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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2012
For the transition period from _____________ to _____________
Commission file number: 0-26480
PSB HOLDINGS, INC.
(Exact name of registrant as specified in charter)
1905 West Stewart Avenue
Wausau, Wisconsin 54401
(Address of principal executive office)
Registrant’s telephone number, including area code: 715-842-2191
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 such report), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date 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).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2) of the Exchange Act).
The number of common shares outstanding at August 13, 2012 was 1,663,472.
PSB HOLDINGS, INC.
PSB Holdings, Inc.
June 30, 2012 unaudited, December 31, 2011 derived from audited financial statements
PSB Holdings, Inc.
PSB Holdings, Inc.
PSB Holdings, Inc.
Six months ended June 30, 2012
PSB Holdings, Inc.
Six months ended June 30, 2012 and 2011
PSB Holdings, Inc.
Consolidated Statements of Cash Flows
Six months ended June 30, 2012 and 2011
PSB Holdings, Inc.
NOTE 1 – GENERAL
In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly PSB Holdings, Inc.’s (“PSB”) financial position, results of its operations, and cash flows for the periods presented, and all such adjustments are of a normal recurring nature. The consolidated financial statements include the accounts of all subsidiaries. All material intercompany transactions and balances are eliminated. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. Any reference to “PSB” refers to the consolidated or individual operations of PSB Holdings, Inc. and its subsidiary Peoples State Bank and, where applicable, its subsidiary Marathon State Bank, which, as described in Note 2 below, was acquired by PSB on June 14, 2012. Dollar amounts are in thousands, except per share amounts.
These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles have been omitted or abbreviated. The information contained in the consolidated financial statements and footnotes in PSB’s Annual Report on Form 10-K for the year ended December 31, 2011 should be referred to in connection with the reading of these unaudited interim financial statements.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing right assets, and the valuation of investment securities.
NOTE 2 – PSB HOLDINGS, INC. ACQUISITION OF MARATHON STATE BANK
On June 14, 2012, PSB completed its purchase of Marathon State Bank, a privately owned bank with $107 million in total assets located in the Village of Marathon City, Wisconsin (“Marathon”). Under the terms of the agreement, PSB paid $5,505 in cash, which was equal to 100% of Marathon’s tangible net book value following a special dividend by Marathon to its shareholders to reduce its book equity ratio to 6% of total assets. The following table outlines the fair value of Marathon assets and liabilities acquired including determination of the gain on bargain purchase using an accounting date of June 1, 2012. A core deposit intangible was not recorded on the purchase as the fair value calculation determined it was insignificant.
PSB recorded a total credit mark down of $490 on Marathon’s loan portfolio on the purchase date, or 1.52% of purchased loan principal (including non-rated commercial paper and bankers’ acceptances). Purchased impaired loan principal totaled $310 on which a $21 credit write-down was recorded. Due to the insignificant amount of total purchased impaired loans, the entire $490 credit mark down will be accreted to income as a yield adjustment based on contractual cash flows over the remaining life of the purchased loans.
Pro forma combined results of operations as if the combination occurred at the beginning of the quarterly and year to date periods ended June 30, 2012:
Pro forma combined results of operations as if the combination occurred at the beginning of the quarterly and year to date periods ended June 30, 2011:
NOTE 3 – SECURITIES
The amortized cost and estimated fair value of investment securities are as follows:
Securities with a fair value of $48,506 and $56,659 at June 30, 2012 and December 31, 2011, respectively, were pledged to secure public deposits, other borrowings, and for other purposes required by law.
NOTE 4 – LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Loans that management has the intent to hold for the foreseeable future or until maturity or pay-off are generally reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest on loans is credited to income as earned. Interest income is not accrued on loans where management has determined collection of such interest is doubtful or those loans which are past due 90 days or more as to principal or interest payments. When a loan is placed on nonaccrual status, previously accrued but unpaid interest deemed uncollectible is reversed and charged against current income. After being placed on nonaccrual status, additional income is recorded only to the extent that payments are received and the collection of principal becomes reasonably assured. Interest income recognition on loans considered to be impaired is consistent with the recognition on all other loans. Loan origination fees and certain direct loan origination costs are deferred and recognized as an adjustment of the related loan yield using the interest method.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely.
Management maintains the allowance for loan losses at a level to cover probable credit losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. In accordance with current accounting standards, the allowance is provided for losses that have been incurred based on events that have occurred as of the balance sheet date. The allowance is based on past events and current economic conditions and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions.
The allowance for loan losses includes specific allowances related to loans which have been judged to be impaired. A loan is impaired when, based on current information, it is probable that PSB will not collect all amounts due in accordance with the contractual terms of the loan agreement. Management has determined that impaired loans include nonaccrual loans, loans identified as restructurings of troubled debt, and loans accruing interest with elevated risk of default in the near term based on a variety of credit factors. Specific allowances on impaired loans are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.
In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require PSB to make additions to the allowance for loan losses based on their judgments of collectability resulting from information available to them at the time of their examination.
The composition of loans, categorized by the type of the loan, is as follows:
The following is a summary of information pertaining to impaired loans at period-end:
Activity in the allowance for loans losses during the six months ended June 30, 2012 follows:
PSB maintains an independent credit administration staff that continually monitors aggregate commercial loan portfolio and individual borrower credit quality trends. All commercial purpose loans are assigned a credit grade upon origination, and credit grades for nonproblem borrowers with aggregate credit in excess of $500 are reviewed annually. In addition, all past due, restructured, or identified problem loans, both commercial and consumer purpose, are reviewed and assigned an up-to-date credit grade quarterly.
PSB uses a seven point grading scale to estimate credit risk with risk rating 1, representing the high credit quality, and risk rating 7, representing the lowest credit quality. The assigned credit grade takes into account several credit quality components which are assigned a weight and blended into the composite grade. The factors considered and their assigned weight for the final composite grade is as follows:
Cash flow (30% weight) – Considers earnings trends and debt service coverage levels.
Collateral (25% weight) – Considers loan to value and other measures of collateral coverage.
Leverage (15% weight) – Considers balance sheet debt and capital ratios compared to Robert Morris & Associates (RMA) industry medians.
Liquidity (10% weight) – Considers balance sheet current, quick, and other working capital ratios compared to RMA industry medians.
Management (5% weight) – Considers the past performance, character, and depth of borrower management.
Guarantor (5% weight) – Considers the existence of a guarantor along with a bank’s past experience with the guarantor and his related liquidity and credit score.
Financial reporting (5% weight) – Considers the relative level of independent financial review obtained by the borrower on its financial statements, from audited financial statements down to existence of only tax returns or potentially unreliable financial information.
Industry (5% weight) – Considers the borrower’s industry and whether it is stable or subject to cyclical or seasonal factors.
Nonclassified loans are assigned a risk rating of 1 to 4 and have credit quality that ranges from well above average to some inherent industry weaknesses that may present higher than average risk due to conditions affecting the borrower, the borrower’s industry, or economic development.
Special mention and watch loans are assigned a risk rating of 5 when potential weaknesses exist that deserve management’s close attention. If left uncorrected, the potential weaknesses may result in deterioration of repayment prospects or in credit position at some future date. Substandard loans are assigned a risk rating of 6 and are inadequately protected by the current worth and borrowing capacity of the borrower. Well-defined weaknesses exist that may jeopardize the liquidation of the debt. There is a possibility of some loss if the deficiencies are not corrected. At this point, the loan may still be performing and accruing interest.
Impaired and other doubtful loans assigned a risk rating of 7 have all of the weaknesses of a substandard credit plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of current facts, conditions, and collateral values highly questionable and improbable. Impaired loans include all nonaccrual loans and all restructured loans including restructured loans performing according to the restructured terms. In special situations, an impaired loan with a risk rating of 7 could still be maintained on accrual status such as in the case of restructured loans performing according to restructured terms.
The commercial credit exposure based on internally assigned credit grade at June 30, 2012, follows:
The consumer credit exposure based on payment activity at June 30, 2012, follows:
The payment age analysis of loans receivable disbursed at June 30, 2012, follows:
Impaired loans as of June 30, 2012, and during the six months then ended, by loan class, follows:
The impaired loans at December 31, 2011, and during the year then ended, by loan class, follows:
Loans on nonaccrual status at period-end, follows:
During the quarter and six months ended June 30, 2012, the commercial related contracts identified below were modified to convert from amortizing principal payments to interest only payments or to capitalize unpaid property taxes and were therefore categorized as troubled debt restructurings. During the quarter and six months ended June 30, 2011, the commercial related contracts identified below were modified to defer principal payments due or lower the interest rate. Specific loan reserves maintained in connection with loans restructured during the year to date period totaled $62 at June 30, 2012 and $515 at June 30, 2011. All modified or restructured loans are classified as impaired loans. Recorded investment as presented in the tables below concerning modified loans represents principal outstanding before specific reserves.
The following table presents information concerning modifications of troubled debt made during the quarter ended June 30, 2012:
The following table presents information concerning modifications of troubled debt made during the six months ended June 30, 2012:
The following table presents information concerning modifications of troubled debt made during the quarter ended June 30, 2011:
The following table presents information concerning modifications of troubled debt made during the six months ended June 30, 2011:
The following table outlines past troubled debt restructurings that subsequently defaulted within twelve months of the last restructuring date. For purposes of this table, default is defined as 90 days or more past due on restructured payments.
No troubled debt restructurings defaulted during the six months ended June 30, 2011 that had defaulted within twelve months of the last restructuring date.
NOTE 5 – FORECLOSED ASSETS
Real estate and other property acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value (after deducting estimated costs to sell) at the date of foreclosure, establishing a new cost basis. Costs related to development and improvement of property are capitalized, whereas costs related to holding property are expensed. After foreclosure, valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Revenue and expenses from operations of foreclosed assets and changes in any valuation allowance are included in loss on foreclosed assets.
A summary of activity in foreclosed assets is as follows:
NOTE 6 – DEPOSITS
The distribution of deposits at period end is as follows:
NOTE 7 – OTHER BORROWINGS
Other borrowings consist of the following obligations at June 30, 2012, and December 31, 2011:
PSB pledges various securities available for sale as collateral for repurchase agreements. The fair value of securities pledged for repurchase agreements totaled $23,096 at June 30, 2012 and $22,977 at December 31, 2011.
The following information relates to securities sold under repurchase agreements and other borrowings:
NOTE 8 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
PSB is exposed to certain risks relating to its ongoing business operations. The primary risk managed by using derivative instruments is interest rate risk. Interest rate swaps are entered into to manage interest rate risk associated with PSB’s variable rate junior subordinated debentures. Accounting standards require PSB to recognize all derivative instruments as either assets or liabilities at fair value in the balance sheet. PSB designates its interest rate swap associated with the junior subordinated debentures as a cash flow hedge of variable-rate debt. For derivative financial instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative instrument representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.
From time to time, PSB will also enter into fixed interest rate swaps with customers in connection with their floating rate loans to PSB. When fixed rate swaps are originated with customers, an identical offsetting swap is also entered into by PSB with a correspondent bank. These swap arrangements are intended to offset each other as “back to back” swaps and allow PSB’s loan customer to obtain fixed rate loan financing via the swap while PSB exchanges these fixed payments with a correspondent bank. In these arrangements, PSB’s net cash flows and interest income are equal to the floating rate loan originated in connection with the swap. These customer swaps are not designated as hedging instruments and are accounted for at fair value with changes in fair value recognized in the income statement during the current period.
PSB is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. PSB controls the credit risk of its financial contracts through credit approvals, limits, and monitoring procedures, and does not expect any counterparties to fail their obligations. PSB swaps originated with correspondent banks are over-the-counter (OTC) contracts. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amounts, exercise prices, and maturity.
At period end, the following interest rate swaps to hedge variable-rate debt were outstanding:
This agreement provides for PSB to receive payments at a variable rate determined by the three-month LIBOR in exchange for making payments at a fixed rate. Actual maturities may differ from scheduled maturities due to call options and/or early termination provisions. No interest rate swap agreements were terminated prior to maturity during the six months ended June 30, 2012 or 2011. Risk management results for the six months ended June 30, 2012 related to the balance sheet hedging of variable rate debt indicates that the hedge was 100% effective, and no component of the derivative instrument’s gain or loss was excluded from the assessment of hedge effectiveness.
As of June 30, 2012, approximately $170 of losses ($103 after tax impacts) reported in other comprehensive income related to the interest rate swap are expected to be reclassified into interest expense as a yield adjustment of the hedged borrowings during the 12-month period ending June 30, 2013. The interest rate swap agreement was secured by cash and cash equivalents of $750 at June 30, 2012, and by $680 at December 31, 2011.
PSB maintains outstanding interest rate swaps with customers and correspondent banks associated with its lending activities that are not designated as hedges. At period end, the following floating interest rate swaps were outstanding with customers:
At period end, the following offsetting fixed interest rate swaps were outstanding with correspondent banks:
NOTE 9 – INCOME TAX EFFECTS ON ITEMS OF COMPREHENSIVE INCOME (LOSS)
NOTE 10 – STOCK-BASED COMPENSATION
Under the terms of an incentive stock option plan adopted during 2001, shares of unissued common stock were reserved for options to officers and key employees at prices not less than the fair market value of the shares at the date of the grant. No additional shares of common stock remain reserved for future grants under the option plan approved by the shareholders, and the last outstanding option shares were exercised during the quarter ended June 30, 2012. As of December 31, 2011, 588 options were outstanding and eligible to be exercised at a price of $16.03 per share which were exercised during the quarter ended June 30, 2012. During the six months ended June 30, 2011, 1,537 options were exercised at $15.08 per share.
PSB granted restricted stock to certain employees having an initial market value of $200 during the three months ended March 31, 2012 and 2011. Restricted shares vest to employees based on continued PSB service over a six-year period and are recognized as compensation expense over the vesting period. Cash dividends are paid on unvested shares at the same time and amount as paid to PSB common shareholders. Cash dividends paid on unvested restricted stock shares are charged to retained earnings as significantly all restricted shares are expected to vest to employees. Unvested shares are subject to forfeiture upon employee termination. During the six months ended June 30, compensation expense recorded from amortization of restricted shares expected to vest to employees was $53 and $39 during 2012 and 2011, respectively.
The following tables summarize information regarding restricted stock outstanding at June 30, 2012 and 2011 including activity during the six months then ended.
Scheduled compensation expense per calendar year assuming all restricted shares eventually vest to employees would be as follows:
Basic earnings per share of common stock are based on the weighted average number of common shares outstanding during the period. Unvested but issued restricted shares are considered to be outstanding shares and used to calculate the weighted average number of shares outstanding and determine net book value per share. Diluted earnings per share is calculated by dividing net income by the weighted average number of shares adjusted for the dilutive effect of outstanding stock options. On June 19, 2012, the Company declared a 5% stock dividend to shareholders of record July 16, 2012, which was paid in the form of additional common stock on July 30, 2012. All references in the accompanying consolidated financial statements and footnotes to the number of common shares and per share amounts have been restated to reflect the 5% stock dividend.
Presented below are the calculations for basic and diluted earnings per share:
In the normal course of business, PSB is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the consolidated financial statements.
Certain assets and liabilities are recorded or disclosed at fair value to provide financial statement users additional insight into PSB’s quality of earnings. Under current accounting guidance, PSB groups assets and liabilities which are recorded at fair value in three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). All transfers between levels are recognized as occurring at the end of the reporting period.
Following is a brief description of each level of the fair value hierarchy:
Level 1 – Fair value measurement is based on quoted prices for identical assets or liabilities in active markets.
Level 2 – Fair value measurement is based on (1) quoted prices for similar assets or liabilities in active markets; (2) quoted prices for identical or similar assets or liabilities in markets that are not active; or (3) valuation models and methodologies for which all significant assumptions are or can be corroborated by observable market data.
Level 3 – Fair value measurement is based on valuation models and methodologies that incorporate at least one significant assumption that cannot be corroborated by observable market data. Level 3 measurements reflect PSB’s estimates about assumptions market participants would use in measuring fair value of the asset or liability.
Some assets and liabilities, such as securities available for sale, loans held for sale, mortgage rate lock commitments, and interest rate swaps, are measured at fair value on a recurring basis under GAAP. Other assets and liabilities, such as impaired loans, foreclosed assets, and mortgage servicing rights are measured at fair value on a nonrecurring basis.
Following is a description of the valuation methodology used for each asset and liability measured at fair value on a recurring or nonrecurring basis, as well as the classification of the asset or liability within the fair value hierarchy.
Securities available for sale – Securities available for sale may be classified as Level 1, Level 2, or Level 3 measurements within the fair value hierarchy and are measured on a recurring basis. Level 1 securities include equity securities traded on a national exchange. The fair value measurement of a Level 1 security is based on the quoted price of the security. Level 2 securities include U.S. government and agency securities, obligations of states and political subdivisions, corporate debt securities, and mortgage-related securities. The fair value measurement of a Level 2 security is obtained from an independent pricing service and is based on recent sales of similar securities and other observable market data and represents a market approach to fair value.
At June 30, 2012 and December 31, 2011, Level 3 securities include a common stock investment in Bankers’ Bank, Madison, Wisconsin that is not traded on an active market. Historical cost of the common stock is assumed to approximate fair value of this investment.
Loans held for sale – Loans held for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value and are measured on a recurring basis. The fair value measurement of a loan held for sale is based on current secondary market prices for similar loans, which is considered a Level 2 measurement and represents a market approach to fair value.
Impaired loans – Loans are not measured at fair value on a recurring basis. Carrying value of impaired loans that are not collateral dependent are based on the present value of expected future cash flows discounted at the applicable effective interest rate and, thus, are not fair value measurements. However, impaired loans considered to be collateral dependent are measured at fair value on a nonrecurring basis. The fair value measurement of an impaired loan that is collateral dependent is based on the fair value of the underlying collateral. Fair value measurements of underlying collateral that utilize observable market data, such as independent appraisals reflecting recent comparable sales, are considered Level 2 measurements. Other fair value measurements that incorporate internal collateral appraisals or broker price opinions, net of selling costs, or estimated assumptions market participants would use to measure fair value, such as discounted cash flow measurements, are considered Level 3 measurements and represent a market approach to fair value.
In the absence of a recent independent appraisal, collateral dependent impaired loans are valued based on a recent broker price opinion generally discounted by 10% plus estimated selling costs. In the absence of a broker price opinion, collateral dependent impaired loans are valued at the lower of last appraisal value or the current real estate tax value discounted by 20% to 50%, depending on internal judgments on the condition of the property, plus estimated selling costs. Property values are impacted by many macroeconomic factors. In general, a declining economy or rising interest rates would be expected to lower fair value of collateral dependent impaired loans while an improving economy or falling interest rates would be expected to increase fair value of collateral dependent impaired loans.
Foreclosed assets – Real estate and other property acquired through, or in lieu of, loan foreclosure are not measured at fair value on a recurring basis. Initially, foreclosed assets are recorded at fair value less estimated costs to sell at the date of foreclosure. Valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Fair value measurements are based on current formal or informal appraisals of property value compared to recent comparable sales of similar property. Independent appraisals reflecting comparable sales are considered Level 2 measurements, while internal assessments of appraised value based on current market activity, including broker price opinions, are considered Level 3 measurements and represent a market approach to fair value. Property values are impacted by many macroeconomic factors. In general, a declining economy or rising interest rates would be expected to lower fair value of foreclosed assets while an improving economy or falling interest rates would be expected to increase fair value of foreclosed assets.
Mortgage servicing rights – Mortgage servicing rights are not measured at fair value on a recurring basis. However, mortgage servicing rights that are impaired are measured at fair value on a nonrecurring basis. Serviced loan pools are stratified by year of origination and term of the loan, and a valuation model is used to calculate the present value of expected future cash flows for each stratum. When the carrying value of a stratum exceeds its fair value, the stratum is measured at fair value. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, custodial earnings rate, ancillary income, default rates and losses, and prepayment speeds. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value. As a result, the fair value measurement of mortgage servicing rights is considered a Level 3 measurement and represents an income approach to fair value. When market mortgage rates decline, borrowers may have the opportunity to refinance their existing mortgage loans at lower rates, increasing the risk of prepayment of loans on which we maintain mortgage servicing rights. Therefore, declining long term interest rates would decrease the fair value of mortgage servicing rights. Significant unobservable inputs at June 30, 2012 used to measure fair value included:
Mortgage rate lock commitments – The fair value of mortgage rate lock commitments is measured on a recurring basis. Fair value is based on current secondary market pricing for delivery of similar loans and the value of originated mortgage servicing rights on loans expected to be delivered, which is considered a Level 2 fair value measurement.
Interest rate swap agreements – Fair values for interest rate swap agreements are based on the amounts required to settle the contracts based on valuations provided by third-party dealers in the contracts, which is considered a Level 2 fair value measurement, and are measured on a recurring basis.
Reconciliation of fair value measurements using significant unobservable inputs:
At June 30, 2012, loans with a carrying amount of $3,516 were considered impaired and were written down to their estimated fair value of $2,907 net of a valuation allowance of $609. At December 31, 2011, loans with a carrying amount of $5,306 were considered impaired and were written down to their estimated fair value of $4,086, net of a valuation allowance of $1,220. Changes in the valuation allowances are reflected through earnings as a component of the provision for loan losses or as a charge-off against the allowance for loan losses.
At June 30, 2012, mortgage servicing rights with a carrying amount of $1,325 were considered impaired and were written down to their estimated fair value of $1,110, resulting in an impairment allowance of $215. At December 31, 2011, mortgage servicing rights with a carrying amount of $1,286 were considered impaired and were written down to their estimated fair value of $1,205, resulting in an impairment allowance of $81. Changes in the impairment allowances are reflected through earnings as a component of mortgage banking income.
PSB estimates fair value of all financial instruments regardless of whether such instruments are measured at fair value. The following methods and assumptions were used by PSB to estimate fair value of financial instruments not previously discussed.
Cash and cash equivalents – Fair value reflects the carrying value of cash, which is a Level 1 measurement.
Securities held to maturity – Fair value of securities held to maturity is based on dealer quotations on similar securities near period-end, which is considered a Level 2 measurement. Certain debt issued by banks or bank holding companies purchased by PSB as securities held to maturity is valued on a cash flow basis discounted using market rates reflecting credit risk of the borrower, which is considered a Level 3 measurement.
Bank certificates of deposit – Fair value of fixed rate certificates of deposit included in other investments is estimated by discounting future cash flows using current rates at which similar certificates could be purchased, which is a Level 3 measurement.
Loans – Fair value of variable rate loans that reprice frequently are based on carrying values. Loans with an active sale market, such as one- to four-family residential mortgage loans, estimate fair value based on sales of loans with similar structure and credit quality. Fair value of other loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings. Fair value of impaired and other nonperforming loans are estimated using discounted expected future cash flows or the fair value of underlying collateral, if applicable. Except for collateral dependent impaired loans valued using an independent appraisal of collateral value, reflecting a Level 2 fair value measurement, fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.
Federal Home Loan Bank stock – Fair value is the redeemable (carrying) value based on the redemption provisions of the Federal Home Loan Bank, which is considered a Level 3 fair value measurement.
Accrued interest receivable and payable – Fair value approximates the carrying value, which is considered a Level 3 fair value measurement.
Cash value of life insurance – Fair value is based on reported values of the assets by the issuer which are redeemable to the insured, which is considered a Level 1 fair value measurement.
Deposits – Fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, by definition, is the amount payable on demand on the reporting date. Fair value of fixed rate time deposits is estimated using discounted cash flows applying interest rates currently offered on issue of similar time deposits. Use of internal discounted cash flows provides a Level 3 fair value measurement.
FHLB advances and other borrowings – Fair value of fixed rate, fixed term borrowings is estimated by discounting future cash flows using the current rates at which similar borrowings would be made as calculated by the lender or correspondent. Fair value of borrowings with variable rates or maturing within 90 days approximates the carrying value of these borrowings. Fair values based on lender provided settlement provisions are considered a Level 2 fair value measurement. Other borrowings with local customers in the form of repurchase agreements are estimated using internal assessments of discounted future cash flows, which is a Level 3 measurement.
Senior subordinated notes and junior subordinated debentures – Fair value of fixed rate, fixed term notes and debentures are estimated internally by discounting future cash flows using the current rates at which similar borrowings would be made, which is a Level 3 fair value measurement.
The carrying amounts and fair values of PSB’s financial instruments consisted of the following:
The carrying amounts and fair values of PSB’s financial instruments consisted of the following at December 31, 2011:
FASB ASC Topic 220, “Comprehensive Income.” In June 2011, new authoritative accounting guidance was approved that required changes to the presentation of comprehensive net income. Effective during the quarter ended March 31, 2012, PSB began to present comprehensive income as a separate financial statement directly after the basic income statement. Adoption of the new presentation standards for comprehensive income did not have any financial impact to PSB’s financial results or operations. The requirements to disclose on the face of the income statement on a line by line basis the impact to current net income on reclassification of items coming out of comprehensive net income was deferred.
FASB ASC Topic 820, “Fair Value Measurements.” In May 2011, new authoritative accounting guidance concerning fair value measurements was issued. Significant provisions of the new guidance now require both domestic and international companies to follow existing United States guidance in measuring fair value. In addition, certain Level 3 unobservable inputs and impacts to fair value from sensitivity of these inputs to changes must be disclosed. Lastly, the level of fair value hierarchy used to estimate fair value of financial instruments not accounted for at fair value on the balance sheet (such as loans receivable and deposits) must be disclosed. These new disclosures were adopted during the quarter ended March 31, 2012 and did not have a significant impact to PSB financial reporting or operations.
FASB ASC Topic 310, “Receivables.” New authoritative accounting guidance issued in July 2010 under ASC Topic 310, “Receivables,” required extensive new disclosures surrounding the allowance for loan losses although it did not change any credit loss recognition or measurement rules. The new rules require disclosures to include a breakdown of allowance for loan loss activity by portfolio segment as well as problem loan disclosures by detailed class of loan. In addition, disclosures on internal credit grading metrics and information on impaired, nonaccrual, and restructured loans are also required. The period-end disclosures were effective for financial periods ending December 31, 2010 but deferred presentation of loan loss allowance by loan portfolio segment until the quarter ended March 31, 2011. PSB adopted the rules for loan loss allowance disclosures by loan segment effective March 31, 2011.
FASB ASC Topic 210, “Balance Sheet.” In December 2011, new authoritative accounting guidance concerning disclosure of information about offsetting and related arrangements associated with derivative instruments was issued. New requirements will require additional disclosures associated with offsetting and collateral arrangements with derivative instruments to enable users of PSB’s financial statements to understand the effect of those arrangements on its financial position. These new disclosures are effective during the quarter ended March 31, 2013 and are not expected to have significant impact to PSB’s financial results or operations upon adoption.
Management has reviewed PSB’s operations for potential disclosure of information or financial statement impacts related to events occurring after June 30, 2012 but prior to the release of these financial statements. Based on the results of this review, no subsequent event disclosures or financial statement impacts to the recently completed quarter are required as of the release date.
Management’s discussion and analysis (“MD&A”) reviews significant factors with respect to our financial condition as of June 30, 2012 compared to December 31, 2011 and results of our operations for the three months and six months ended June 30, 2012 compared to the results of operations for the three months and six months ended June 30, 2011. The following MD&A concerning our operations is intended to satisfy three principal objectives:
Management’s discussion and analysis, like other portions of this Quarterly Report on Form 10-Q, includes forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, our anticipated future financial performance involves risks and uncertainties that may cause actual results to differ materially from those described in our forward-looking statements. A cautionary statement regarding forward-looking statements is set forth under the caption “Forward-Looking Statements” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011, and, from time to time, in our other filings with the Securities Exchange Commission. We do not intend to update forward-looking statements. This discussion and analysis should be considered in light of that cautionary statement. Additional risk factors relating to an investment in our common stock are also described under Item 1A of the 2011 Annual Report on Form 10-K.
This discussion should be read in conjunction with the consolidated financial statements, notes, tables, and the selected financial data presented elsewhere in this report. All figures are in thousands, except per share data and per employee data.
Results of Operations
June 2012 quarterly earnings were $1,918, or $1.15 per diluted share, compared to $1,226, or $.74 per diluted share during the June 2011 quarter. Year to date earnings for the six months ended June 30, 2012 were $3,098, or $1.86 per diluted share, compared to $2,511, or $1.51 per diluted share during the six months ended June 30, 2011. The June 2012 quarter included a special non-recurring gain on bargain purchase of Marathon State Bank (“Marathon”) of $515 (after tax impacts of $336), which increased June 2012 quarterly and year to date earnings by $.31 per share. Separate from the bargain purchase, we also incurred $75 of merger expenses (after tax benefits) during the June 2012 quarter (which decreased net income by $.05 per share) after $117 of merger expenses (after tax benefits) during the March 2012 quarter ($.07 per share). Excluding the special gain on bargain purchase and related merger expenses, diluted earnings per share would have been $.89 and $.74 during the quarters ended June 30, 2012 and 2011, respectively. Similarly, diluted earnings per share would have been $1.67 and $1.51, during the six months ended June 30, 2012 and 2011, respectively.
Separate from the merger related items, increased earnings were propelled by a decrease in credit costs, defined as the provision for loan losses plus loss on foreclosed assets, which offset an increase in operating expenses. Credit costs totaled $169 during the June 2012 quarter and $708 during the June 2011 quarter, a decrease of $539, or 76%. Similarly, these expenses totaled $562 during the six months ended June 30, 2012 and $1,363 during the six months ended June 30, 2011, a decrease of $801, or 59%. Considered before credit costs, income from continuing operations would have been $1,580 and $1,655 during the quarter ended June 30, 2012 and 2011, respectively. Similarly, income from continuing operations would have been $3,116 and $3,337 during the six months ended June 30, 2012 and 2011, respectively. Future quarterly period net income growth is likely dependent on declining credit costs as net interest margin will be pressured to decline and operating costs remain at similar levels.
During the remainder of 2012, PSB expects to incur substantial additional merger costs up to $600 before income tax benefits related to the data conversion of Marathon customer information. While a portion of the cost is expected to be capitalized as premises and equipment, the majority of the cost will be recorded as additional expense. Integration costs may also include a loss on disposal of the existing Peoples Marathon branch location later in 2012 if market and sale conditions for the real estate decline. The remaining premises and equipment investment in the Peoples’ Marathon branch is approximately $190. Integration of Peoples’ existing Marathon branch with Marathon State Bank later in 2012 is expected to generate annual run-rate expense savings of approximately $250 to be fully phased in by the end of 2013. Marathon State Bank will become a branch of Peoples State Bank later in 2012. During all of 2012, our acquisition of Marathon is expected to increase 2012 earnings by 0% to 5%, net of all merger related items including the June 2012 gain on bargain purchase and data conversion expenses.
Total nonperforming assets of $17,360 at June 30, 2012 decreased $523, or 2.9%, since December 31, 2011 due to a decrease in restructuring of troubled debt maintained on accrual status and a decrease in foreclosed assets, totaling $656. Total nonperforming assets were 2.45% and 2.87% of total assets at June 30, 2012 and December 31, 2011, respectively. At June 30, 2012, the allowance for loan losses was $7,648, or 1.61% of total loans (55% of nonperforming loans), compared to $7,941, or 1.78% of total loans (56% of nonperforming loans) at December 31, 2011. Restructured loans maintained on accrual status and performing according to terms were 34% and 35% of total nonperforming assets at June 30, 2012 and December 31, 2011, respectively. Looking ahead, we continue to face the likelihood of restructuring certain problem commercial related loans to minimize potential credit losses, which may increase nonperforming assets in future quarters even if restructured loans perform according to their new terms.
Total assets were $709,024 at June 30, 2012, up $86,157, or 13.8% compared to $622,867 at December 31, 2011. The increase in total assets was due to the acquisition of Marathon State Bank during the June 2012 quarter, which added $107,364 of total assets at the acquisition date. However, total asset growth since December 31, 2011 was also impacted by a $20,464 decline in cash and cash equivalents held by our Peoples State Bank subsidiary during the six months ended June 30, 2012 caused by a $20,007 decline in total deposits, primarily seasonal deposits, including municipal and commercial demand deposits. Wholesale funding, including brokered and national certificates of deposits, FHLB advances, and other borrowings, were $142,642 at June 30, 2012, compared to $144,381 at December 31, 2011, down $1,739, or 1.2%. Wholesale funding was 20.1% of total assets at June 30, 2012 compared to 23.2% of total assets at December 31, 2011.
We regularly maintain access to wholesale markets to fund loan originations and manage local depositor needs. At June 30, 2012, unused (but available) wholesale funding was approximately $254 million, or 36% of total assets, compared to $238 million, or 38% of total assets at December 31, 2011. Unused wholesale funding sources include federal funds purchased lines of credit, Federal Reserve Discount Window advances, FHLB advances, brokered and national certificates of deposit, and a holding company correspondent bank line of credit. Our ability to borrow funds on a short-term basis from the Federal Reserve Discount Window is an important part of our liquidity analysis and represented 34% and 42% of unused but available liquidity at June 30, 2012 and December 31, 2011, respectively.
During the six months ended June 30, 2012, stockholders’ equity increased $2,270 primarily from $2,483 in retained net income net of $615 of cash dividends paid. Net book value per share at June 30, 2012 was $31.64 compared to $30.44 at December 31, 2011. Net book value and other references to per share information reflect the impact of PSB’s 5% dividend paid in common stock declared June 19, 2012 and paid July 30, 2012. Common stockholders’ equity was 7.42% of total assets at June 30, 2012 compared to 8.09% at December 31, 2011. The stockholders’ equity ratio declined since December 31, 2011 due to the cash purchase of Marathon which increased total assets without a new issue of common stock.
For regulatory purposes, the $7 million 8% senior subordinated notes maturing July 2019 and $7.7 million junior subordinated debentures maturing September 2035 reflected as debt on the Consolidated Balance Sheet are reclassified as Tier 2 and Tier 1 regulatory equity capital, respectively. We were considered “well capitalized” under banking regulations at June 30, 2012 with a leverage capital ratio of 9.18% and a total risk adjusted capital ratio of 14.53% compared to a leverage ratio of 9.27% and a total risk adjusted capital ratio of 14.99% at December 31, 2011. As with the book stockholders’ equity ratio, regulatory capital ratios declined as a result of the increased assets recorded with the Marathon acquisition. PSB retains the ability to prepay its $7 million in 8% senior subordinated notes on a monthly basis beginning July 1, 2012. After considering total regulatory capital needs for loan growth, regulatory changes impacting capital minimums, and merger and acquisition activities, we may prepay some or all of the 8% notes during 2012. Repayment of these debentures in their entirety would reduce interest expense by approximately $140 per quarter.
Approximately 20% of our total regulatory capital at June 30, 2012 is comprised of debt instruments including junior and senior debentures and notes which, unlike common stock, require quarterly payments of interest aggregating $223 (before tax benefits). Therefore, although no current plans exist, future capital needs during the next several years would likely be met by issuance of our authorized common or preferred stock as needed. Due to relatively high cost of capital options, the cash purchase acquisition of Marathon State Bank, and potential future merger and acquisition activities requiring capital, we do not expect to buy back significant treasury stock shares during 2012, although we do expect to continue to pay our traditional semi-annual cash dividend assuming continued profitable operations and projections of adequate future capital levels for growth.
During the June 2012 quarter, the banking regulatory agencies, including the Board of Governors of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), issued two new regulatory capital proposals that are likely to have a significant impact on our regulatory capital needs if finalized. Among other significant changes, the proposal would phase out our current $7.7 million of junior subordinated debentures from Tier 1 capital and move them to Tier 2 capital classification over a 10 year period beginning in 2013. This change would reduce our leverage capital ratio and our Tier 1 risk adjusted capital ratio. Separately, proposed changes to the calculation of risk weighted assets would increase the denominator of risk adjusted capital ratios, including the Tier 1 capital and Tier 2 (“Total”) capital ratio, which would reduce our risk adjusted capital ratios. The regulatory agencies have estimated that industry wide total risk adjusted assets are likely to increase an average of 20% due to the proposed changes. Lastly, under the proposal, minimum capital ratios to be considered well capitalized, including the impact of the proposed “capital buffer,” would be 6.50% for the leverage ratio, 8.50% for the Tier 1 to risk adjusted capital ratio, and 10.50% for the total risk adjusted capital ratio, up from 5.00%, 6.00%, and 10.00%, respectively.
Following the passage of the Dodd-Frank Wall Street Reform Act of 2010, which grandfathered existing junior subordinated debentures as Tier 1 capital for banks with less than $15 billion in total assets, the community banking industry had believed the proposed disallowance of junior subordinated debentures would apply only to large international banks, and the extent of the Federal Reserve’s recent actions was unexpected. We continue to internally review the timing and extent of the proposed changes on our regulatory capital position. As a reference for this discussion, assuming the immediate loss of junior subordinated debentures as Tier 1 capital and a 20% increase in total risk adjusted assets, our pro forma June 30, 2012 leverage ratio would have been 7.17% instead of 9.18%, our Tier 1 risk adjusted capital ratio would have been 8.61% instead of 11.85%, and our total risk adjusted capital ratio would have been 12.31% instead of 14.53%.
Off Balance –Sheet Arrangements and Contractual Obligations
Our largest volume off-balance sheet activity involves our servicing of payments and related collection activities on approximately $258 million of residential 1 to 4 family mortgages sold to FHLB and FNMA at June 30, 2012. At June 30, 2012, we provided a credit enhancement against FHLB loss under five separate “master commitments” associated with 16% of the total serviced principal (down from 20% at December 31, 2011), up to a maximum guarantee of $1.9 million in the aggregate. However, we would incur such loss only if the FHLB first lost $1.9 million on this remaining loan pool of approximately $42 million as part of their “First Loss Account” (discussed here in the aggregate, although the guarantee is applied on an individual master commitment basis). Since inception of our guarantees to the FHLB beginning in 2000, only $0.3 million of $425 million of loans originated with guarantees have incurred a principal loss, all of which has been borne by the FHLB within their First Loss Account. No loans have been sold by us to the FHLB with our Credit Enhancement Guarantee of principal since October 2008 and we do not intend to originate future loans with the guarantee.
We also utilize interest rate swaps to hedge costs associated with certain variable rate debt (notional amount of $7,500 at June 30, 2012) and as a tool for our customers to obtain long-term fixed rate commercial loan financing (offsetting notional amounts of $15,298). These arrangements and related off balance sheet commitments are outlined in Note 8 in the Notes to Consolidated Financial Statements. Aggregate net unrealized losses on fair value of all interest rate swaps were $678 and $576 at June 30, 2012 and December 31, 2011, respectively before tax benefits.
We provide various commitments to extend credit for both commercial and consumer purposes totaling approximately $94 million at June 30, 2012 compared to $99 million at December 31, 2011. These lending commitments are a traditional and customary part of lending operations and many of the commitments are expected to expire without being drawn upon.
RESULTS OF OPERATIONS
Quarter and six months ended June 30, 2012 compared to June 30, 2011
June 2012 quarterly earnings were $1,918, or $1.15 per diluted share compared to $1,226, or $.74 per diluted share during June 2011, an increase of $692, or $.41 per share, up 55.4%. The increase was due primarily to a $515 gain on bargain purchase of Marathon State Bank (net of $336 in income tax expense), or $.31 per share, during the June 2012 quarter. Refer to Note 2 of the Notes to Consolidated Financial Statements for the calculation of the bargain purchase and the assets and liabilities acquired with the Marathon purchase. Year to date earnings for the six months ended June 30, 2012 were $3,098, or $1.86 per diluted share compared to $2,511, or $1.51 per diluted share during 2011, an increase of $587, or $.35 per share, up 23.2%. Excluding the gain on bargain purchase and merger related expenses, June 2012 quarterly earnings were $.89 per share compared to $.74 per share in June 2011, up 20.2%. Similarly, earnings for the six months ended June 30, 2012 were $1.66 per share compared to $1.51 per share in June 2011, up 9.9%. Increased earnings before the special merger impacts were due to lower credit related costs, defined as provision for loan losses and loss on foreclosed assets, which offset increases in other operating expenses during 2012 compared to 2011. Table 1 below outlines the merger related adjustments and the impact of declining credit costs by comparing net income from continuing operations before credit costs to net income as reported.
Table 1: Impact of Special Income and Expense Items on Continuing Operations (a non-GAAP measure)
Return on average assets was 1.21% (.93% before the Marathon merger related items) and .82% during the quarters ended June 30, 2012 and 2011, respectively. Return on average stockholders’ equity was 14.60% (11.22% before the merger items) and 10.04% during the quarters ended June 30, 2012 and 2011, respectively.
Return on average assets was 1.00% (.89% before the Marathon merger related items) and .83% during the six months ended June 30, 2012 and 2011, respectively. Return on average stockholders’ equity was 11.99% (10.74% before the merger items) and 10.50% during the six months ended June 30, 2012 and 2011, respectively.
The following Table 2 presents PSB’s consolidated quarterly summary financial data.
Table 2: Financial Summary
(2)The yield on tax-exempt loans and securities is computed on a tax-equivalent basis using a tax rate of 34%.
(3)Due to rounding, cumulative quarterly per share performance may not equal annual per share totals.
(4)Tangible stockholders’ equity excludes intangible assets and any preferred stock capital elements.
Balance Sheet Changes and Analysis
At June 30, 2012, total assets were $709,024, compared to $606,788 at March 31, 2012, and $622,867 at December 31, 2011, an increase of $102,236 (16.8%) and $86,157 (13.8%), respectively. The increase in total assets was due to the acquisition of Marathon State Bank during the June 2012 quarter, which added $107,364 in total assets at the acquisition date. Changes in assets during the three months and six months ended June 30, 2012 consisted of:
Table 3: Change in Balance Sheet Assets Composition
Marathon’s largest asset classes were agency and municipal investment securities ($50,547 at the acquisition date), loans receivable ($23,760), and cash and due from banks ($20,392) which made up 88% of total fair value of assets acquired and contributed to the increases categorized in Table 3 for the three months ended June 30, 2012.
Changes in net assets during the three months and six months ended June 30, 2012 impacted funding sources as follows:
Table 4: Change in Balance Sheet Liabilities and Equity Composition
Marathon contributed $100,866 of deposits on the acquisition date, which included $1,559 of brokered certificates of deposit. These new deposits contributed to the increase in core deposits and certificates seen during the three months ended June 30, 2012.
Loans Receivable and Credit Quality
Table 5: Period-End Loan Composition
Loans held for investment continue to consist primarily of commercial related loans, including commercial and industrial and commercial real estate loans, representing 71% of total loans at June 30, 2012 and 74% of total loans at December 31, 2011. Loans for the purpose of construction, land development, and other land loans (including residential construction and development) were $34,421 at June 30, 2012 and $33,497 at December 31, 2011 (including loan principal in process of disbursement) and represented just 7% of total gross loans. Our markets have traditionally supplied opportunities for loan growth and loan participations purchased were just $12,464 and $12,196 at June 30, 2012 and December 31, 2011, respectively. The majority of loan participations purchased are arrangements with other community banks in Wisconsin that work together to meet the credit needs of each other’s largest credit customers and are underwritten in the same manner as loans originated solely for our own portfolio. At June 30, 2012, only $554 of loan participations were purchased from sources other than traditional banks with substantial operations in Wisconsin.
Since 2010, local loan growth opportunities have been limited resulting in sporadic net loan growth and periodic quarter to quarter loan declines. Competition from larger banks in our markets is becoming stronger as such banks with higher capital levels and substantial deposit growth look to lending for higher yielding assets as investment security returns remain very low. Banks including BMO Harris Bank (the acquirer of M&I Bank and the bank having the largest deposit market share in our markets), U.S. Bank, Associated Bank, and Chase Bank appear to have relaxed credit terms for high credit quality borrowers and lowered lending interest rate spreads in an effort to aggressively increase their loan market share. We expect strong competition to continue through 2012 which could impact the pace of 2012 loan growth and could negatively impact net interest margin and net interest income. We could experience a small decrease in our loans outstanding during the remainder of 2012 compared to loans receivable held at June 30, 2012.
To support loan growth and invest deposits previously held in low yielding overnight funds, we maintained a temporary program to originate 15-year fully amortizing fixed rate residential first mortgage loans and retain those loans on our balance sheet rather than selling them to secondary market investors as is our normal practice. The loans were fully underwritten and conforming to secondary market standards. However, if the property was located in a rural area in which an adequate number of recent comparable sales were not available, some of the mortgages may not have been underwritten with a qualifying secondary market appraisal, although a current appraisal was obtained on each loan. The program originated approximately $10.1 million in residential mortgage loans at a 3.17% weighted average interest rate during the six months ended June 30, 2012 which contributed to the increase in residential mortgage loans in Table 5 above. If commercial related loan growth does not reinvest liquidity obtained from the Marathon State Bank acquisition, this 15 year fixed rate residential mortgage origination program is likely to be utilized in a similar manner during the remainder of 2012 to support loan and net interest income growth.
The loan portfolio is our primary asset subject to credit risk. Our process for monitoring credit risk includes quarterly analysis of loan quality, delinquencies, nonperforming assets, and potential problem loans. Loans are placed on a nonaccrual status when they become contractually past due 90 days or more as to interest or principal payments. All interest accrued but not collected for loans (including applicable impaired loans) that are placed on nonaccrual status or charged off is reversed against interest income. Nonaccrual loans and restructured loans maintained on accrual status remain classified as nonperforming loans until the uncertainty surrounding the credit is eliminated. In general, uncertainty surrounding the credit is eliminated when the borrower has displayed a history of regular loan payments using a market interest rate that is expected to continue as if a typical performing loan. Some borrowers continue to make loan payments while maintained on non-accrual status. We apply all payments received on nonaccrual loans to principal until the loan is returned to accrual status or repaid. Total nonperforming assets as a percentage of total tangible common equity including the allowance for loan losses was 29.34%, 31.32%, and 35.03% at June 30, 2012, December 31, 2011, and June 30, 2011, respectively (refer to Table 24). For the purpose of this measurement, tangible common equity is equal to total common stockholders’ equity less mortgage servicing right assets.
Nonperforming assets include: (1) loans that are either contractually past due 90 days or more as to interest or principal payments, on a nonaccrual status, or the terms of which have been renegotiated to provide a reduction or deferral of interest or principal (restructured loans), (2) investment securities in default as to principal or interest, and (3) foreclosed assets.
Table 6: Nonperforming Assets
Total nonperforming assets decreased $523, or 2.9% since December 31, 2011 from a $359 decrease in restructured loans maintained on accrual status and a $297 decrease in foreclosed assets. In certain situations, particularly for loans supported by collateral with depressed valuations or with borrowers undergoing what could be temporary financial difficulties, we will consider restructuring existing debt in an attempt to protect as much of our loan principal as possible. Typical restructured terms will convert a loan from amortizing payments to interest only payments, or lower the interest rate to a level less than market rates for the borrower’s risk profile. Existing restructurings have not forgiven borrower loan principal and have been associated with commercial related loans, not residential mortgage loans. At June 30, 2012, 71% of restructured loan principal shown in the table above remained on accrual status.
While we believe the most significant declines in general credit quality and the economy in our local markets have occurred, some borrowers continue to manage fragile cash flows and debt servicing ability as the economy has yet to sustain a meaningful recovery. Such conditions are seen in the level of problem borrowers with restructured loan terms. The longer significant recovery is delayed, the more difficult it will be for some borrowers to continue scheduled debt payments as previously unencumbered collateral is pledged for new working capital and balance sheet equity is drawn down, potentially increasing future provisions for loan losses. In light of these conditions, we expect to see an increase in borrowers requiring restructured loan terms which would increase our level of nonperforming loans. Foreclosed assets may also increase during the next several quarters as we work through ongoing collection and foreclosure actions. A continued slow local economy impacts the value of collateral and foreclosed assets, potentially increasing losses on foreclosed borrowers and properties during the coming quarters.
At June 30, 2012, all nonperforming assets aggregating to $500 or more measured by gross principal outstanding per credit relationship are summarized in the following table and represented 43% of all nonperforming assets compared to 52% of nonperforming assets at December 31, 2011. In the table, loans presented as “Accrual TDR” represent troubled debt restructured loans maintained on accrual status.
Table 7: Largest Nonperforming Assets at June 30, 2012 ($000s)
No large nonperforming assets in excess of $500 were added to Table 7 during the June 2012 quarter. At March 31, 2012, we included a large nonperforming loan with $1,233 in outstanding principal and $295 in specific reserves secured by multi-family rental apartment units and vacant land in Table 7 above. However, during the June 2012 quarter, the majority of this troubled debt restructured loan maintained on accrual status was settled with the borrower in which we received a payment of $833 on the sale of the property and recorded a $34 charge-off. We continue to have a $359 loan receivable outstanding with the borrower on which $190 in specific reserves are maintained. Our settlement with the borrower decreased our required specific reserves on the relationship by $71, net of the charge-off incurred.
During March 2011, we were informed by Johnson Financial Capital Trust of its intent to defer payment of interest on its 7% trust preferred capital debentures. Johnson Financial Group is the holding company for Johnson Bank, headquartered in Racine, Wisconsin. Our investment in the $750 debentures was placed on nonaccrual status at March 31, 2011 and all accrued but uncollected interest was reversed against income. Our internal evaluation has determined this investment is not other than temporarily impaired and no charge against net income for impairment has been recorded. During the March 2012 quarter, Johnson Financial Group received a significant new capital injection from its shareholders and is expected to return to profitability within the next several years. We expect to be repaid all interest due on the debentures in future years. Total Johnson Financial Capital Trust interest not accrued totaled $79 at June 30, 2012. Similar bank holding company investments held in our portfolio (identified by name of the operating bank subsidiary) include $800 par value to McFarland State Bank (Madison, WI), and $500 par value to River Valley Bank (Wausau, WI). These other investments are supported by the continued profitable operations and reasonable credit quality metrics represented within their portfolios and are expected to continue to remit scheduled quarterly payments of interest.
In addition to nonperforming loans, we have classified some performing loans as impaired loans under accounting standards due to heightened risk of nonperformance within the next year or other factors. Impaired loans maintained on accrual status that have not been restructured are not reported as nonperforming loans. At June 30, 2012, all impaired but performing loans aggregating to $500 or more measured by gross principal outstanding per credit relationship are summarized in the following table.
Table 8: Largest Performing, but Impaired Loans at June 30, 2012 ($000s)
Provision for Loan Losses and Loss of Foreclosed Assets
We determine the adequacy of the provision for loan losses based on past loan loss experience, current economic conditions, and composition of the loan portfolio. Accordingly, the amount charged to expense is based on management’s evaluation of the loan portfolio. It is our policy that when available information confirms that specific loans, or portions thereof, including impaired loans, are uncollectible, these amounts are promptly charged off against the allowance.
Our provision for loan losses was $165 in the June 2012 quarter compared to $430 in the June 2011 quarter. The lower quarterly provision needed was due to a modest $2.1 million in June 2012 quarterly net loan growth (excluding loans recorded at net fair value associated with the Marathon State Bank acquisition) and favorable resolution of a large problem loan that reduced specific loan reserves discussed previously. In addition, quarterly loss on foreclosed assets declined to $4 in June 2012 compared to $278 in June 2011 (which included a valuation write-down of $233 during 2011). Combined credit costs totaled $169 during the June 2012 quarter and $708 during the June 2011 quarter. The decline in credit costs compared to 2011 was an important driver of June 2012 quarterly increased earnings.
Year to date for the six months ended June 30, provision for loan losses was $325 during 2012 and $790 during 2011. Loss on foreclosed assets was $237 during 2012 and $573 during 2011. Combined credit costs were $562 during the six months ended June 30, 2012 compared to $1,363 during 2011, down 59%. Valuation write-downs included as loss on foreclosed assets were $205 during 2012 and $457 during 2011. Refer to Note 5 in the Notes to Consolidated Financial Statements for more information on foreclosed asset activity during the three months and six months ended June 30, 2012 and 2011.
Nonperforming loans are reviewed to determine exposure for potential loss within each loan category. The adequacy of the allowance for loan losses is assessed based on credit quality and other pertinent loan portfolio information. The adequacy of the allowance and the provision for loan losses is consistent with the composition of the loan portfolio and recent internal credit quality assessments. We maintain our headquarters and one branch location in the City of Wausau, Wisconsin, and maintain the majority of our deposits (including six of our nine locations, including Marathon State Bank), and loan customers in Marathon County, Wisconsin. During the June 2012 quarter, the 7.1% unemployment rate in Marathon County (not seasonally adjusted) declined from 8.2% at March 2012 but remained above the 6.5% measured during December 2011 due to two separate large manufacturing employers who announced plant closures cutting approximately 1,000 Marathon County jobs during the March 2012 quarter. The unemployment rate for all of Wisconsin (not seasonally adjusted) was 6.8% during May 2012. Despite the increased local unemployment rate, the current 7.1% Marathon County rate compares favorably to national levels and is in line with Wisconsin’s overall level. Outside of these plant closures in the paper and window industries, manufacturing and other local economies are seeing slow but consistent improvement. Because of these and other factors, we expect credit costs during the remainder of 2012 to continue to be slightly less than that seen during 2011. However, future provisions will be impacted by the actual amount of impaired and other problem loans identified by internal procedures or regulatory agencies. In addition, fair value of existing foreclosed assets continue to be reviewed in light of local market data and may be subject to a partial write-down of value during the remainder of 2012.
Table 9: Allowance for Loan Losses
Net charge-offs of loan principal were $272 and $618 during the quarter and six months ended June 30, 2012 respectively. Net loan recoveries were $10 during the June 2011 quarter and net loan charge-offs were $933 during the six months ended June 30, 2011. During the June 2012 quarter, four borrowers represented 68% of all charge-offs including $34 charged off in connection with a problem loan settlement discussed previously. Charge-offs during the six months ended June 30, 2011 were led by a $700 charge-off related to a customer line of credit secured by building supply inventory and accounts receivable. Annualized net loan charge offs were .24% during the June 2012 quarter and were a net recovery of principal of .01% during the June 2011 quarter. Annualized net loan charge-offs were 0.28% and 0.43% during the six months ended June 30, 2012 and 2011, respectively.
Net Interest Income
Quarter ended June 30, 2012 compared to June 30, 2011
Net interest income is the most significant component of earnings. Tax adjusted net interest income totaled $5,086 during the June 2012 quarter compared to $5,051 during the June 2011 quarter, an increase of $35, or 0.7%. Although net interest income remained largely unchanged, net interest margin declined from 3.57% in June 2011 to 3.42% during June 2012 as loan and investment security yields declined faster than average deposit costs. The decline in margin was also impacted by the Marathon acquisition as approximately 47% of the assets acquired ($50,547) were agency and municipal securities yielding 1.81% on a tax adjusted basis. Increased earning asset volume during the June 2012 quarter compared to June 2011 offset the decline in net interest income from reduced net margin as average earning assets increased 5.6%. During the June 2012 quarter, long-term market rates declined significantly (for example, the 10 year U.S. Treasury rate declined from 2.15% to 1.66% during the June 2012 quarter) and the rate decline experienced in the national economy during the 2008-2009 recession continues and loans, securities, and funding continue to reprice lower to current rate levels.
Reinvestment yields for investment security cash flows remain very low and taxable securities yields are expected to continue to decline throughout 2012. In addition, loan yields may decline significantly due to competitive pressures as competitors seek to increase loan originations while quality credit demand remains weak in addition to domestic and global economic actions which have lowered long-term rates. With average cost of interest bearing deposits (representing 72% of total average liabilities) at 1.01% during the June 2012 quarter, further reduction of deposit costs to offset lower loan yields may be difficult. Asset yields are expected to continue to decline faster than funding costs during the remainder of 2012 and net interest income is likely to decline if earning assets do not grow from existing levels. Although a portion of the decline in earning asset rates will be offset by further declines in certificate of deposit funding costs and nonmaturity deposit costs, September 2012 quarterly net interest margin is anticipated to continue in a range of 3.35% to 3.40%.
Six months ended June 30, 2012 compared to June 30, 2011
Tax adjusted net interest income totaled $10,082 during the six months ended June 30, 2012 compared to $10,011 during the six months ended June 30, 2011, an increase of $71, or 0.7%. As during the June 2012 quarter, year to date net interest income increased slightly from increased earning asset volume which offset a decline in net margin from 3.51% during 2011 to 3.46% during 2012.
We have increased net interest margin since 2009 by inserting interest rate floors in commercial-related loans and retail residential home equity lines of credit to avoid the negative impacts to net interest margin from a sustained low interest rate environment and to appropriately price for credit risk in the current market. At June 30, 2012, approximately 80% of our $124 million in adjustable rate loans carried a contractual interest rate floor and, of those loans with floors, approximately 97% carried current loan yields in excess of the normal adjustable rate coupon due to the interest rate floor. Of those loans with current loan yields in excess of the normal adjustable coupon rate, approximately 76% of principal have “in the money” loan floors which increased the adjustable rate between 100 basis points and 200 basis points. If current interest rate levels were assumed to remain the same, the annualized increase to net interest income and net interest margin would be approximately $1,340 and .22%, respectively, based on those existing loan floors and average quarterly earning assets at June 30, 2012. During a period of rising short-term interest rates, we expect average funding costs (which are not currently subject to contractual caps on the interest rate) to rise while the yield on loans with interest rate floors would remain the same until those loans’ adjustable rate index caused coupon rates to exceed the loan rate floor. This mismatch compared to rising funding costs is likely to lower net interest margin and possibly period over period net interest income. The speed in which short-term interest rates increase is expected to have a significant impact on net interest income from loans with interest rate floors. Quickly rising short-term rates would allow adjustable rate loans with floors to reprice to rates higher than the existing floor more quickly, impacting net interest income less adversely than if short-term rates rose slowly or deliberately.
During the September 2011 quarter, the Dodd-Frank Wall Street Reform Act repealed the prohibition on paying interest on commercial checking accounts. We currently provide an earnings credit against account fees in lieu of an interest payment and do not expect costs to increase because of this change in the short term. Despite the law change, we do not sell or promote an interest bearing commercial checking account at this time. However, the change could have greater long-term implications as competitor banks begin to use premium interest rate levels on commercial deposits in attempts to raise deposits in coming years.
The following Tables present a schedule of yields and costs for the quarter and six months ended June 30, 2012 compared to the prior year periods ended June 30, 2011 and the interest income and expense volume and rate analysis for the six months ended June 30, 2012 compared to the six months ended June 30, 2011.
Table 10: Net Interest Income Analysis (Quarter)
(1)Nonaccrual loans are included in the daily average loan balances outstanding.
(2)The yield on tax-exempt loans and securities is computed on a tax-equivalent basis using a tax rate of 34%.
Table 11: Net Interest Income Analysis (Six Months)