates and for the years indicated.
 
   
At and For The Year Ended
 
   
June 30,
 
   
2012
   
2011
   
2010
 
   
(Dollars in thousands)
 
                   
Maximum amount of advances outstanding
                 
at any month end during the year:
                 
FHLB advances
  $ 83,500     $ 98,500     $ 120,500  
Securities sold under agreements to repurchase with customers
    12,236       11,651       15,179  
Average advances outstanding during the year:
                       
FHLB advances
    72,692       93,799       106,473  
Securities sold under agreements to repurchase with customers
    6,303       7,671       9,154  
Balance outstanding at end of year:
                       
FHLB advances
    53,500       83,500       100,500  
Securities sold under agreements to repurchase with customers
    3,653       4,244       5,896  
Weighted average interest rate during the year:
                       
FHLB advances
    3.79 %     3.84 %     3.95 %
Securities sold under agreements to repurchase with customers
    0.21       0.28       1.03  
Weighted average interest rate at end of year:
                       
FHLB advances
    3.47 %     3.88 %     3.89 %
Securities sold under agreements to repurchase with customers
    0.16       0.27       0.33  
 
Subsidiary Activities
 
PSB Holdings Inc.’s only subsidiary is Putnam Bank. Putnam Bank has three subsidiaries, Windham North Properties, LLC, PSB Realty, LLC and Putnam Bank Mortgage Servicing Company. Windham North Properties, LLC is used to acquire title to selected properties on which Putnam Bank forecloses. As of June 30, 2012, Windham North Properties, LLC, owned five such properties.  PSB Realty, LLC owns a parcel of real estate located immediately adjacent to Putnam Bank’s main office. This real estate is utilized as a loan center for Putnam Bank and there are no outside tenants that occupy the premises. PSB Realty, LLC also owns the 40 High Street, Norwich branch building and real estate.  Putnam Bank Mortgage Servicing Company is a qualified “passive investment company” that is intended to reduce Connecticut state taxes on interest earned on real estate loans.
 
Personnel
 
As of June 30, 2012, we had 82 full-time employees and 40 part-time employees. Our employees are not represented by any collective bargaining group. Management believes that we have good working relations with our employees.
 
FEDERAL AND STATE TAXATION
 
Federal Taxation
 
General. PSB Holdings, Inc. and Putnam Bank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below.
 
 
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The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to PSB Holdings, Inc. or Putnam Bank.
 
Method of Accounting. For federal income tax purposes, PSB Holdings, Inc. and Putnam Bank currently report their income and expenses on the accrual method of accounting and use a tax year ending June 30 for filing their federal income tax returns.
 
Bad Debt Reserves. Prior to the Small Business Protection Act of 1996 (the “1996 Act”), Putnam Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions could, within specified formula limits, be deducted in arriving at our taxable income. As a result of the 1996 Act, Putnam Bank was required to use the specific charge off method in computing its bad debt deduction beginning with its 1996 federal tax return. Savings institutions were required to recapture any excess reserves over those established as of December 31, 1987 (base year reserve). At June 30, 2012, Putnam Bank had no reserves subject to recapture in excess of its base year reserves.
 
Taxable Distributions and Recapture. Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if Putnam Bank failed to meet certain thrift asset and definitional tests. Federal legislation has eliminated these thrift-related recapture rules. At June 30, 2012, our total federal pre-1988 base year reserve was approximately $2.3 million. However, under current law, pre-1988 base year reserves remain subject to recapture if Putnam Bank makes certain non-dividend distributions, repurchases any of its stock, pays dividends in excess of tax earnings and profits, or ceases to maintain a bank charter.
 
Alternative Minimum Tax. The Internal Revenue Code of 1986, as amended (the “Code”) imposes an alternative minimum tax (AMT) at a rate of 20% on a base of regular taxable income plus certain tax preferences, which we refer to as “alternative minimum taxable income.” The AMT is payable to the extent such alternative minimum taxable income is in excess of an exemption amount and the AMT exceeds the regular income tax. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain AMT payments may be used as credits against regular tax liabilities in future years. At June 30, 2012, PSB Holdings, Inc. had $1.0 million of AMT payments available to carry forward to future periods.
 
Net Operating Loss Carryovers. A financial institution may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. At June 30, 2012, Putnam Bank had $1.4 million in net operating loss carry forwards for federal income tax purposes.
 
Corporate Dividends-Received Deduction. PSB Holdings, Inc. may exclude from its income 100% of dividends received from Putnam Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is 80% in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, and corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf.
 
State Taxation
 
Connecticut State Taxation. PSB Holdings, Inc. and Putnam Bank and its subsidiaries, are subject to the Connecticut corporation business tax. Both entities are required to pay the regular corporation business tax (income tax).
 
The Connecticut corporation business tax is based on the federal taxable income before net operating loss and special deductions and makes certain modifications to federal taxable income to arrive at Connecticut taxable income. Connecticut taxable income is multiplied by the state tax rate of 7.5% to arrive at Connecticut income tax.
 
In 1998, the State of Connecticut enacted legislation permitting the formation of passive investment companies by financial institutions. This legislation exempts qualifying passive investment companies from the Connecticut corporation business tax and excludes dividends paid from a passive investment company from the taxable income of the parent financial institution. Putnam Bank established a passive investment company, Putnam Bank Mortgage Servicing Company, during 2007 and eliminated the state income tax expense of Putnam Bank effective July 1, 2006. If the State of Connecticut were to pass legislation in the future to eliminate the passive investment company exemption Putnam Bank would be subject to state income taxes in Connecticut.
 
The state tax returns have not been audited for the last five years.
 
 
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SUPERVISION AND REGULATION
 
General
 
Putnam Bank is examined and supervised by the Office of the Comptroller of the Currency. This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the Federal Deposit Insurance Corporation’s deposit insurance funds and depositors. Under this system of federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Following completion of its examination, the federal agency critiques the institution’s operations and assigns its rating (known as an institution’s CAMELS rating). Under federal law, an institution may not disclose its CAMELS rating to the public. Putnam Bank also is a member of and owns stock in the Federal Home Loan Bank of Boston, which is one of the twelve regional banks in the Federal Home Loan Bank System. Putnam Bank also is regulated to a lesser extent by the Board of Governors of the Federal Reserve System, governing reserves to be maintained against deposits and other matters. The Office of the Comptroller of the Currency examines Putnam Bank and prepares reports for the consideration of its Board of Directors on any operating deficiencies. Putnam Bank’s relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in matters concerning the ownership of deposit accounts and the form and content of Putnam Bank’s mortgage documents.
 
Any change in these laws or regulations, whether by the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency or Congress, could have a material adverse impact on PSB Holdings, Inc. and Putnam Bank and their operations.
 
Regulatory Agreement
 
On June 20, 2012, Putnam Bank entered into an agreement with the Office of Comptroller of the Currency (the “Agreement”).  As part of the Agreement, the Office of Comptroller of the Currency (required Putnam Bank to take a number of specific corrective actions, and required that Putnam Bank not undertake certain actions without obtaining prior approval of the Office of the Comptroller of the Currency.  The Agreement replaces a memorandum of understanding that Putnam Bank entered into with the Office of Thrift Supervision.
 
The actions and forbearances contained in the Agreement require Putnam Bank’s Board of Directors (the “Board”) to, among other matters:
 
 
Appoint a Compliance Committee of the Board to monitor compliance with the Agreement.
 
 
The Compliance Committee must prepare and