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Section 1: 10-K (ANNUAL REORT)

 

 

FORM 10-K

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2014

 

☐ 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: 0-26480

 

PSB HOLDINGS, INC.

www.psbholdingsinc.com

 

WISCONSIN 39-1804877

 

1905 Stewart Avenue

Wausau, Wisconsin 54401

 

Registrant’s telephone number, including area code: 715-842-2191

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, no par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ☐                  No ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes ☐                  No ☒

 

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.

Yes ☒                  No ☐

 

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 ☒                  No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) 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 amendment to this Form 10-K. £

 

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.

 

  Large accelerated filer £   Accelerated filer £  
  Non-accelerated filer £   Smaller reporting company T  
  (Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2) of the Exchange Act).

Yes ☐                  No ☒

 

The aggregate market value of the voting stock held by non-affiliates as of June 30, 2014, was approximately $49,609,000. For purposes of this calculation, the registrant has assumed its directors, executive officers, and employee 401(k) profit-sharing plan are affiliates. As of March 1, 2015, 1,630,228 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None

 

 

 

 
 

 

FORM 10-K

 

PSB HOLDINGS, INC.

 

TABLE OF CONTENTS

 

PART I      
       
  ITEM    
       
  1. Business 1
  1A. Risk Factors. 15
  1B. Unresolved Staff Comments. 22
  2. Properties 22
  3. Legal Proceedings 22
  4. Mine Safety Disclosures 22
       
PART II      
       
  5. Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities 23
  6. Selected Financial Data 24
7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 25
  7A. Quantitative and Qualitative Disclosures About Market Risk 77
  8. Financial Statements and Supplementary Data F-1
  9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 78
  9A. Controls and Procedures 78
  9B. Other Information 78
       
PART III      
       
  10. Directors and Executive Officers of the Registrant 79
  11. Executive Compensation 81
   12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 85
  13. Certain Relationships and Related Transactions 86
  14. Principal Accounting Fees and Services 87
       
PART IV      
       
  15. Exhibits, Financial Statement Schedules 89

 

 
 

 

PART I

 

Item 1.       BUSINESS.

 

Business Operations and Products

 

PSB Holdings, Inc. (“PSB”) owns and operates Peoples State Bank (“Peoples”), a commercial community bank formed in 1962 and headquartered in Wausau, Wisconsin. For 52 years, Peoples has sought to meet the financial needs of local business owners and their families for the betterment of our communities by providing a wide range of beneficial products delivered with fair prices and integrity. Through its 143 full time employees, Peoples serves approximately 17,000 retail households and commercial businesses with our north central Wisconsin network of nine full service locations including five in the greater Wausau, Wisconsin area, and locations in Rhinelander, Minocqua, and Eagle River. Our primary market area has a combined population of approximately 192,000. PSB held $735 million in total assets at December 31, 2014 and maintained the second highest deposit market share in Marathon County, Wisconsin.

 

We operate as a local community bank, but offer virtually the same products as larger regional banks. We are engaged in general commercial and retail banking and serve individuals, businesses, and governmental units. We offer most forms of commercial lending, including lines and letters of credit, secured and unsecured term loans, equipment and lease financing, and commercial mortgage lending. Commercial customers may use available cash management, lockbox, and merchant banking products, including tools to protect deposit accounts against fraud and facilitate on-site electronic commercial deposits. In addition, we provide a full range of personal banking services, including checking accounts, savings and time deposit accounts, a local network of automated teller machines, online computer banking, mobile banking, credit and debit cards, installment and other personal loans, as well as long-term fixed rate mortgage loans. New services are regularly added to our commercial and retail banking product line-ups. In addition to these traditional banking products, we offer brokerage and financial advisory services including the sale of annuities, mutual funds, other investments, and retirement financial planning consultation services to our customers and the general public. We recognize many opportunities for continued growth in products, customers, assets, and profits both within north central Wisconsin and nearby markets.

 

Commercial-related loans represent our largest type of asset and approximately 69% of our gross loans receivable. Our typical commercial customers are local small to medium sized business owners with annual sales of less than $25 million. We provide a growing suite of deposit and cash management products in addition to meeting customer credit needs. We build customer relationships on a frequent face to face basis and deliver value by providing capital and liquidity management advice and recommendations specific to our customers’ businesses. Since inception, we have maintained low loan loss ratios through conservative lending practices, emphasis on knowing our customer by establishing deep relationships with each of them, and maintaining focus on serving communities with which we are familiar.

 

Peoples has a long tradition of strong retail banking products. This emphasis has allowed us to be a leader in local residential real estate lending consistently resulting in number one or number two market share based on mortgage filings. The majority of our residential real estate loans are sold on the secondary market with servicing rights retained. We also maintain a diversified portfolio of local core deposits, including noninterest bearing deposits, savings and retail time deposits less than $100,000, and money market deposits, which make up approximately 84% of total deposits and 71% of total assets. We believe the combination of competitively priced residential mortgage financing and low cost transactional deposit accounts builds a profitable core retail customer base with ongoing growth potential.

 

We meet the needs of customers with an emphasis on customer service, flexibility, and local decision making. Customers and prospects are identified and served on a face to face basis through relationships directly with bank staff. The vast majority of our customers live or work or have relationships with those within our Bank’s primary market area in north central Wisconsin. Our employees are substantial participants in community activities, averaging over 40 hours of community service per employee during 2014 and 2013, for the betterment of our market area.

 

More information on PSB, its operations and financial results including past annual and quarterly reports on Forms 10-K and 10-Q, is available free of charge at our investor relations website, www.psbholdingsinc.com. Alternatively, you may contact us directly at 1-888-929-9902 to receive paper or electronic copies of information filed with the United States Securities and Exchange Commission without cost. On November 25, 2014, we filed Form 15 with the SEC to voluntarily deregister our common stock from SEC registration. Therefore, financial reports will no longer be filed with the SEC following February 23, 2015 except for the final filing of our Annual Report on Form 10-K for the year ended December 31, 2014. However, we will continue to post quarterly financial information on our investor relations website, www.psbholdingsinc.com for investors. Bid and ask prices for purchase or sale of PSB common stock are quoted on the OTC Markets Exchange (www.OTCMarkets.com) under the stock symbol PSBQ.

 

1
 

 

Competitive Position

 

There is a mix of retail, health care, manufacturing, agricultural, and service businesses in the areas we serve. We have substantial competition in our market areas. Much of this competition comes from companies that are larger and have greater resources than us. We compete for deposits and other sources of funds with other banks, savings associations, credit unions, finance companies, mutual funds, life insurance companies, and other financial and non financial companies. Many of these nonbank competitors offer products and services which are functionally equivalent to the products and services we offer, and new bank and nonbank competitors continue to enter our markets on a regular basis.

 

Our relative size (compared to other area community banks, thrifts, and credit unions) allows us to offer a wide array of financial service products. Although we are larger than a typical community bank, traditional community bank customer service and flexibility differentiate us from larger financial service providers. Therefore, we can offer better service to customers disenfranchised by poor service received from larger banks, higher-cost retail deposit products, and the perception of government “bailouts” provided to larger banks, while allowing customers to continue their practice of one-stop shopping and local service support. We can compete against smaller local community banks and credit unions by continuing the same level of service these customers expect while providing them an expanded and competitively priced product lineup due in part to economies of scale and access to wholesale funding sources and capital at comparatively lower cost.

 

Based on publicly available deposit market share information as of June 30, 2014, the following is a list of the largest FDIC insured banks in each of our primary markets and a comparison of our deposit market share to these primary competitors. The Wausau-Marathon County, Wisconsin MSA is our largest market in which we have the second largest market share. As in most Wisconsin communities, BMO Harris Bank holds the largest market share and represents the greatest opportunity to increase deposits from competitors.

 

   June 30, 2014      June 30, 2013 
   Deposit $’s   Market      Deposit $’s   Market 
   ($000s)   Share      ($000s)   Share 
                    
Marathon County, Wisconsin          Marathon County, Wisconsin        
                    
BMO Harris Bank  $545,469    19.2%  BMO Harris Bank  $513,500    18.2%
Peoples State Bank (2nd of 22)   461,256    16.2%  Peoples State Bank (2nd of 23)   444,520    15.8%
Associated Bank   316,466    11.2%  River Valley Bank   323,611    11.5%
River Valley Bank   315,890    11.1%  Associated Bank   316,222    11.2%
All other FDIC insured institutions   1,203,206    42.3%  All other FDIC insured institutions   1,217,836    43.3%
Totals  $2,842,287    100.0%  Totals  $2,815,689    100.0%
                        
Oneida County, Wisconsin            Oneida County, Wisconsin          
                        
BMO Harris Bank  $163,344    23.5%  BMO Harris Bank  $166,335    24.8%
Associated Bank   115,785    16.7%  Peoples State Bank (2nd of 8)   116,497    17.4%
Peoples State Bank (3rd of 8)   114,951    16.6%  Associated Bank   107,428    15.9%
River Valley Bank   88,394    12.7%  River Valley Bank   85,602    12.8%
All other FDIC insured institutions   211,279    30.5%  All other FDIC insured institutions   195,375    29.1%
Totals  $693,753    100.0%  Totals  $671,237    100.0%
                        
Vilas County, Wisconsin            Vilas County, Wisconsin          
                        
BMO Harris Bank  $91,334    21.9%  BMO Harris Bank  $96,973    22.9%
First National Bank of Eagle River   85,881    20.6%  First National Bank of Eagle River   85,317    20.2%
Headwaters State Bank   55,764    13.4%  Headwaters State Bank   55,580    13.2%
Peoples State Bank (6th of 10)   25,516    6.1%  Peoples State Bank (7th of 10)   19,467    4.6%
All other FDIC insured institutions   158,716    38.0%  All other FDIC insured institutions   165,482    39.1%
Totals  $417,211    100.0%  Totals
  $422,819    100.0%

 

2
 

 

Our primary source of income is loan interest income earned on commercial and residential loans made to local customers, which together represented a range of approximately 66% to 69% of our gross revenue during the past three years. We originate and sell long-term fixed rate mortgage loans to the secondary market and service future payments on these loans for a substantial amount of fee income which is reported as mortgage banking income. Depositors pay us various service fees, including overdraft charges and commercial service fees, which contribute to noninterest income. Deposits raised from local customers provide the most significant source of funding to provide loans and credit products to customers. Loan product sales in excess of local deposit growth are supplemented by wholesale and national funding such as brokered deposits, FHLB advances, and repurchase agreements. We do not have a dependence on any major customers. The primary sources of revenue are outlined below:

 

   2014   2013   2012 
Revenue source   $   % of revenue    $   % of revenue    $   % of revenue 
                         
Interest on commercial related loans  $15,243    47.2%  $15,767    48.6%  $16,253    48.1%
Interest on residential mortgage loans   6,798    21.1%   6,532    20.2%   6,172    18.3%
Interest on securities   3,902    12.1%   3,609    11.1%   3,695    10.9%
Service fees and charges   1,656    5.1%   1,580    4.9%   1,648    4.9%
All other revenue   1,394    4.3%   1,206    3.7%   1,221    3.6%
Mortgage banking   1,373    4.2%   1,591    4.9%   1,795    5.3%
Investment and insurance sales commissions   946    2.9%   944    2.9%   736    2.2%
Increase in cash surrender value of life insurance   404    1.3%   402    1.3%   407    1.2%
Loan fees   391    1.2%   522    1.6%   724    2.1%
Interest on consumer loans   202    0.6%   305    0.9%   310    0.9%
Gain on sale of securities   3    0.0%   12    0.0%       0.0%
Gain on bargain purchase       0.0%       0.0%   851    2.5%
Loss on sale of credit card loan principal       0.0%   (31)   -0.1%       0.0%
                               
Total gross revenue  $32,312    100.0%  $32,439    100.0%  $33,812    100.0%

 

During 2014, we purchased the Rhinelander, Wisconsin branch of the Northwoods National Bank, a branch of The Baraboo National Bank (“Northwoods Rhinelander”), adding $21 million in loans and $41 million in deposits. During 2012, we acquired Marathon State Bank (“Marathon”), a privately owned bank with $107 million in assets and combined it with our existing Peoples’ branch located in Marathon City, Wisconsin. The acquisition of Marathon was our first “whole bank” purchase and our first merger and acquisition activity. Historically, we had pursued a market expansion plan that included de novo (start-up) branching into adjacent market areas. Full-service bank de novo branches were opened in Eagle River, Rhinelander, Minocqua, and Weston, Wisconsin, during 2001 through 2005, in part to expand our market area into northern Wisconsin. During those periods, we believed opening in adjacent markets capitalized on existing management resources and minimized costs for name recognition and awareness while increasing the speed in which customers are obtained via new locations while improving convenience of service for existing customers. No new branch locations have been opened since 2005. We intend to pursue opportunities to acquire additional bank subsidiaries or banking offices in new or adjacent markets so that, at any time, we may be engaged in some tentative or preliminary discussions for such purposes with officers, directors, or principal stockholders of other holding companies or banks. We also actively search for key sales personnel in new or adjacent markets which would permit us to open a de novo lending operation or branch location to generate new market growth.

 

Current banking law provides us with a competitive environment, and competition for our products and services is likely to continue. For example, current federal law permits adequately capitalized and managed bank holding companies to engage in interstate banking on a broad scale. In addition, financial holding companies are permitted to conduct a broad range of banking, insurance, and securities activities. Banking regulators generally permit the formation of new banks if those banks are able to raise the necessary capital, and some large financial institutions such as investment banks also hold banking charters. We believe that the combined effects of more interstate banking and expansion via branching of existing competitors and large investment banks are likely to increase the overall level of competition and attract competitors who will compete for our customers.

 

In addition to competition, our business is and will continue to be affected by general economic conditions, including the level of interest rates and the monetary policies of the Federal Reserve and actions of the U.S. Treasury Department (see “Regulation and Supervision”). This competition may cause us to seek out opportunities to provide additional financial services to replace or supplement traditional net interest income or deposit fee income.

 

Organizational Structure

 

Our organizational structure is commonly referred to as a “one bank holding company.” PSB was formed in a 1995 tax-free reorganization and is the 100% owner of Peoples State Bank, its only significant subsidiary. This holding company structure permits more active market-based trading of the banking operation’s common stock as well as providing various vehicles in which to obtain equity capital to inject into the bank subsidiary. To facilitate the issuance of junior subordinated debentures in connection with a pooled trust preferred capital issue during 2005, the holding company also owns common stock in PSB Holdings Statutory Trust I. The holding company has no significant revenue producing activities other than ownership of Peoples State Bank.

 

3
 

 

Since its formation in 1962, all day to day revenue and expense producing activities are conducted by Peoples State Bank. Peoples employs a wholly owned Nevada subsidiary, PSB Investments, Inc., to hold and manage virtually all of the Bank’s investment securities portfolio including the activities of pledging securities against customer deposits and repurchase agreements as needed.

 

All of our products and services are directly or indirectly related to the business of community banking and all of our activity is reported as one segment of operations. Therefore, revenues, profits and losses, and assets are all reported in one segment and represent our entire operations. We maintain a traditional retail and commercial banking business model and do not regularly employ or sell stand-alone derivative instruments to hedge our cash flow and fair value risks. As of March 1, 2015, we operated with 143 full-time equivalent (“FTE”) employees, including 16 FTE employed on a part time basis. As is common in the banking industry, none of our employees is covered by a collective bargaining agreement.

 

Regulation and Supervision

 

PSB Holdings, Inc. (“PSB”) and Peoples State Bank (“Peoples”) are subject to extensive state and federal banking laws and regulations that impose restrictions on and provide for general regulatory oversight of their operations. These laws and regulations are generally intended to protect depositors and not stockholders. Legislation and related regulations promulgated by government agencies influence, among other things:

 

how, when, and where we may expand geographically;
   
into what product or service markets we may enter;
   
how we must manage our assets; and
   
under what circumstances money may or must flow between the parent bank holding company (PSB) and the subsidiary bank (Peoples).

 

Set forth below is an explanation of the major pieces of legislation and regulation affecting the banking industry and how that legislation and regulation affects our actions. The following summary is qualified by reference to the statutory and regulatory provisions discussed. Changes in applicable laws or regulations may have a material effect on our business and prospects, and legislative changes and the policies of various regulatory authorities may significantly affect our operations. We cannot predict the effect that fiscal or monetary policies, or new federal or state legislation may have on our future business and earnings.

 

Regulation of PSB Holdings, Inc.

 

Because PSB owns all of the capital stock of Peoples State Bank, it is a bank holding company under the federal Bank Holding Company Act of 1956 (the “Bank Holding Company Act”). As a result, PSB is primarily subject to the supervision, examination, and reporting requirements of the Bank Holding Company Act and the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). As a bank holding company located in Wisconsin, the Wisconsin Department of Financial Institutions (“WDFI”) also regulates and monitors all significant aspects of its operations.

 

Acquisitions of Banks

 

The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

 

acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;
   
acquiring all or substantially all of the assets of any bank; or
   
merging or consolidating with any other bank holding company.

 

Additionally, The Bank Holding Company Act provides that the Federal Reserve may not approve any of these transactions if it would result in or tend to create a monopoly, substantially lessen competition, or otherwise function as a restraint of trade, unless the anti-competitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks involved in the transaction and the convenience and needs of the community to be served. The Federal Reserve’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.

 

4
 

 

Under The Bank Holding Company Act, if adequately capitalized and adequately managed, PSB or any other bank holding company located in Wisconsin may purchase a bank located outside of Wisconsin. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Wisconsin may purchase a bank located inside Wisconsin. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits.

 

Change in Bank Control

 

Subject to various exceptions, The Bank Holding Company Act and the Change in Bank Control Act, together with related regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:

 

the bank holding company has registered securities under Section 12 of the Securities Act of 1934; or
   
no other person owns a greater percentage of that class of voting securities immediately after the transaction.

 

Permitted Activities

 

The Bank Holding Company Act has generally prohibited a bank holding company from engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those determined by the Federal Reserve to be closely related to banking or managing or controlling banks as to be a proper incident thereto. Provisions of the Gramm-Leach-Bliley Act have expanded the permissible activities of a bank holding company that qualifies as a financial holding company. Under the regulations implementing the Gramm-Leach-Bliley Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to financial activities. Those activities include, among other activities, certain insurance and securities activities. PSB has not elected to become a financial holding company at this time.

 

Support of Subsidiary Institutions

 

Under Federal Reserve policy, PSB is required to act as a source of financial strength for Peoples and to commit resources to support Peoples. This support may be required at times when, without this Federal Reserve policy, PSB might not be inclined to provide it. In addition, any capital loans made by PSB to Peoples will be repaid only after Peoples’ deposits and various other obligations are repaid in full. In the unlikely event of its bankruptcy, any commitment that PSB gives to a bank regulatory agency to maintain the capital of Peoples will be assumed by the bankruptcy trustee and entitled to a priority of payment.

 

Sarbanes-Oxley Act of 2002

 

On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) was signed into law with sweeping federal legislation addressing accounting, corporate governance, and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant requirements for public company governance and disclosure requirements.

 

In general, the Sarbanes-Oxley Act mandated important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It established new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and created a new regulatory body to oversee auditors of public companies. It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created new criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and provided new federal corporate whistleblower protection.

 

The economic and operational effects of this legislation on public companies, including us, are significant in terms of the time, resources and costs associated with complying with this law. Because the Sarbanes-Oxley Act, for the most part, applies equally to larger and smaller public companies, we are presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in its market.

 

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law and included a permanent delay of the implementation of section 404(b) of the Sarbanes-Oxley Act for companies with non-affiliated public float under $75 million. Section 404(b) is the requirement to have an independent accounting firm audit and attest to the effectiveness of a company’s internal controls. As PSB does not exceed the public float threshold described above, there are no additional costs anticipated for complying with Section 404(b) in 2014.

 

5
 

 

The Dodd-Frank Act of 2010

 

The Dodd-Frank Act has had a broad impact on the financial services industry, including significant regulatory and compliance changes previously discussed and including, among other things, (1) enhanced resolution authority of troubled and failing banks and their holding companies; (2) increased regulatory examination fees; and (3) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve Board, the OCC, and the FDIC.

 

Many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of its business activities; require changes to certain of its business practices; impose upon us more stringent capital, liquidity, and leverage ratio requirements; or otherwise adversely affect its business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

 

Regulation of Peoples State Bank

 

Because Peoples State Bank is chartered as a state bank with the WDFI, it is primarily subject to the supervision, examination, and reporting requirements of Wisconsin Banking Statute Chapter 221 and related rules and regulations of the WDFI. The WDFI regularly examines Peoples’ operations and has the authority to approve or disapprove mergers, the establishment of branches, and similar corporate actions. The WDFI also has the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law. Because Peoples’ deposits are insured by the FDIC to the maximum extent provided by law, it is also subject to FDIC regulations and the FDIC also has examination authority and primary federal regulatory authority over Peoples. Peoples is also subject to numerous other state and federal statutes and regulations that affect its business, activities, and operations.

 

Branching

 

Under Wisconsin law, Peoples may open branch offices throughout the state with the prior approval of the WDFI. In addition, with prior regulatory approval, Peoples may acquire branches of existing banks located in Wisconsin or other states. Prior to the enactment of the Dodd-Frank Act, Peoples and any other national- or state-chartered banks were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national- and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch.

 

Prompt Corrective Action

 

The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each category.

 

As a bank’s capital position deteriorates, federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized.

 

A “well-capitalized” bank is one that is not required to meet and maintain a specific capital level for any capital measure, pursuant to any written agreement, order, capital directive, or prompt corrective action directive, and has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% (8% beginning January 1, 2015), and a Tier 1 leverage ratio of at least 5%. Generally, a classification as well capitalized will place a bank outside of the regulatory zone for purposes of prompt corrective action. However, a well-capitalized bank may be reclassified as “adequately capitalized” based on criteria other than capital, if the federal regulator determines that a bank is in an unsafe or unsound condition, or is engaged in unsafe or unsound practices, which requires certain remedial action.

 

An “adequately-capitalized” bank meets the required minimum level for each relevant capital measure, including a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% (6% beginning January 1, 2015) and a Tier 1 leverage ratio of at least 4%. A bank that is adequately capitalized is prohibited from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the applicable regulatory authorities. Institutions that are not well capitalized are also prohibited, except in very limited circumstances where the FDIC permits use of a higher local market rate, from paying yields for deposits in excess of 75 basis points above a national average rate for deposits of comparable maturity, as calculated by the FDIC. In addition, all institutions are generally prohibited from making capital distributions and paying management fees to controlling persons if, subsequent to such distribution or payment, the institution would be undercapitalized. Finally, an adequately-capitalized bank may be forced to comply with operating restrictions similar to those placed on undercapitalized banks.

 

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An “undercapitalized” bank fails to meet the required minimum level for any relevant capital measure. A bank that reaches the undercapitalized level is likely subject to a formal agreement, consent order or another formal supervisory sanction. An undercapitalized bank is not only subject to the requirements placed on adequately-capitalized banks, but also becomes subject to the following operating and managerial restrictions, which:

 

prohibit capital distributions;

 

prohibit payment of management fees to a controlling person;

 

require the bank to submit a capital restoration plan within 45 days of becoming undercapitalized;

 

require close monitoring of compliance with capital restoration plans, requirements and restrictions by the primary federal regulator;

 

restrict asset growth by requiring the bank to restrict its average total assets to the amount attained in the preceding calendar quarter;

 

prohibit the acceptance of employee benefit plan deposits; and

 

require prior approval by the primary federal regulator for acquisitions, branching and new lines of business.

 

Finally, an undercapitalized institution may be required to comply with operating restrictions similar to those placed on significantly-undercapitalized institutions.

 

A “significantly-undercapitalized” bank has a total risk-based capital ratio less than 6%, a Tier 1 risk-based capital less than 3% (4% beginning January 1, 2015), and a Tier 1 leverage ratio less than 3%. In addition to being subject to the restrictions applicable to undercapitalized institutions, significantly undercapitalized banks may, at the discretion of the bank’s primary federal regulator, also become subject to the following additional restrictions, which:

 

require the sale of enough capital stock so that the bank is adequately capitalized or, if grounds for conservatorship or receivership exist, the merger or acquisition of the bank;

 

restrict affiliate transactions;

 

restrict interest rates paid on deposits;

 

further restrict growth, including a requirement that the bank reduce its total assets;

 

restrict or prohibit all activities that are determined to pose an excessive risk to the bank;

 

require the bank to elect new directors, dismiss directors or senior executive officers, or employ qualified senior executive officers to improve management;

 

prohibit the acceptance of deposits from correspondent banks, including renewals and rollovers of prior deposits;

 

require prior approval of capital distributions by holding companies;

 

require holding company divestiture of the financial institution, bank divestiture of subsidiaries and/or holding company divestiture of other affiliates; and

 

require the bank to take any other action the federal regulator determines will “better achieve” prompt corrective action objectives.

 

Finally, without prior regulatory approval, a significantly undercapitalized institution must restrict the compensation paid to its senior executive officers, including the payment of bonuses and compensation that exceeds the officer’s average rate of compensation during the 12 calendar months preceding the calendar month in which the bank became undercapitalized.

 

A “critically-undercapitalized” bank has a ratio of tangible equity to total assets that is equal to or less than 2%. In addition to the appointment of a receiver in not more than 90 days, or such other action as determined by an institution’s primary federal regulator, an institution classified as critically undercapitalized is subject to the restrictions applicable to undercapitalized and significantly-undercapitalized institutions, and is further prohibited from doing the following without the prior written regulatory approval:

 

entering into material transactions other than in the ordinary course of business;

 

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extending credit for any highly leveraged transaction;

 

amending the institution’s charter or bylaws, except to the extent necessary to carry out any other requirements of law, regulation or order;

 

making any material change in accounting methods;

 

engaging in certain types of transactions with affiliates;

 

paying excessive compensation or bonuses, including golden parachutes;

 

paying interest on new or renewed liabilities at a rate that would increase the institution’s weighted average cost of funds to a level significantly exceeding the prevailing rates of its competitors; and

 

making principal or interest payment on subordinated debt 60 days or more after becoming critically undercapitalized.

 

In addition, a bank’s primary federal regulator may impose additional restrictions on critically-undercapitalized institutions consistent with the intent of the prompt corrective action regulations. Once an institution has become critically undercapitalized, subject to certain narrow exceptions such as a material capital remediation, federal banking regulators will initiate the resolution of the institution.

 

FDIC Insurance Assessments

 

Peoples’ deposits are insured by the Deposit Insurance Fund (the “DIF”) of the FDIC up to the maximum amount permitted by law, which was permanently increased to $250,000 by the Dodd-Frank Act. The FDIC uses the DIF to protect against the loss of insured deposits if an FDIC-insured bank or savings association fails. Pursuant to the Dodd-Frank Act, the FDIC must take steps, as necessary, for the DIF reserve ratio to reach 1.35% of estimated insured deposits by September 30, 2020. Peoples is thus subject to FDIC deposit premium assessments.

 

Currently, the FDIC uses a risk-based assessment system that assigns insured depository institutions to one of four risk categories based on three primary sources of information — supervisory risk ratings for all institutions, financial ratios for most institutions, including Peoples, and a “scorecard” calculation for large institutions. The FDIC adopted rules, effective April 1, 2011, redefining the assessment base and adjusting the assessment rates. Previously, the assessment base was domestic deposits; the new rule uses an assessment base of average consolidated total assets minus tangible equity, which is defined as Tier 1 Capital. Under the current rules, institutions assigned to the lowest risk category must pay an annual assessment rate now ranging between 2.5 and 9 cents per $100 of the assessment base. For institutions assigned to higher risk categories, assessment rates now range from 9 to 45 cents per $100 of the assessment base. These ranges reflect a possible downward adjustment for unsecured debt outstanding and, in the case of institutions outside the lowest risk category, possible upward adjustments for brokered deposits.

 

The new rules retain the FDIC Board’s flexibility to, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (1) increase or decrease the total rates from one quarter to the next by more than two basis points, or (2) deviate by more than two basis points from the stated base assessment rates. Although the Dodd-Frank Act requires that the FDIC eliminate its requirement to pay dividends to depository institutions when the reserve ratio exceeds a certain threshold, the FDIC’s new rule establishes a decreasing schedule of assessment rates that would take effect when the DIF reserve ratio first meets or exceeds 1.15%. If the DIF reserve ratio meets or exceeds 1.15% but is less than 2%, base assessment rates would range from 1.5 to 40 basis points; if the DIF reserve ratio meets or exceeds 2% but is less than 2.5%, base assessment rates would range from 1 to 38 basis points; and if the DIF reserve ratio meets or exceeds 2.5%, base assessment rates would range from 0.5 to 35 basis points.

 

On November 12, 2009, the FDIC adopted a rule requiring nearly all FDIC-insured depository institutions, including Peoples, to prepay their DIF assessments for the fourth quarter of 2009 and for the following three years on December 30, 2009. At that time, the FDIC indicated that the prepayment of DIF assessments was in lieu of additional special assessments; however, there can be no guarantee that continued pressures on the DIF will not result in additional special assessments being collected by the FDIC in the future.

 

On October 19, 2010, the FDIC adopted a new DIF Restoration Plan that foregoes the uniform three basis point-increase previously scheduled to take effect on January 1, 2011. The FDIC indicated that this change was based on revised projections calling for lower than previously expected DIF losses for the period 2010 through 2014, continued stresses on the earnings of insured depository institutions, and the additional time afforded to reach the DIF reserve ratio required by the Dodd-Frank Act.

 

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The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and these assessments will continue until the FICO issued debt matures between 2017 and 2019.

 

The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC.

 

Allowance for Loan Losses (“ALLL”)

 

The ALLL represents one of the most significant estimates in Peoples’ financial statements and regulatory reports. Because of its significance, we have developed a system by which we develop, maintain, and document a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the provision for loan losses. “The Interagency Policy Statement on the Allowance for Loan and Lease Losses,” issued on December 13, 2006, encourages all banks to ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the bank’s stated policies and procedures, management’s best judgment, and relevant supervisory guidance. Consistent with supervisory guidance, we maintain a prudent and conservative, but not excessive, ALLL at a level appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. Our estimate of credit losses reflects consideration of all significant factors that affect the collectability of the portfolio as of the evaluation date. See “Management’s Discussion and Analysis — Critical Accounting Policies.”

 

Commercial Real Estate Lending

 

On December 6, 2006, the federal banking regulators issued final guidance to remind financial institutions of the risk posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans, and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines for its examiners to help identify institutions that are potentially exposed to significant CRE risk and may warrant greater supervisory scrutiny:

 

total reported loans for construction, land development and other land represent 100% or more of the institution’s total capital, or

 

total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

 

Enforcement Powers

 

The Financial Institution Reform Recovery and Enforcement Act (“FIRREA”) expanded and increased civil and criminal penalties available for use by the federal regulatory agencies against depository institutions and certain “institution-affiliated parties.” Institution-affiliated parties primarily include management, employees, and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs. These practices can include the failure of an institution to timely file required reports or the filing of false or misleading information or the submission of inaccurate reports. Civil penalties may be as high as $1.1 million per day for such violations. Criminal penalties for some financial institution crimes have been increased to 20 years. In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.

 

Possible enforcement actions include the termination of deposit insurance. Furthermore, banking agencies’ power to issue regulatory orders were expanded. Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate. The Dodd-Frank Act increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

 

Community Reinvestment Act

 

The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the federal banking agencies evaluate the record of each financial institution in meeting the credit needs of its local community, including low- and moderate-income neighborhoods. These facts are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on us. Additionally, we must publicly disclose the terms of various Community Reinvestment Act-related agreements.

 

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Other Regulations

 

Interest and other charges collected or contracted for by us are subject to state usury laws and federal laws concerning interest rates. Our loan operations are also subject to federal laws applicable to credit transactions, such as the:

 

Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed, or other prohibited factors in extending credit;

 

Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, certain identity theft protections, and certain credit and other disclosures;

 

Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

National Flood Insurance Act and Flood Disaster Protection Act, requiring flood insurance to extend or renew certain loans in flood plains;

 

Real Estate Settlement Procedures Act, requiring certain disclosures concerning loan closing costs and escrows, and governing transfers of loan servicing and the amounts of escrows in connection with loans secured by one-to-four family residential properties;

 

Soldiers’ and Sailors’ Civil Relief Act of 1940, as amended, governing the repayment terms of, and property rights underlying, secured obligations of persons currently on active duty with the United States military;

 

Talent Amendment in the 2007 Defense Authorization Act, establishing a 36% annual percentage rate ceiling, which includes a variety of charges including late fees, for certain types of consumer loans to military service members and their dependents;

 

Bank Secrecy Act, as amended by the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), imposing requirements and limitations on specific financial transactions and account relationships, intended to guard against money laundering and terrorism financing;

 

sections 22(g) and 22(h) of the Federal Reserve Act which set lending restrictions and limitations regarding loans and other extensions of credit made to executive officers, directors, principal shareholders and other insiders; and

 

rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

 

Our deposit operations are subject to federal laws applicable to depository accounts, such as the following:

 

Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

 

Truth-In-Savings Act, requiring certain disclosures for consumer deposit accounts;

 

Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

 

rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

 

As part of the overall conduct of the business, we must comply with:

 

privacy and data security laws and regulations at both the federal and state level; and

 

anti-money laundering laws, including the USA Patriot Act.

 

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The Consumer Financial Protection Bureau

 

The Dodd-Frank Act created the Consumer Financial Protection Bureau (the “Bureau”) within the Federal Reserve Board. The Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The Bureau has rulemaking authority over many of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the Bureau and state attorneys general are permitted to enforce consumer protection rules adopted by the Bureau against state-chartered institutions.

 

Ability-to-Repay and Qualified Mortgage Rule

 

Pursuant to the Dodd-Frank Act, the Bureau issued a final rule on January 10, 2013 (effective on January 10, 2014) amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers’ ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the covered transaction; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mortgage-related obligations; (vi) current debt obligations, alimony and child support; (vii) the monthly debt-to-income ratio or residual income; and (viii) credit history. Alternatively, the mortgage lender can originate “qualified mortgages,” which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a qualified mortgage is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Qualified mortgages that are “higher priced” (e.g. subprime loans) are given a safe harbor of compliance. Peoples is predominantly an originator of compliant qualified mortgages.

 

Capital Adequacy

 

PSB and Peoples are required to comply with the capital adequacy standards established by the Federal Reserve Board, in the case of PSB, and the WDFI and FDIC, in the case of Peoples. The Federal Reserve Board has established a risk-based and a leverage measure of capital adequacy for bank holding companies. Peoples is also subject to risk-based and leverage capital requirements adopted by the FDIC, which are substantially similar to those adopted by the Federal Reserve Board for bank holding companies.

 

The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items, such as letters of credit and unfunded loan commitments, are assigned to broad risk categories, each with appropriate risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.

 

The minimum guideline for the ratio of total capital to risk-weighted assets, and classification as adequately capitalized, is 8%. A bank that fails to meet the required minimum guidelines is classified as undercapitalized and subject to operating and management restrictions. A bank, however, that exceeds its capital requirements and maintains a ratio of total capital to risk-weighted assets of 10% is classified as well capitalized.

 

Total capital consists of two components: Tier 1 capital and Tier 2 capital. Tier 1 capital generally consists of common stockholders’ equity, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and other specified intangible assets. Tier 1 capital must equal at least 4% of risk-weighted assets (6% of risk-weighted assets beginning January 1, 2015). Tier 2 capital generally consists of subordinated debt, other preferred stock and hybrid capital, and a limited amount of loan loss reserves. The total amount of Tier 2 capital is limited to 100% of Tier 1 capital. Refer to Note 20 of the Notes to Consolidated Financial Statements for information on our current regulatory capital ratios at December 31, 2014.

In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies, which are intended to further address capital adequacy. The FDIC has adopted substantially similar requirements for banks. These guidelines provide for a minimum ratio of Tier 1 capital to average assets, less goodwill and other specified intangible assets, of 3% for institutions that meet specified criteria, including having the highest regulatory rating and implementing the risk-based capital measure for market risk. All other institutions generally are required to maintain a leverage ratio of at least 4%. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without reliance on intangible assets. The banking regulators consider the leverage ratio and other indicators of capital strength in evaluating proposals for expansion or new activities.

 

Through a provision known as “The Collins Amendment,” the Dodd-Frank Act establishes certain regulatory capital deductions with respect to hybrid capital instruments, such as trust preferred securities, that will effectively disallow the inclusion of such instruments in Tier 1 capital for all such capital instruments issued on or after May 19, 2010. However, securities issued prior to May 19, 2010 by bank holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, such as PSB, are “grandfathered” and therefore not subject to these required capital deductions. Finally, bank holding companies subject to the Federal Reserve Board’s Small Bank Holding Company Policy Statement as in effect on May 19, 2010 — generally, holding companies with less than $500 million in consolidated assets — are exempt from the trust preferred treatment changes required by the Dodd-Frank Act.

 

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On July 2, 2013, the Federal Reserve Board approved a final rule that implements changes to the regulatory capital framework for all banking organizations as required by the Dodd-Frank Act. The new rules are effective for us on January 1, 2015 and include increases to the minimum regulatory capital ratios and introduction of a capital “buffer”. In addition, the definition of capital included in determination of regulatory capital ratios was changed. Lastly, the standardized approach for risk weighting assets was changed which increased the risk weights on certain higher risk assets, effectively requiring greater minimum levels of capital for those assets. The more significant changes impacting our regulatory capital ratios under the final rule include:

 

Beginning in 2016, and phased in through 2019, a new common equity to risk weighted assets Tier 1 capital ratio was introduced with a minimum ratio of 4.5% for capital adequacy. In general, common equity includes that represented by common stock and surplus and retained earnings less the majority of regulatory capital deductions.

 

The minimum for capital adequacy was increased for the Tier 1 to risk weighted assets ratio, from 4% to 6%.

 

A new “capital conservation buffer” equal to 2.5% of risk weighted assets above the minimum capital ratios for capital adequacy must now be considered before payment of certain executive compensation or distributions to shareholders or stock repurchases are allowed. The amount of payout as a percentage of eligible retained income based on the amount of the capital conservation buffer is shown in the table below:

 

  Capital Conservation Buffer  Maximum Payout % of Eligible Retained Income  
        
  Less than or = .625%  0%  
  Less than or = 1.25% and greater than .625%  20%  
  Less than or = 1.875% and greater than 1.25%  40%  
  Less than or = 2.50% and greater than 1.875%  60%  
  Greater than 2.5%  no payment limit applies  

 

Mortgage servicing rights and deferred tax assets are subject to more stringent limits and a 250% risk weighting.

 

Delinquent loans and certain “high volatility” commercial real estate development loans are subject to a 150% risk weighting (up from 100% weighting previously).

 

Unused commercial lines of credit or other commitments with an original maturity of one year or less are now subject to a 20% risk weighting (up from 0% risk weighting previously).

 

Our expected impact of the new regulatory capital framework is to increase risk weighted assets primarily from greater risk weights related to past due loan exposures, unused loan commitments, and construction and land development loans. Because we manage regulatory capital levels to remain above those to be considered well capitalized (rather than to simply to remain above those for capital adequacy) and because we intend to continue our historical cash dividend payments, our internally targeted regulatory capital minimums are 7.0% for common equity Tier 1 capital ratio (a new ratio), 6.5% for the Tier 1 leverage ratio (up from 5.0%), 8.5% for the Tier 1 risk weighted capital ratio (up from 6.0%), and 10.5% for the Tier 2 total risk weighted capital ratio (up from 10.0%). We continue to research the specific impacts on our regulatory capital levels and operations due to these changes but remained significantly above these new ratios upon implementation on January 1, 2015.

 

Another significant new requirement originating from these new capital rules is that capital “stress testing” will be required for all banking organizations, including PSB, with the level and complexity of analysis varying significantly based on asset size. For community banks such as PSB with total assets under $10 billion, stress testing must be conducted annually although specific timing, due dates, and disclosure of findings are still to be determined by regulation. The stress test must consider capital impacts over a two year planning horizon and estimate loan losses under stress scenarios with estimated impacts on earnings. Results of stress test scenarios could also impact our ability to pay shareholder dividends or conduct share repurchases even if regulatory capital levels were currently above well capitalized minimums and the capital conservation buffer.

 

Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and certain other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements. See “Prompt Corrective Action” above.

 

The WDFI, the Federal Reserve Board, and the FDIC have authority to compel or restrict certain actions if our capital should fall below adequate capital standards as a result of operating losses, or if its regulators otherwise determine that it has insufficient capital. Among other matters, the corrective actions may include, removing officers and directors; and assessing civil monetary penalties; and taking possession of and closing and liquidating Peoples.

 

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Payment of Dividends

 

PSB is a legal entity separate and distinct from Peoples. The principal source of PSB’s cash flow, including cash flow to pay dividends to its shareholders, are dividends that Peoples State Bank pays to PSB as Peoples State Bank’s sole shareholder. Statutory and regulatory limitations apply to Peoples’ payment of dividends to PSB as well as to PSB’s payment of dividends to its shareholders. If, in the opinion of the FDIC or WDFI, Peoples State Bank was engaged in or about to engage in an unsafe or unsound practice, the WDFI or FDIC could require that Peoples stop or refrain from engaging in the practice. The federal banking agencies have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level, would be an unsafe and unsound banking practice. In addition, as noted previously, new capital rules that begin to phase in effective January 1, 2016 would prevent us from paying any cash dividends if regulatory capital ratios do not maintain at least some portion of the 2.5% capital conservation buffer (fully phased in during 2019) above those minimum ratios required to be considered adequately capitalized.

 

Peoples is required by federal law to obtain prior approval of the WDFI for payment of dividends if the total of all dividends declared by Peoples in any year will exceed the total of its net profits for that year if, during any of the preceding two years, Peoples dividends also exceeded the total of net profits during that preceding year. The payment of dividends by PSB and Peoples may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines, any conditions or restrictions that may be imposed by regulatory authorities in connection with their approval of a merger, or the requirements of any written agreements that either PSB or Peoples may enter into with their respective regulatory authorities.

 

Furthermore, the Federal Reserve Board clarified its guidance on dividend policies for bank holding companies through the publication of a Supervisory Letter, dated February 24, 2009. As part of the letter, the Federal Reserve Board encouraged bank holding companies to consult with the Federal Reserve Board prior to dividend declarations and redemption and repurchase decisions even when not explicitly required to do so by federal regulations. This guidance is largely consistent with prior regulatory statements encouraging bank holding companies to pay dividends out of net income and to avoid dividends that could adversely affect the capital needs or minimum regulatory capital ratios of the bank holding company and its subsidiary bank.

 

Any future determination relating to PSB’s dividend policy will be made at the discretion of the Board of Directors and will depend on many of the statutory and regulatory factors mentioned above.

 

Restrictions on Transactions with Affiliates

 

PSB and Peoples are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

 

a bank’s loans or extensions of credit to affiliates;

 

a bank’s investment in affiliates;

 

assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve Board;

 

loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates; and

 

a bank’s guarantee, acceptance, or letter of credit issued on behalf of an affiliate.

 

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. Peoples must also comply with other provisions designed to avoid taking low-quality assets.

 

PSB and Peoples are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.

 

Peoples is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders, and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Effective July 21, 2011, an insured depository institution will be prohibited from engaging in asset purchases or sales transactions with its officers, directors, or principal shareholders unless (1) the transaction is on market terms and, (2) if the transaction represents greater than 10% of the capital and surplus of the bank, a majority of the disinterested directors has approved the transaction.

 

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Limitations on Senior Executive Compensation

 

In June of 2010, federal banking regulators issued guidance designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking or undermine the safety and soundness of the organization. In connection with this guidance, the regulatory agencies announced that they will review incentive compensation arrangements as part of the regular, risk-focused supervisory process. Regulatory authorities may also take enforcement action against a banking organization if (1) its incentive compensation arrangement or related risk management, control, or governance processes pose a risk to the safety and soundness of the organization and (2) the organization is not taking prompt and effective measures to correct the deficiencies. To ensure that incentive compensation arrangements do not undermine safety and soundness at insured depository institutions, the incentive compensation guidance sets forth the following key principles:

 

incentive compensation arrangements should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose the organization to imprudent risk;

 

incentive compensation arrangements should be compatible with effective controls and risk management; and

 

incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the board of directors.

 

As noted previously for payment of dividends, new rules effective January 1, 2016 will also limit certain executive compensation involving discretionary bonus payments if regulatory capital ratios do not maintain at least some portion of the 2.5% capital conservation buffer (fully phased in during 2019) above those minimum ratios required to be considered adequately capitalized.

 

Proposed Legislation and Regulatory Action

 

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which its business may be affected by any new regulation or statute.

 

Effect of Governmental Monetary Policies

 

Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board affect the levels of bank loans, investments, and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks, and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

Our Participation in Federal Government Support Programs Targeted to the Banking Industry

 

Beginning in 2008, the banking industry experienced dramatic governmental intervention in an effort to support the capital needs of certain large banks, to spur growth in bank lending, and to increase consumer and business confidence in the banking industry through passage of the Troubled Asset Relief Program (“TARP”). TARP provided various support to the industry, some available to all banks, and some available to specific large institutions deemed to require exceptional assistance. Through programs generally available to all banks, TARP increased the insurance limit on certain deposit accounts and provided an FDIC guarantee for certain debt issued by banks and bank holding companies through the Temporary Liquidity Guarantee Program (“TLGP”), and invested government funds into some banks in the form of preferred stock through the Capital Purchase Program (“CPP”), among other actions. During 2009, our application to receive TARP CPP capital from the U.S. Treasury was approved. However, we declined participation due to concern such capital would be perceived by customers or prospects as a bailout due to negative perceptions of many of larger national banks receiving such funds. PSB also retained the right to issue unsecured capital notes with FDIC guarantees under the TLGP program, but did not exercise this right or issue such unsecured notes.

 

Peoples was a participant in the TLGP Program within the Transaction Account Guarantee (“TAG”) Program of TLGP and continued participation in the Program through December 31, 2012 as required by Dodd-Frank. The TAG program expired following December 31, 2012. Under the program, customers in noninterest bearing demand accounts were fully 100% guaranteed against loss by the FDIC.

 

In December 2010, the U.S. Treasury introduced a new small bank capital program known as the “Small Business Lending Fund (SBLF)” established by the Small Business Jobs Act with funding up to $30 billion in an effort to spur small business lending. Under the program, only available to well performing banks less than $10 billion in assets such as Peoples, banks may issue preferred stock to the U.S. Treasury with a variable dividend rate that could later be fixed as low as 1% depending on the level of small business lending growth during the first 10 quarters following issuance of the preferred stock. The preferred stock dividend later resets to 9% on the 4 ½ year anniversary of the preferred stock issue until repaid. Although our application for SBLF capital was approved by the Treasury, we declined participation in the program due to low projected local loan growth demand and significant limitations on use of the SBLF capital for purposes other than small business loan growth.

 

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Item 1A.       RISK FACTORS.

 

Forward-Looking Statements

 

This Annual Report on Form 10-K, including “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Item 7, contains forward-looking statements that involve risks, uncertainties, and assumptions. Forward-looking statements are not guarantees of performance. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of PSB Holdings, Inc. and its consolidated subsidiaries (hereinafter referred to as “PSB,” or “Peoples” or “we,” or “our,” or “us”) may differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements. Forward-looking statements may be identified by, among other things, expressions of beliefs or expectations that certain events may occur or are anticipated, and projections or statements of expectations. Risks, uncertainties, and assumptions relating to forward-looking statements include, among other things, actions or changes by competitors in our markets that put us at a competitive disadvantage, public perception of economic prospects and the banking industry, failure to comply with or changes in government regulations, changes in interest rates, deterioration of the credit quality of our loan portfolio, the adequacy of our allowance for loan losses, exposure to small and mid-size business credits, inadequate liquidity, disruptions in the financial markets, inability to operate profitably because of competition, the inability to execute expansion plans, changes in economic conditions within our market area, increased deposit insurance costs due to an increase in failure of FDIC insured banks, the potential of dilutive common stock issues due to increased regulatory capital minimums, the inability to implement required technologies, problems in the operation of our information technology systems, the inability of our principal subsidiary to pay dividends, potential credit risk associated with our large investment in debt issued by federal, state, and local municipalities, environmental and fraud risk associated with our credit arrangements with customers, increased funding costs, changes in customers’ preferences for types and sources of financial services, loss of key personnel, the rights of debt holders senior to common shareholders upon liquidation, lack of FDIC insurance available to common shareholders over their investment in our common stock, failure to maintain and enforce adequate internal controls, unforeseen liabilities arising from current or prospective claims or litigation, lack of marketability of our common or other equity stock, the effect of certain organizational anti-takeover provisions, changes in accounting principles and tax laws, and unexpected disruptions in our business. These and other risks, uncertainties, and assumptions are described under the caption “Risk Factors” in Item 1A of this Annual Report on Form 10-K and from time to time in our other filings with the Securities and Exchange Commission after the date of this report. We assume no obligation, and do not intend, to update these forward-looking statements.

 

An investment in PSB Holdings, Inc. common stock involves a significant degree of risk. The following paragraphs describe what we believe are the most significant risks of investing in PSB common stock. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations. We cannot assure you that any of the events discussed in the risk factors below will not occur. If they do, our business, financial condition or results of operations could be materially and adversely affected.

 

The impact of the current economic environment on performance of other financial institutions in our markets; actions taken by our competitors to address continued slow economic conditions; and public perception of and confidence in the economy generally, and the banking industry specifically, may present significant challenges for us and could adversely affect our performance.

 

We operate in a challenging and uncertain economic environment, including generally uncertain national conditions and slow local conditions in our primary markets. Financial institutions continue to be affected by depressed valuations in real estate markets and community banks are faced with constrained financial and capital markets. While we take steps to decrease and limit our exposure to certain types of loans secured by commercial real estate collateral, we nonetheless retain direct exposure to the real estate markets, and are affected by these events. Continued declines in real estate values and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition and results of operations.

 

In addition, the market value of the real estate securing our loans as collateral has been adversely affected by the slowing economy and unfavorable changes in economic conditions in our market areas and could be further adversely affected in the future. As of December 31, 2014, approximately 46% of our loans were secured by commercial-based real estate and 36% of our loans receivable were secured by residential real estate. Any sustained period of increased payment delinquencies, foreclosures, or losses caused by the adverse market and economic conditions, including the downturn in the real estate market, within our markets will continue to adversely affect the value of our assets, revenues, results of operations, and financial condition.

 

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The overall deterioration in economic conditions may subject us to increasing regulatory scrutiny. In addition, further deterioration in national economic conditions or the economic conditions in our local markets could drive losses beyond the amount provided for in our allowance for loan losses, resulting in the following other consequences: increased loan delinquencies, problem assets, and foreclosures; decline in demand for our products and services; decrease in deposits, adversely affecting our liquidity position; and decline in value of collateral, reducing our customers’ borrowing power and the value of assets and collateral associated with our existing loans. These consequences could also result in decreased earnings or a decline in the market value of our common stock. As a community bank, we are less able to spread the risk of unfavorable economic conditions than larger national or regional banks. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas even if they do occur.

 

We are subject to extensive regulation that could limit or restrict our activities.

 

We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various regulatory agencies. Our compliance with these regulations, including compliance with our regulatory commitments, is costly and may restrict certain of our activities, including the declaration and payment of cash dividends to stockholders, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth and operations.

 

The laws and regulations applicable to the banking industry have recently changed and may continue to change, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the cost of compliance could adversely affect our ability to operate profitably. The Dodd-Frank Act was enacted on July 21, 2010. The full implications of the Dodd-Frank Act, or its implementing regulations, on our business are unclear at this time, but it may adversely affect our business, results of operations, and the underlying value of our stock. New regulatory capital rules called for by Dodd-Frank became effective for us on January 1, 2015 and are expected to decrease our regulatory capital ratios upon implementation, which could impact our ability to grow via merger and acquisition activities. The full effect of this legislation will not be even reasonably certain until all implementing regulations are promulgated, which could take several years in some cases.

 

To be considered “well capitalized” by banking regulatory agencies, we are subject to minimum capital levels defined by banking regulation that are based on total assets and risk adjusted assets. This highest regulatory capital designation is required to unilaterally participate in the brokered certificate of deposit market. In addition, being considered well capitalized is a key component of risk classification used by the Federal Home Loan Bank (“FHLB”) and the Federal Reserve concerning the amount of credit available to us and the type and amount of collateral required against such advances. Maintaining well capitalized status is also required by the covenants of our holding company line of credit. Failure to retain the well capitalized regulatory designation would both limit the availability of, and increase the cost of wholesale funding, which has been an important source of funding for growth. In addition, banks not considered to be well capitalized are subject to a cap on interest rates paid to depositors as published by the FDIC. Such depositor interest rate caps could impede our ability to raise local deposits to replace wholesale funding sources no longer available if we were not considered to be well capitalized which could have a material adverse effect on our business, liquidity, financial condition, and results of operations.

 

Some or all of the changes, including the new rulemaking authority granted to the newly-created Consumer Financial Protection Bureau, may result in greater reporting requirements, assessment fees, operational restrictions, capital requirements, and other regulatory burdens for us while many of our competitors that are not banks or bank holding companies may remain free from such limitations. This could affect our ability to attract and maintain depositors, to offer competitive products and services, and to expand our business. Congress may consider additional proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies. Such legislation may change existing banking statutes and regulations, as well as the current operating environment significantly. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand our permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, financial condition, or results of operations.

 

Our financial condition and results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve. Actions by monetary and fiscal authorities, including the Federal Reserve, could have an adverse effect on our deposit levels, loan demand, stock price, ability to pay dividends, business or earnings. See “Regulation and Supervision” earlier in this Annual Report on Form 10-K.

 

Changes in the interest rate environment could reduce our net interest income, which could reduce our profitability.

 

As a financial institution, our earnings significantly depend on net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes in federal fiscal and monetary policies, affects us more than non-financial institutions and can have a significant effect on our net interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin and results of operations.

 

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In addition, we cannot predict whether interest rates will continue to remain at present levels. Changes in interest rates may cause significant changes, up or down, in our net interest income. Depending on our portfolio of loans and investments, our results of operations may be adversely affected by changes in interest rates. If there is a substantial increase in interest rates, our investment portfolio is at risk of experiencing price declines that may negatively impact our total capital position through changes in other comprehensive income. During a rising rate period, it is likely our funding costs would reprice to new rates more quickly than our fixed rate loan portfolio. In addition, any significant increase in prevailing interest rates could adversely affect our mortgage banking business because higher interest rates could cause customers to request fewer refinancings and purchase money mortgage originations.

 

Management uses simulation analysis to produce an estimate of interest rate exposure based on assumptions and judgments related to balance sheet growth, new products, and pricing. Simulation analysis involves a high degree of subjectivity and requires estimates of future risks and trends. Accordingly, there can be no assurance that actual results will not differ from those derived in simulation analysis due to the timing, magnitude, and frequency of interest rate changes, changes in balance sheet composition, and the possible effects of unanticipated or unknown events. Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected, and/or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.

 

We are subject to credit risk and changes in the allowance for loan losses could adversely affect our profitability.

 

Our success depends to a significant extent upon the quality of our assets, particularly loans. In originating loans, there is a substantial likelihood that we will experience credit losses. The risk of loss will vary with, among other things, general economic conditions, the type of loan, the creditworthiness of the borrower over the term of the loan, and, in the case of a collateralized loan, the quality of the collateral for the loan.

 

We provide credit services within our local communities. Our ability to diversify our economic risks is limited by our own local markets and economies. We lend primarily to individuals and small to medium-sized businesses, which may expose us to greater lending risks than those of banks lending to larger, better-capitalized businesses with longer operating histories. We manage our credit exposure through careful monitoring of loan applicants and loan concentrations in particular industries, and through loan approval and review procedures.

 

Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. As a result, we may experience significant loan losses, which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses that may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions, and other pertinent information.

 

If management’s assumptions are wrong, our current allowance may not be sufficient to cover future loan losses, and we may need to make adjustments to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. We expect our allowance to continue to fluctuate; however, given current and future market conditions, we can make no assurance that our allowance will be adequate to cover future loan losses.

 

In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulators could have a negative effect on our operating results.

 

We are subject to liquidity risk in our operations.

 

Liquidity risk is the possibility of being unable, at a reasonable cost and within acceptable risk tolerances, to pay obligations as they come due, to capitalize on growth opportunities as they arise, or to pay regular dividends because of an inability to liquidate assets or obtain adequate funding on a timely basis. Liquidity is required to fund various obligations, including credit obligations to borrowers, mortgage originations, withdrawals by depositors, repayment of debt, dividends to stockholders, operating expenses, and capital expenditures. Liquidity is derived primarily from retail deposit growth and retention, principal and interest payments received on loans and investment securities, net cash provided from operations, and access to other funding sources. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action. Our ability to borrow could also be impaired by factors that are not specific to us, such as a severe disruption in the financial markets or negative views and expectations about the prospects for the financial services industry as a whole, such as the turmoil faced by banking organizations in the domestic and worldwide credit markets during 2008 through 2010. Currently, we have access to liquidity to meet our current anticipated needs; however, our access to additional borrowed funds could become limited in the future, and we may be required to pay above market rates for additional borrowed funds, if we are able to obtain them at all, which may adversely affect our results of operations.

 

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Competition in the banking industry is intense and we face strong competition from larger, more established competitors.

 

The banking business is highly competitive, and we experience strong competition from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other financial institutions that operate in our primary market areas and elsewhere.

 

We compete with these institutions both in attracting depositors and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established, much larger financial institutions. While we believe we can successfully compete with these other financial institutions in our markets, we may face a competitive disadvantage as compared to large national or regional banks as a result of our smaller size and lack of geographic diversification.

 

Although we compete by concentrating our marketing efforts in our primary market area with local advertisements, personal contacts, and greater flexibility in working with local customers, we can give no assurance that this strategy will be successful.

 

Potential acquisitions may disrupt our business and dilute shareholder value.

 

Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:

 

potential exposure to unknown or contingent liabilities of the acquired company;

 

exposure to potential asset quality issues of the acquired company;

 

difficulty and expense of integrating the operations and personnel of the acquired company;

 

potential disruption to our business;

 

potential diversion of our management’s time and attention;

 

the possible loss of key employees and customers of the acquired company;

 

difficulty in estimating the value (including goodwill) of the acquired company;

 

difficulty in estimating the fair value of acquired assets, liabilities, and derivatives of the acquired company; and

 

potential changes in banking or tax laws or regulations that may affect the acquired company.

 

We may evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, future mergers or acquisitions involving cash, or debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over the target’s book value or include a portion of goodwill “blue sky,” and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.

 

Our success depends upon local and regional economic conditions.

 

The core industries in our market area are healthcare, building supplies, industrial fans, education, retail distribution, paper, insurance, and tourism. Our success depends primarily on economic conditions in the markets in which we operate due to concentrations of loans and other business activities in geographic areas where our branches are principally located. In addition, the residential and commercial real estate markets throughout these areas depend primarily on the strength of these core industries.

 

The regional economic conditions in areas in which we conduct our business have an impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions caused by inflation, recession, an act of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets, or other factors, such as severe declines in the value of homes and other real estate, could also impact these regional economies and, in turn, have a material adverse effect on our financial condition and results of operations. A material decline in any of the core industries in our market area will affect the communities we serve and could negatively impact our financial results and have a negative impact on profitability.

 

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The FDIC Deposit Insurance assessments that we are required to pay may materially increase in the future, which would have an adverse effect on our earnings.

 

As a member institution of the FDIC, we are assessed a quarterly deposit insurance premium. Failure of a large national bank or series of other bank failures could deplete the insurance fund and reduced the ratio of reserves to insured depositors. As a result, we may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings if the number of bank failures were to increase.

 

On October 19, 2010, the FDIC adopted a Deposit Insurance Fund (“DIF”) Restoration Plan, which requires the DIF to attain a 1.35% reserve ratio by September 30, 2020. In addition, the FDIC modified the method by which assessments are determined and, effective April 1, 2011, adjusted assessment rates, which will range from 2.5 to 45 basis points (annualized), subject to adjustments for unsecured debt and, in the case of small institutions outside the lowest risk category and certain large and highly complex institutions, brokered deposits. Further increased FDIC assessment premiums, due to a change in our risk classification, emergency assessments, or implementation of the modified DIF reserve ratio, could adversely impact our earnings.

 

We may need to raise additional capital in the future for several factors, including through the increased minimum capital thresholds effective January 1, 2015 established by our regulators as part of their implementation of the Dodd-Frank Act, but that capital may not be available when it is needed or may be dilutive to our shareholders.

 

We are required by federal and state regulatory authorities to maintain adequate capital levels to support our operations. New regulations implementing the Dodd-Frank Act capital standards require financial institutions to maintain higher minimum capital rations and place a greater emphasis on common equity as a component of Tier 1 capital. In order to support our operations and comply with regulatory standards, we may need to raise capital in the future. Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on favorable terms. The capital and credit markets have experienced significant volatility in recent years. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of volatility occur, our ability to raise additional capital may be disrupted. If we cannot raise additional capital when needed, our results of operations and financial condition may be adversely affected, and our banking regulators may subject us to regulatory enforcement action, including receivership. In addition, the issuance of additional shares of our equity securities under these adverse conditions would dilute the economic ownership interest of our common shareholders.

 

We continually encounter technological change and we may have fewer resources than our competition to continue to invest in technological improvements; our information systems may experience an interruption or breach in security.

 

The banking and financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our customers by using technology to provide products and services that enhance customer convenience, as well as create additional efficiencies in operations. Many of our competitors have greater resources to invest in technological improvements, and we may not be able to effectively implement new technology-driving products and services, which could reduce our ability to effectively compete.

 

In addition, we rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in customer relationship management, general ledger, deposit, loan functionality and the effective operation of other systems. While we have policies and procedures designed to prevent or limit the effect of a failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

 

We rely on dividends from our Peoples State Bank subsidiary for virtually all of our funds.

 

PSB is a legal entity separate and distinct from its subsidiary, Peoples State Bank. PSB receives substantially all of its cash flow from dividends from Peoples State Bank. These dividends are PSB’s principal source of funds to pay interest and principal on its debt and dividends on its common stock. Various laws and regulations limit the amount of dividends that Peoples State Bank may pay to PSB. Also, PSB’s right to participate in a distribution of assets upon Peoples State Bank’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event Peoples State Bank is unable to pay dividends to PSB, PSB may not be able to service its debt, pay its other obligations, or pay dividends on its common stock. The inability to receive dividends from Peoples State Bank could have a material adverse effect on PSB’s financial condition and results of operations.

 

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Investments in debt issued by government-sponsored agencies subject us to risk from government action and legal changes.

 

Peoples State Bank invests a portion of its assets in obligations of the Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA, or “Fannie Mae”), Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”), and other U.S. government-sponsored entities; as well as state, county, and municipal obligations, and federal funds sold.  While the FHLB, FNMA, and FHLMC are U.S. government-sponsored agencies, investments in these securities are not guaranteed by the U.S. Government.  The investments are purchased and held in relation to our loan demand and deposit growth and are generally used to provide for the investment of excess funds at reduced yields and risks, relative to yields and risks of the loan portfolio. The investments may also provide liquidity to fund increases in loan demand or to offset fluctuations in deposits. If the financial performance of one of the U.S. government-sponsored agencies, or state, county, or municipal entities declines, it could have a negative economic impact on our business and expose us to credit losses.

 

We rely on the accuracy and completeness of information about customers and counterparties, and inaccurate or incomplete information could negatively impact our financial condition and results of operations.

 

In deciding whether to extend credit or enter into other transactions with customers and counterparties, Peoples State Bank may rely on information provided by such customers and counterparties, including financial statements and other financial information. It may also rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. Our financial condition and results of operations could be negatively impacted to the extent Peoples State Bank relies on financial statements that do not comply with generally accepted accounting principles or that are inaccurate or misleading.

 

Our funding costs may increase if consumers decide not to use banks as their primary source to invest liquid or other personal assets.

 

While the banking industry has historically held a majority of available deposits, generational factors and trends in using other non-banking providers for investment of funds may reduce the level of deposits available to fund banking assets and increase the cost of funding over the long term. Demographic trends in the United States point to a growing transfer of wealth to the next generation in the following decades that could accelerate this transfer of wealth out of the banking system and into other non-banking providers. If this change occurs, our funding costs could increase and adversely affect our results of operations.

 

During recent years, the banking industry has seen a large increase in deposits as consumers sought to increase liquidity and reduce investment risk. When consumer confidence in the economy grows, it is likely much of these increased deposits will be withdrawn for reinvestment in equity securities or for purchase of increased goods and services supported by a stronger economy, reducing our liquidity or increasing our deposit costs.

 

We may lose fee income and deposits if a significant portion of consumers decide not to use banks to complete their financial transactions.

 

Technology and other changes are allowing parties to complete financial transactions that historically have involved banks at one or both ends of the transaction. For example, consumers can now pay bills and transfer funds directly without banks. In addition, regulation now allows retail merchants to accept payment on in-store debit or credit cards in an effort to reduce bank interchange income. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and income generated from investment of those deposits.

 

We may not be able to attract and retain skilled people.

 

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people can be intense and we may not be able to hire or retain the people we want or need. Although we maintain employment agreements with certain key employees, and have incentive compensation plans aimed, in part, at long-term employee retention, the unexpected loss of services of one or more of our key personnel could still occur, and such events may have a material adverse impact on our business because of the loss of the employee’s skills, customer contacts, technical knowledge, knowledge of our market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.

 

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Holders of our subordinated debentures have rights that are senior to those of our common stockholders.

 

We have supported our continued growth by issuing trust preferred securities and accompanying junior subordinated debentures, as well as senior subordinated notes. As of December 31, 2014, we had outstanding trust preferred securities and associated junior subordinated debentures with aggregate principal of $7.7 million, senior subordinated notes of $4 million, and a correspondent bank term senior note of $0.5 million.

 

We have unconditionally guaranteed the payment of principal and interest on our trust preferred securities. Also, the junior debentures issued to the special purpose trusts that relate to those trust preferred securities, as well as the senior subordinated notes outstanding, are senior to our common stock. As a result, we must make payments on the senior subordinated notes and junior subordinated debentures before we can pay any dividends on our common stock, and in the event of our bankruptcy, dissolution or liquidation, holders of our senior subordinated notes and junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We do have the right to defer distributions on our junior subordinated debentures (and related trust preferred securities) for up to five years, but during that time would not be able to pay dividends on our common or preferred stock.

 

Ownership of our common stock securities is not FDIC insured.

 

Our securities are not savings or deposit accounts or other obligations of Peoples State Bank and are not insured by the Deposit Insurance Fund, or any other agency or private entity and are subject to investment risk, including the possible loss of some or all of the value of your investment.

 

We are subject to operational risk, and our internal controls and procedures may fail or be circumvented.

 

We, like all businesses, are subject to operational risk, which represents the risk of loss resulting from human error, inadequate or failed internal processes and systems, and external events. Operational risk also encompasses compliance (legal) risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, regulations, prescribed practices, or ethical standards. Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Although we seek to mitigate operational risk through a system of internal controls, resulting losses from operational risk could take the form of explicit charges, increased operational costs, harm to our reputation, or foregone opportunities, any and all of which could have a material adverse effect on our financial condition and results of operations.

 

Unexpected liabilities resulting from current or future claims or contingencies may have a material adverse effect on our business, financial condition, and results of operations.

 

We may be involved from time to time in a variety of litigation arising out of our business. Our insurance may not cover all claims that may be asserted against us, regardless of merit or eventual outcome, and such claims may harm our reputation. In addition, we may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms, if at all. Should the ultimate judgments or settlements in any actual or threatened claims or litigation exceed our insurance coverage, they could have a material adverse effect on our business, operating results, and financial condition.

 

Investors may not be able to liquidate their PSB common stock when desired because there is no active public trading market for PSB stock.

 

There is no active public established trading market for PSB stock. As a result, investors may not be able to resell shares at the price or time they desire. In addition, because our shares are thinly traded, there is oftentimes a significant spread between the “bid” and “ask” prices for our shares, often ranging from 1% to 3% of the bid price. Lack of an active market and other factors limit, to some extent, our ability to raise capital by selling additional shares of our stock.

 

Our articles of incorporation could make more difficult or discourage an acquisition of PSB.

 

Our articles of incorporation require the approval of two-thirds of all shares outstanding in order to effect a merger, share exchange, or other reorganization of PSB. This provision may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price, or otherwise adversely affect the market price of our common stock.

 

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Our earnings may be adversely affected by changes in accounting principles and in tax laws.

 

Changes in U.S. generally accepted accounting principles could have a significant adverse effect on our reported financial results. Although these changes may not have an economic impact on our business, they could affect our ability to attain targeted levels for certain performance measures, which could reduce our ability to meet existing financial covenants, obtain additional funding, or raise capital. We, like all businesses, are subject to tax laws, rules, and regulations. Changes to tax laws, rules, and regulations, including changes in the interpretation or implementation of tax laws, rules, and regulations by the Internal Revenue Service (the “IRS”) or other governmental bodies, could affect us in substantial and unpredictable ways. The Federal government could also choose to assess excise or other income related taxes targeted at the banking industry in response to widespread financial disruptions or perceived industry abuses that impacted taxpayers as a whole. Such changes could subject us to additional costs, among other things. Failure to appropriately comply with tax laws, rules, and regulations could result in sanctions by regulatory agencies, civil money penalties, and/or reputational damage, which could have a material adverse effect on our business, financial condition, and results of operations.

 

Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business.

 

Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, impair our ability to process or complete customer transactions, and/or cause us to incur additional expenses. Although management has established disaster recovery plans and procedures, the occurrence of any such event could have a material adverse effect on our business, financial condition, and results of operations.

 

Item 1B.    UNRESOLVED STAFF COMMENTS.

 

Not applicable.

 

Item 2.       PROPERTIES.

 

Our administrative offices are housed in the same building as Peoples State Bank’s primary customer service location at 1905 Stewart Avenue in Wausau, Wisconsin, which was constructed in 2004. Our other Wisconsin branch locations, in the order they were first purchased or opened for business, include Rib Mountain, Wausau (Eastside), Eagle River (in the Trig’s grocery store), Rhinelander Anderson Street, Minocqua, Weston, Marathon City, and Rhinelander Lincoln Street. The branch in the Trig’s grocery store occupies leased space within the supermarket designed for community banking operations. We own the other eight locations without encumbrance, and these locations are occupied solely by us and are suitable for current operations.

 

Based on information filed with regulators by other banking organizations headquartered in Wisconsin with at least $100 million in total assets, the average age of our banking facilities is comparable with other banks. In addition, our average revenues and number of accounts per branch are similar to the state average, giving us adequate capacity for organic growth within existing markets reducing the need for significant further investment in existing facilities.

 

Item 3.       LEGAL PROCEEDINGS.

 

We are subject to claims and litigation in the ordinary course of business, but we do not believe that any of these claims or litigation matters that are currently outstanding will have a material adverse effect on our consolidated financial position, results of operations, or liquidity.

 

Item 4.       MINE SAFETY DISCLOSURES.

 

Not applicable.

 

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PART II

 

Item 5.       MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

Market

 

PSB common stock bid and ask prices are quoted on the OTC Markets Exchange under the stock symbol “PSBQ.” There is no active established public trading market in our common stock and transactions in the stock are limited and sporadic. Approximately 11% of average shares outstanding traded during 2014 compared to 7% during 2013 and 10% during 2012.

 

Although our primary focus is to preserve existing capital for growth, merger and acquisition activities, and new regulation which increases regulatory capital requirements, we periodically repurchase our shares of common stock on the open market or directly from shareholders. During 2014, we repurchased 27,244 shares of our common stock (1.6% of total average shares outstanding) at an average cost of $33.54 per share. During 2013, we repurchased 10,030 shares of our common stock (0.6% of total average shares outstanding) at an average cost of $26.78 per share. During 2012, we repurchased 10,210 shares of our common stock at an average cost of $25.68 per share (0.6% of total average shares outstanding).

 

Holders

 

As of December 31, 2014, there were 769 holders of record of our common stock. Some of our shares are held in “street” name brokerage accounts and the number of beneficial owners of these shares is not known and therefore not included in the foregoing number.

 

Dividends

 

We have paid regular and increasing dividends since our inception in 1995. We expect to continue our practice of paying semi-annual dividends on our common stock, although the payment of future dividends will continue to depend upon our earnings, capital requirements, financial condition, and other factors. The principal source of funds for our payment of dividends is dividend income received from our bank subsidiary. When declared, dividends are paid to all stockholders, including employees holding shares of unvested restricted stock as described in Item 8, Note 19 of the Notes to Consolidated Financial Statements. Payment of dividends by Peoples State Bank to PSB Holdings, Inc. is subject to various limitations under banking laws and regulations. To maintain regulatory capital ratios above the minimums to be considered “well capitalized”, the maximum amount of dividends that could have been paid by Peoples State Bank at December 31, 2014, was approximately $23 million. Furthermore, any Bank dividend distributions to PSB above customary or historical levels are subject to approval by the FDIC, the Bank’s primary federal regulator, and the Wisconsin Department of Financial Institutions, the Bank’s state regulator.

 

Market Prices and Dividends

 

Price ranges of over-the-counter quotations and dividends declared per share on our common stock for the periods indicated are:

 

   2014 Prices   2013 Prices 
Quarter  High   Low   Dividends   High   Low   Dividends 
1st  $32.00   $30.10   $   $28.10   $25.25   $ 
2nd  $32.76   $31.75   $0.40   $29.60   $27.80   $0.39 
3rd  $33.60   $32.10   $   $31.50   $29.40   $ 
4th  $36.15   $33.65   $0.40   $31.00   $29.75   $0.39 

 

Prices detailed for the common stock represent the bid prices reported on the OTC Markets Exchange. The prices do not reflect retail mark-up, mark-down, or commissions, and may not necessarily represent actual transactions.

 

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Item 6.       SELECTED FINANCIAL DATA.

 

Table 1: Earnings Summary and Selected Financial Data (dollars in thousands, except per share data)

 

Consolidated summary of earnings:                    
Years ended December 31,  2014   2013   2012   2011   2010 
                     
Total interest income  $26,618   $26,816   $27,244   $28,314   $29,665 
Total interest expense   4,486    5,511    7,091    8,757    10,566 
                          
Net interest income   22,132    21,305    20,153    19,557    19,099 
Provision for loan losses   560    4,015    785    1,390    1,795 
                          
Net interest income after loan loss provision   21,572    17,290    19,368    18,167    17,304 
Total noninterest income   5,694    5,623    6,568    5,337    5,363 
Total noninterest expense   17,920    16,506    17,392    15,778    15,925 
                          
Net income before income taxes   9,346    6,407    8,544    7,726    6,742 
Provision for income taxes   2,906    1,663    2,535    2,421    1,988 
                          
Net income  $6,440   $4,744   $6,009   $5,305   $4,754 

 

Consolidated summary balance sheets:                    
As of December 31,  2014   2013   2012   2011   2010 
                     
Cash and cash equivalents  $25,106   $31,522   $48,847   $38,205   $40,331 
Securities   144,157    133,279    145,209    108,677    108,379 
Total loans receivable, net of allowance   525,583    509,880    477,991    437,557    431,801 
Premises and equipment, net   10,841    9,669    10,240    9,928    10,464 
Cash surrender value of life insurance   13,230    12,826    11,813    11,406    10,899 
Other assets   15,450    14,365    17,866    17,094    19,219 
                          
Total assets  $734,367   $711,541   $711,966   $622,867   $621,093 
                          
Total deposits  $622,951   $577,514   $565,442   $481,509   $465,257 
FHLB advances   20,271    38,049    50,124    50,124    57,434 
Other borrowings   10,324    20,441    20,728    19,691    31,511 
Senior subordinated notes   4,000    4,000    7,000    7,000    7,000 
Junior subordinated debentures   7,732    7,732    7,732    7,732    7,732 
Other liabilities   7,628    7,052    6,493    6,449    5,469 
Stockholders’ equity   61,461    56,753    54,447    50,362    46,690 
                          
Total liabilities and stockholders’ equity  $734,367   $711,541   $711,966   $622,867   $621,093 

 

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Performance ratios:  2014   2013   2012   2011   2010 
                     
Basic earnings per share  $3.90   $2.87   $3.61   $3.21   $2.89 
Diluted earnings per share  $3.90   $2.87   $3.61   $3.21   $2.89 
Common dividends declared per share  $0.80   $0.78   $0.74   $0.71   $0.69 
Dividend payout ratio   20.43%   27.17%   20.75%   22.02%   23.73%
Tangible net book value per share at year-end  $37.52   $34.36   $32.93   $30.44   $28.43 
Average common shares outstanding   1,651,045    1,652,700    1,663,147    1,652,861    1,642,469 
                          
Return on average stockholders’ equity   10.75%   8.37%   11.33%   10.78%   10.59%
Return on average assets   0.90%   0.68%   0.91%   0.87%   0.79%
Net interest margin (tax adjusted)   3.38%   3.38%   3.41%   3.55%   3.51%
Net loan charge-offs to average loans   0.18%   0.92%   0.28%   0.32%   0.33%
Noninterest income to average assets   0.79%   0.81%   1.00%   0.88%   0.89%
Noninterest income to tax adjusted net interest margin   24.70%   25.25%   31.23%   26.29%   26.93%
                          
Efficiency ratio (tax adjusted)   62.33%   59.17%   63.02%   61.55%   63.01%
Salaries and benefits expense to average assets   1.37%   1.31%   1.39%   1.37%   1.40%
Other expenses to average assets   1.12%   1.07%   1.25%   1.23%   1.23%
FTE employees at year-end   143    131    131    124    126 
Non-performing loans to gross loans at year-end   2.40%   1.67%   2.20%   3.19%   2.60%
Allowance for loan losses to loans at year-end   1.20%   1.31%   1.53%   1.78%   1.81%
Allowance for loan losses to non-performing loans   50.22%   78.52%   69.55%   55.80%   69.62%
Average common equity to average assets   8.34%   8.16%   8.04%   8.11%   7.43%
Non-performing assets to common equity and allowance for loan losses at year-end   21.25%   16.35%   20.13%   30.67%   29.99%

 

Item 7.       MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Management’s discussion and analysis (“MD&A”) reviews significant factors with respect to our financial condition and results of our operations for each of the three years in the period ended December 31, 2014. The following MD&A concerning our operations is intended to satisfy three principal objectives:

 

Provide a narrative explanation of our financial statements that enables investors to see the company through the eyes of management;

 

Enhance the overall financial disclosure and provide the context within which our financial information should be analyzed; and,

 

Provide information about the quality of, and potential variability of, our earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.

 

Management’s discussion and analysis, like other portions of this Annual Report on Form 10-K, includes forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, our anticipated future financial performance involves risks and uncertainties that may cause actual results to differ materially from those described in our forward-looking statements. A cautionary statement regarding forward-looking statements is set forth under the caption “Forward-Looking Statements” in Item 1A of this Annual Report on Form 10-K. This discussion and analysis should be considered in light of that cautionary statement.

 

This discussion should be read in conjunction with the consolidated financial statements, notes, tables, and the selected financial data presented elsewhere in this report. All figures are in thousands, except per share data and per employee data.

 

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EXECUTIVE LEVEL OVERVIEW

 

Results of Operations

 

Earnings reached a record high of $3.90 per share (on net income of $6,440) during 2014 compared to earnings of $2.87 per share (on net income of $4,744) during 2013, an increase of 36% per share. Earnings in 2014 benefited from significantly lower provision for loan losses expense compared 2013, which included a $3,340 credit write-down related to customer fraud. However, 2014 included $371 of merger and acquisition expense on the purchase of the Northwoods National Bank, Rhinelander, Wisconsin branch of The Baraboo National Bank (“Northwoods Rhinelander”). As shown in Table 2, excluding these non-recurring items and other gains and losses, proforma 2014 earnings would have been $4.06 per share (on proforma net income of $6,698), compared to proforma 2013 earnings of $3.91 per share (on proforma net income of $6,463), an increase of 4% per share. Compared to 2013 before special items, an $827 increase in net interest income due to asset growth and a $310 decline in 2014 credit costs, down 28%, offset an $824 increase in operating costs, up 5%.

 

During 2015, we expect net interest income to increase slightly compared to 2014 on slower loan growth with similar net interest margin. Mortgage banking revenue is also expected to increase over 2014 on an improving local real estate market and continued increase in market share. Operating expenses are anticipated to grow an inflationary amount. In addition, an accelerated stock buyback program during 2015 is expected to support earnings per share growth. Taken together, 2015 earnings per share are expected to increase slightly from 2014 earnings of $3.90 per share but could be negatively impacted by an increase in short-term interest rates by the Federal Reserve expected to occur during 2015 which could reduce net interest margin.

 

Earnings declined during 2013 to $2.87 per share (on net income of $4,744) compared to earnings in 2012 of $3.61 per share (on net income of $6,009), a decrease of 21% per share. Earnings during 2013 and 2012 were significantly impacted by special items including a $3,340 credit write-down related to customer fraud during 2013 and nonrecurring income and expense from our acquisition of Marathon State Bank during 2012. As shown in Table 2, excluding non-recurring items and other gains and losses, proforma 2013 earnings per share would have been $3.91 (on proforma net income of $6,463), compared to proforma 2012 earnings of $3.48 per share (on proforma net income of $5,783), an increase of 12% per share. Increased 2013 proforma earnings were driven by increased net interest income on earning assets during 2013 compared to 2012.

 

Earnings reached a then record high of $3.61 per share in 2012 (on net income of $6,009) compared to earnings of $3.21 per share in 2011 (on net income of $5,305), an increase of 13% per share. Earnings benefited significantly from the acquisition of Marathon State Bank in June 2012, and approximately $463, or 66%, of the 2012 increase in net income over 2011 was due to the purchase of Marathon. We recorded an $851 gain on bargain purchase of Marathon ($726 after tax effects), but also incurred $670 of data conversion expense and professional fees due to the merger ($498 after tax effects) during 2012. Excluding these non-recurring items associated with the Marathon acquisition and other items as shown in Table 2, proforma earnings per share would have been $3.48 per share during 2012 (on proforma net income of $5,783), an increase of 9% per share over proforma 2011 earnings of $3.19 per share (on proforma net income of $5,277).

 

Credit Quality

 

During 2014, the total provision for loan losses and loss on foreclosed assets (“credit costs”) were $793, compared to $4,443 during 2013. The 2013 credit costs included a $3,340 provision for loan losses due to the write down of a loan to a grain commodities dealer who was discovered to have misrepresented financial statements, inventory records, and federal warehouse receipts taken as collateral in a fraud that impacted several banks. Total credit costs before the large grain loss were $1,103 in 2013 compared to $793 in 2014, a decline of $310, down 28% on a proforma basis. Total 2014 net loan charge-offs were .18% of average loans outstanding compared to .92% of average loans (.26% excluding the large grain charge-off) during 2013. During 2014, nonperforming assets increased $4,034, or 39%, led by a $3,092 increase in performing but restructured loans on the addition of a $2,775 restructured municipal loan. Total nonperforming assets were $14,423, or 1.96%, of total assets at December 31, 2014 compared $10,389, or 1.46% of total assets at December 31, 2013.

 

During 2015, total credit costs are expected to remain similar to those during 2014 as loss on foreclosed assets is expected to decline slightly due to a smaller inventory of foreclosed assets and projected lower write-down of foreclosed asset values compared to 2014, while the provision for loan losses is expected to increase slightly due to loan growth. However, we continue to work through existing problem loans and foreclosed assets with uncertain outcomes, which could increase nonperforming assets and credit and foreclosure costs greater than expected, negatively impacting 2015 net income.

 

During 2013, the total provision for loan losses and loss on foreclosed assets were $4,443, which included the $3,340 large grain loan loss. Total credit costs before the large grain loss were $1,103 compared to $1,358 during 2012. Total 2013 net loan charge-offs were .92% of average loans outstanding (.26% excluding the large grain charge-off) compared to .28% during 2012. During 2013, nonperforming assets declined $2,065, or 17%, led by a decline in restructured loans accruing interest while nonaccrual loans also declined slightly. Total nonperforming assets were $10,389, or 1.46%, of total assets at December 31, 2013 compared to $12,454, or 1.75%, of total assets at December 31, 2012.

 

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During 2012, total credit costs of $1,358 declined $1,229, or 48% compared to 2011 due to recognition of fewer new problem loans, and lower holding costs and write-downs of foreclosed assets. The reduction in credit costs was a significant driver of increased net income during 2012. During 2012, total nonperforming assets declined $5,429, or 30%, due to favorable resolution of three problem credit relationships and sale of our largest foreclosed asset. Resolution of these four problem assets represented $5,375, or 99% of the net decline in total nonperforming assets during 2012 compared to 2011. Total nonperforming assets were $12,454, or 1.75% of total assets at December 31, 2012 compared to $17,883, or 2.87% of total assets at December 31, 2011.

 

Asset Growth and Liquidity

 

Total assets were $734,367 at December 31, 2014 compared to $711,541 at December 31, 2013, up $22,826, or 3.2%, due to an increase in net loans receivable of $15,703, up 3.1%. The loan increase included $16,591 of purchased Northwoods branch loans held at December 31, 2014, and an $888 decline in existing market loans year to date. In addition to loan growth, a $10,878 increase in investment securities was primarily funded by a $6,416 decline in cash and cash equivalents during the year ended December 31, 2014. Total local deposits increased $52,658 during the year ended December 31, 2014 due in part to $33,054 in purchased Northwoods branch deposits retained at December 31, 2014 (approximately 82% of the original purchased deposits) with other existing market deposits increasing $19,604, or 3.8% since December 31, 2013. In addition to funding loan growth, the increase in total deposits was used to repay $32,999 of wholesale funding year to date. Wholesale funding (including brokered certificates of deposit, Federal Home Loan Bank advances, and wholesale repurchase agreements) was $75,909 (10.3% of total assets) at December 31, 2014 compared to $108,908 (15.3% of total assets) at December 31, 2013. During 2015, loan growth is expected to increase slightly on increased customer demand but be limited by a very competitive lending market, which could reduce net interest margins. A decline in loan growth or in net interest margin compared to 2014 would likely reduce net interest income, negatively impacting 2015 net income.

 

During the year ended December 31, 2013, cash and cash equivalents and investment securities declined $29,255 to fund $12,777 in commercial related loan growth, up 3.7%, and $18,878 in residential real estate loan growth, up 13.5%. Since December 31, 2012, local deposits increased $9,170, up 1.8%, which were used to pay down maturing wholesale funding by $9,173, down 7.8%. Wholesale funding (including brokered certificates of deposit, Federal Home Loan Bank advances, and wholesale repurchase agreements) was $108,908 (15.3% of total assets) at December 31, 2013 compared to $118,081 (16.6% of total assets) at December 31, 2012.

 

Our most significant sources of liquidity and wholesale funding include federal funds purchased from correspondent banks, FHLB advances, brokered and national certificates of deposit, and Federal Discount Window advances. In addition to our existing $25,106 in cash and cash equivalents at December 31, 2014, we have $347,823 of unused funding available at December 31, 2014, which is considered adequate to meet customer, operational, and growth needs during 2015. Most of our wholesale funding sources require either pledging of assets, maintenance of well-capitalized regulatory status, or additional purchases of FHLB capital stock (or all of these items) to continue or expand participation in the funding program. In particular, $138,881 of potential FHLB advance funding considered available at December 31, 2014, would require additional purchase of up to $4,388 of additional FHLB capital stock, which pays a nominal dividend and for which no trading market exists.

 

Capital Resources

 

During the year ended December 31, 2014, stockholders’ equity increased $4,708 primarily from $5,124 of retained net income during the period after payment of $1,316 in shareholder dividends. During 2014, the company repurchased 27,244 shares of common stock at an average cost of $33.54 per share which reduced equity $913, while 10,030 shares were repurchased at an average cost of $26.78 per share during the year ended December 31, 2013 which reduced equity $269. PSB intends to continue its quarterly stock buyback plan during 2015 quarter with shares purchased directly from shareholders or on the open market at prevailing prices as opportunities arise. All other increases to stockholders’ equity during 2014 total $497 including a $288 increase in other comprehensive income.

 

Tangible net book value increased to $37.52 per share at December 31, 2014, compared to $34.36 per share at December 31, 2013, an increase of 9.2%. Our stockholders’ equity to assets ratio increased to 8.37% at December 31, 2014 compared to 7.98% at December 31, 2013 due to increased retained earnings with modest asset growth during 2014. For regulatory purposes, the $7.7 million junior subordinated debentures maturing September 2035 reflected as debt on the Consolidated Balance Sheet are reclassified as Tier 1 regulatory equity capital. PSB’s subsidiary, Peoples State Bank, was considered “well capitalized” under banking regulations at December 31, 2014.

 

In July 2013, the banking regulatory agencies finalized new regulatory rules applicable to all banks which were described previously in Item 1 to this Annual Report on Form 10-K under the subheading Capital Adequacy. The new rules expand the number of capital measurements and the new minimums over which a bank may pay dividends, certain executive compensation, or be considered adequately capitalized. Other changes addressed the amount of capital required on a “risk adjusted” basis for certain assets and other obligations. The new rules were effective on January 1, 2015, with an extended implementation period for certain measures. We expect regulatory capital ratios to be negatively impacted when the changes are fully implemented, but do not expect to issue additional common stock solely to meet the new requirements or that recurring operations or growth potential will be significantly impacted.

 

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During 2015, we expect to continue payment of our semi-annual cash dividend assuming continued profits and adequate regulatory capital ratios after consideration of risk, new regulatory capital demands, and growth potential. Because our primary growth focus is on market and core deposit expansion via merger and acquisition of other banks with relatively low credit risk profiles and near our current markets, we could retain capital for potential acquisitions. However, if value added merger and acquisition options do not materialize in the near term, we expect to expand our repurchase of treasury stock on the open market under a discretionary buyback program. Stock buybacks would decrease existing capital ratios but would be expected to increase current earnings or net book value per share. Any future growth through merger and acquisition activities should be expected to drain excess capital levels and could increase the likelihood of a new common or preferred stock capital raise, potentially diluting existing stockholders.

 

During 2013, total stockholders’ equity increased $2,306, primarily from $4,744 of net income less $1,289 of dividends declared and further offset by a $1,204 reduction in unrealized gains on fixed rate securities as national interest rates increased in response to expected actions by the Board of Governors of the Federal Reserve if national economic conditions improve. During 2013 we repurchased 10,030 shares of treasury stock on the open market at an average price of $26.78 per share, which reduced equity $269. Tangible net book value increased to $34.36 per share at December 31, 2013 compared to $32.93 per share at December 31, 2012, an increase of 4.3%. Common stockholders’ equity was 7.98% of total assets at December 31, 2013 compared to 7.65% of assets at December 31, 2012. During 2013, we refinanced $7 million of 8% senior subordinated notes with $1 million of cash and $6 million in proceeds from issuance of new debt. The new debt included $4 million of privately placed senior subordinated notes carrying a 3.75% fixed interest rate with interest only payments, due in 2018, and $2 million in a fully amortizing term note with a correspondent bank carrying a floating rate of interest and maturing in 2015. Although the previous 8% notes qualified as Tier 2 regulatory capital, the new $6 million in notes do not qualify as regulatory capital. The refinancing reduced 2013 interest expense by $340 compared to 2012 and contributed to increased proforma net income (prior to the large grain loss) in 2013 compared to the prior year.

 

Off-Balance-Sheet Arrangements and Contractual Obligations

 

Our largest volume off-balance sheet activity involves our servicing of payments and related collection activities on $279,865 of residential 1 to 4 family mortgages sold to FHLB and FNMA at December 31, 2014, up $7,585, or 2.8%, from $272,280 at December 31, 2013, which was up 1.0% from $269,554 at December 31, 2012. In general, we are paid an annualized servicing fee of .25% of serviced principal which is recorded as a component of mortgage banking revenue. We expect to see lower mortgage refinance activity during 2015 and serviced mortgage loan principal is likely to grow at a slower pace than seen during 2014.

 

At December 31, 2014, we have provided a credit enhancement against FHLB loss on $18,834, or 6.7%, of the serviced principal, up to a maximum guarantee of $949 in the aggregate. However, we would incur such loss only if the FHLB first lost $1,412 on this loan pool as part of their “First Loss Account”. We have not provided a credit enhancement guarantee on any loans sold to the FHLB since prior to 2009 and we have no intentions of originating future loans with the guarantee. Loan pools containing our guarantees were originated during 2000 through 2008 and have incurred cumulative life to date principal losses of $631 out of $424,452 of loan principal originated with guarantees, all of which has been borne by the FHLB within their First Loss Account. We do not maintain any recourse liability for credit enhancement guarantee losses because we do not expect to incur any significant future losses under this guarantee.

 

All loans sold to FHLB or FNMA in which we retain the loan servicing are subject to underwriting representations and warranties made by us as the originator and we are subject to annual underwriting audits from both entities. Our representations and warranties would allow FHLB or FNMA to require us to repurchase inadequately originated loans for any number of underwriting violations even if we had not provided a credit enhancement on the mortgage. Provision for representation and warranty losses were $8, $294, and $0 during 2014, 2013, and 2012, respectively. We maintained a reserve liability for potential future representation and warranty losses of $85 at December 31, 2014.

 

We provide various commitments to extend credit for both commercial and consumer purposes totaling approximately $124 million at December 31, 2014 compared to $119 million at December 31, 2013 and $105 million at December 31, 2012. These lending commitments are a traditional and customary part of lending operations and many of the commitments are expected to expire without being drawn upon.

 

Our primary long-term contractual obligations are related to repayment of funding sources such as FHLB advances, long-term other borrowings, and customer time deposits, which make up 93% of our total long-term contractual obligations. For all contractual obligations outstanding at December 31, 2014, $94 million, or 44%, will require repayment, or extension through refinancing, during 2015, including $10 million of FHLB advances and $84 million of time deposits, both of which are regularly renewed in the normal course of business.

 

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We offer certain high credit quality customers fixed interest rate swaps to hedge their risk on variable rate commercial real estate loans with us. Fixed interest rate swaps sold to customers (in which we pay a variable rate and receive a fixed rate) are simultaneously offset by our purchase of a variable interest rate swap from a correspondent bank (in which we pay a fixed rate and receive a variable rate). Such swap sale programs are often referred to “back to back” interest rate swaps as the resulting fixed interest rate risk with our customer is offset by our variable interest rate risk with our counterparty. At December 31, 2014 and 2013, there were $13,646 and $14,323, respectively, in back to back swaps outstanding with variable rate commercial real estate loan customers.

 

RESULTS OF OPERATIONS

 

Earnings

 

Table 1 of Item 6 of this Annual Report on Form 10-K presents various financial performance ratios and measures for each of the five years in the period ended December 31, 2014. A number of separate or nonrecurring factors impacted our earnings during this period. Table 2 presents our net income for each of the five years in the period ended December 31, 2014, before certain tax-adjusted nonrecurring income and expense items.

 

Table 2: Summary Operating Income

 

Year ended December 31,
($000s)   2014    2013    2012    2011    2010 
                          
Net income before special items, net of tax  $6,698   $6,463   $5,783   $5,277   $4,770 
                          
Net gain (loss) on sale of assets:                         
                          
Net gain (loss) on write-down and sale of securities   2    7        19    (12)
Net gain (loss) on sale of premises and equipment   (35)       (2)   9    (4)
Net loss on sale of credit card loan principal       (19)            
                          
Total net gain (loss) on sale of assets, net of tax   (33)   (12)   (2)   28    (16)
                          
Large grain customer fraud credit loss:                         
                          
Provision for grain credit loss       (2,031)            
Grain credit loss legal and collection expense       (27)            
Reduced employee benefits related to grain credit loss       278             
                          
Total large grain customer fraud credit loss, net of tax       (1,780)            
                          
Nonrecurring merger and acquisition income (expense):                         
                          
Gain on bargain purchase           726         
Merger and acquisition professional expense   (89)       (233)        
Data processing conversion expense   (136)       (265)        
Benefit from amendment of acquired bank tax returns       73              
                          
Total nonrecurring merger and acquisition income, net of tax   (225)   73    228         
                          
Net income as reported  $6,440   $4,744   $6,009   $5,305   $4,754 
                          
Diluted earnings per share before special items  $4.06   $3.91   $3.48   $3.19   $2.90 
Diluted earnings per share as reported  $3.90   $2.87   $3.61   $3.21   $2.89 

 

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2014 compared to 2013

 

Earnings per share increased 35.9% during 2014 to $3.90 per share compared to earnings of $2.87 per share during 2013. Prior year earnings were reduced $1,780 after tax benefits from a fraudulent large grain credit write-down. During 2014, earnings were also impacted by merger and conversion costs related to our purchase of Northwoods Rhinelander. Table 2 above outlines these significant nonrecurring items and displays proforma 2014 net income before these items of $6,698 ($4.06 per share) compared to proforma net income of $6,463 ($3.91 per share) during 2013, an increase of 3.8% per share. Return on average assets was .90% (.93% before the special items outlined in Table 2) and .68% (.93% before the special items) during 2014 and 2013, respectively. Return on average stockholders’ equity was 10.75% (11.18% before the special items outlined in Table 2) and 8.37% (11.40% before the special items) during 2014 and 2013, respectively. Compared to the prior year before the special items, an $827 increase in net interest income due to asset growth and a $310 decline in 2014 credit costs, down 28%, offset an $824 increase in operating costs, up 5%.

 

During 2015, we expect net interest margin to remain similar to that seen during 2014 but for loan growth to be challenging. Total noninterest income and noninterest expense are expected to increase similar amounts, resulting in net operating expense to be similar to 2014. Because 2015 earnings growth is likely to be dependent on loan growth and stable net interest margin, strong levels of competition amount lenders in our market and the timing of an expected increase in short-term interest rates by the Federal Reserve Open Markets Committee could have a negative impact on 2015 net income.

 

2013 compared to 2012

 

Earnings per share declined 20.5% during 2013 to $2.87 per share compared to record earnings of $3.61 per share during 2012. Both periods included significant non-recurring items which impacted net income, including a $1,780 reduction to net income in 2013 related to a fraudulent large grain credit write-down of $3,340 while our purchase of Marathon State Bank during 2012 increased net income by $228 primarily due to a gain on bargain purchase. Table 2 above outlines these significant nonrecurring items and displays proforma 2013 net income before these items of $6,463 ($3.91 per share) compared to proforma net income of $5,783 ($3.48 per share) during 2012, an increase of 12.3% per share. Return on average assets was .68% (.93% before the special items outlined in Table 2) and .91% (.88% before the special items) during 2013 and 2012, respectively. Return on average stockholders’ equity was 8.37% (11.40% before the special items outlined in Table 2) and 11.33% (10.91% before the special items) during 2013 and 2012, respectively.

 

Excluding the 2013 special items outlined in Table 2, proforma 2013 net income benefited from a $1,245 increase in tax adjusted net interest income, up 5.9% and a $215 reduction in credit costs (including provision for loan losses and loss on foreclosed assets), down 15.8% compared to 2012. Offsetting these income increases was a $346 increase in proforma operating expense (excluding losses on foreclosed assets for both 2013 and 2012), up 2.1%. Proforma noninterest income before gain (loss) on sale of other assets declined $84, or 1.5% during 2013 compared to 2012 as a $204 decline (11.4%) in mortgage banking income was offset by a $208 increase (28.3%) in investment and insurance sales commissions.

 

2012 compared to 2011

 

Earnings were a then record high $3.61 per diluted share during 2012 but were significantly impacted by non-recurring income and expense associated with the purchase of Marathon State Bank during 2012. An $851 gain on the purchase was recorded, which increased net income $726 after tax expense. Separately, we incurred $233 of merger and acquisition legal and other professional fees which reduced net income $233 after taxes as such costs were treated as an adjustment to the Marathon cost basis under tax rules and were therefore not deductible. Lastly, we incurred $438 of data conversion expense associated with placing Marathon customer and account information on our operating system, which reduced net income $265 after tax benefits. As shown in Table 2, diluted earnings per share before special items were $3.48 during 2012 compared to $3.19 during 2011, an increase of 9.1%. Return on average assets was .91% (.88% before the special items outlined in Table 2) and .87% during 2012 and 2011, respectively. Return on average stockholders’ equity was 11.33% (10.91% before the special items outlined in Table 2) and 10.78% during 2012 and 2011, respectively.

 

Separate from Marathon’s special acquisition items noted above, Marathon’s recurring operations increased our net interest income and operating expense during the seven months following our purchase. Net interest income of $20,153 during 2012 increased $596, or 3.0%, compared to 2011. Our noninterest income before the gain on purchase of Marathon increased $380, or 7.1%, during 2012, compared to 2011, from a $422 increase in mortgage banking income on customer refinance activity. Lastly, income benefited significantly from a decline in credit costs (provision for loan losses and loss on foreclosed assets) of $1,229, or 47.5%, during 2012 compared to 2011. Offsetting these income gains was an increase in operating expense before Marathon’s special items and credit costs of $1,567, or 10.7%. The expense increase was led by higher wages and benefits, up $832, or 10.0%, and higher data processing expense (excluding the Marathon conversion costs) of $476, up 34.4%, as one-time fee reductions we enjoyed following our bank-wide data processing conversion during 2010 and 2011 expired.

 

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Net Interest Income

 

Net interest income is our largest source of revenue from operations. Net interest income represents the difference between interest earned on loans, securities, and other interest-earning assets, and the interest expense associated with the deposits and borrowings that fund them. Interest rate fluctuations together with changes in volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. Additionally, net interest income is impacted by the sensitivity of the balance sheet to change in interest rates, contractual maturities, and repricing frequencies. Net interest income is our most significant item of revenue generated by operations.

 

Table 3 presents changes in the mix of average earning assets and interest bearing liabilities for the three years ending December 31, 2014. In general, net interest income earned on loans funded by savings and demand deposits is greater than that earned on securities funded by time deposits. Therefore, a balance sheet that contains a growing allocation of loans funded by a growing allocation of savings and demand deposits would normally provide greater net interest income than a growing allocation of securities funded by a growing allocation of time deposits.

 

Table 3: Mix of Average Interest Earning Assets and Average Interest Bearing Liabilities

 

Year ending December 31,  2014   2013   2012 
             
Loans   76.8%   77.1%   75.0%
Taxable securities   12.9%   12.6%   14.9%
Tax-exempt securities   7.9%   8.1%   6.8%
FHLB stock   0.4%   0.5%   0.5%
Other   2.0%   1.7%   2.8%
                
Total interest earning assets   100.0%   100.0%   100.0%
                
Savings and demand deposits   32.3%   31.4%   29.4%
Money market deposits   25.3%   22.1%   21.0%
Time deposits   31.2%   29.9%   33.5%
FHLB advances   5.7%   10.4%   9.7%
Other borrowings   3.4%   4.0%   3.6%
Senior subordinated notes   0.7%   0.8%   1.3%
Junior subordinated debentures   1.4%   1.4%   1.5%
                
Total interest bearing liabilities   100.0%   100.0%   100.0%

 

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Tables 4, 5, and 6 present average balance sheet data and related average interest rates on a tax equivalent basis and the impact of changes in the earnings assets base for the three years in the period ended December 31.

 

Table 4: Average Balances and Interest Rates

 

   2014   2013   2012 
   Average Balance   Interest   Yield/ Rate   Average Balance   Interest   Yield/ Rate   Average Balance   Interest   Yield/ Rate 
Assets                                    
Interest-earning assets:                                    
Loans(1)(2)(3)  $523,712   $22,784    4.35%  $508,454   $23,316    4.59%  $462,237   $23,667    5.12%
Taxable securities   87,930    2,398    2.73%   83,049    2,098    2.53%   91,747    2,402    2.62%
Tax-exempt securities(2)   53,822    2,279    4.23%   53,549    2,289    4.27%   41,825    1,959    4.68%
FHLB stock   2,556    13    0.51%   3,138    14    0.45%   2,817    9    0.32%
Other   14,208    69    0.49%   11,542    67    0.58%   17,445    82    0.47%
                                              
Total(2)   682,228    27,543    4.04%   659,732    27,784    4.21%   616,071    28,119    4.56%
                                              
Non-interest-earning assets:                                             
Cash and due from banks   10,410              10,476              17,979           
Premises and equipment, net   10,579              9,935              10,078           
Cash surrender value life insurance   13,014              12,257              11,597           
Other assets   9,434              9,557              11,427           
Allowance for loan losses   (6,821)             (7,426)             (7,799)          
                                              
Total  $718,844             $694,531             $659,353           
                                              
Liabilities & stockholders’ equity                                             
Interest-bearing liabilities:                                             
Savings and demand deposits  $179,449   $296    0.16%  $172,249   $383    0.22%  $154,428   $782    0.51%
Money market deposits   140,248    368    0.26%   121,351    406    0.33%   110,587    586    0.53%
Time deposits   172,784    2,171    1.26%   164,392    2,262    1.38%   176,187    2,793    1.59%
FHLB borrowings   31,591    601    1.90%   57,035    1,285    2.25%   50,941    1,414    2.78%
Other borrowings   18,649    560    3.00%   21,862    650    2.97%   19,190    596    3.11%
Senior subordinated notes   4,000    150    3.75%   4,600    184    4.00%   7,000    578    8.26%
Junior subordinated debentures   7,732    340    4.40%   7,732    341    4.41%   7,732    342    4.42%
                                              
Total   554,453    4,486    0.81%   549,221    5,511    1.00%   526,065    7,091    1.35%
                                              
Non-interest-bearing liabilities:                                             
Demand deposits   97,884              82,506              73,135           
Other liabilities   6,583              6,117              7,128           
Stockholders’ equity   59,924              56,687              53,025           
                                              
Total  $718,844             $694,531             $659,353           
                                              
Net interest income       $23,057             $22,273             $21,028      
Rate spread             3.23%             3.21%             3.21%
Net yield on interest-earning assets             3.38%             3.38%             3.41%

 

(1) Nonaccrual loans are included in the daily average loan balances outstanding.

(2) The yield on tax-exempt loans and securities is computed on a tax-equivalent basis using a tax rate of 34%.

(3) Loan fees are included in total interest income as follows: 2014 - $391, 2013 - $522, 2012 - $724.

 

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Table 5: Interest Income and Expense Volume and Rate Analysis

 

  2014 compared to 2013   2013 compared to 2012 
   increase (decrease) due to (1)   increase (decrease) due to (1) 
   Volume   Rate   Net   Volume   Rate   Net 
                         
Interest earned on:                        
 Loans(2)  $664   $(1,196)  $(532)  $2,121   $(2,472)  $(351)
 Taxable securities   133    167    300    (220)   (84)   (304)
 Tax-exempt securities(2)   12    (22)   (10)   501    (171)   330 
 FHLB stock   (3)   2    (1)   1    4    5 
 Other interest income   13    (11)   2    (34)   19    (15)
                               
Total   819    (1,060)   (241)   2,369    (2,704)   (335)
                               
Interest paid on:                              
 Savings and demand deposits   12    (99)   (87)   39    (438)   (399)
 Money market deposits   49    (87)   (38)   36    (216)   (180)
 Time deposits   106    (197)   (91)   (163)   (368)   (531)
 FHLB borrowings   (483)   (201)   (684)   137    (266)   (129)
 Other borrowings   (96)   6    (90)   79    (25)   54 
 Senior subordinated notes   (23)   (11)   (34)   (96)   (298)   (394)
 Junior subordinated debentures       (1)   (1)       (1)   (1)
                               
Total   (435)   (590)   (1,025)   32    (1,612)   (1,580)
                               
Net interest earnings  $1,254   $(470)  $784   $2,337   $(1,092)  $1,245 

 

(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

(2) The yield on tax-exempt loans and investment securities has been adjusted to its fully taxable equivalent using a 34% tax rate.

 

Table 6: Yield on Earning Assets

 

Year ended December 31,  2014   2013   2012 
   Yield   Change   Yield   Change   Yield   Change 
                         
Yield on earning assets   4.04%   -0.17%   4.21%   -0.35%   4.56%   -0.52%
                               
Effective rate on all liabilities as a percent of earning assets   0.66%   -0.17%   0.83%   -0.32%   1.15%   -0.38%
                               
Net yield on earning assets   3.38%   0.00%   3.38%   -0.03%   3.41%   -0.14%

 

2014 compared to 2013

 

During the year ended December 31, tax adjusted net interest income totaled $23,057 (on net margin of 3.38%) during 2014 and $22,273 (3.38%) during 2013, up $784, or 3.5%. During 2014, net interest income increased $1,254 from higher asset volume (on the purchase of Northwoods Rhinelander in April 2014), offsetting a $470 reduction to net interest income from changes in loan yields and funding costs. The decrease in asset yields and interest bearing funding costs during 2014 compared to the prior year was less than that seen during the prior 2 years, as asset and funding costs settled into current market interest rate levels following several years of falling interest rates. Both yield on earning assets and rate paid on liabilities declined .17% during 2014 compared to 2013. Since the 2014 effective rate on interest bearing liabilities of .66% of earning assets is near a functional rate floor of 0%, a continued prolonged period of low rates or a decline in rates would negatively impact net interest income as asset yields would fall faster than funding costs.

 

Repayment or refinance of maturing high cost FHLB advances during 2014 was a significant contributor to increased net interest income. Reduced FHLB advance interest expense contributed to 87% of the increase in net interest income during the year ended December 31, 2014 compared to 2013. Interest expense savings from maturing high cost wholesale funding will decline significantly during 2015 compared to 2014. Therefore, continued declines in loan yields may decrease net interest margin or reduce net interest income during 2015, particularly if loan growth does not materialize.

 

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During 2014, net interest margin benefited from interest rate floors on certain commercial-related loans and retail residential home equity lines of credit. The coupon rate on approximately $69 million, or 13.0%, of gross loans at December 31, 2014 was supported by an average interest rate floor approximately 111 basis points greater than the normal adjustable rate. If current interest rate levels were assumed to remain the same, the annualized increase to net interest income and net interest margin was approximately $762 and .11%, respectively, based on those existing loan floors and average total earning assets during the year ended December 31, 2014. 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. 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 above the floor more quickly, impacting net interest income less adversely than if short-term rates rose slowly or deliberately.

 

Because a future increase in short-term funding rates could cause a mismatch between floating rate loan yields and short-term funding costs due to existing interest rate floors, such positions are modeled and reviewed as part of our asset-liability management strategy each quarter. Current interest rate simulations based on more extreme rate scenarios such as short-term rates up 500 basis points combined with a flattening of the yield curve during a 24 month period could reduce net interest income by 4.9% to 7.0% ($676 to $962 after tax impacts) per year during the first two years of the rate increase. Refer to Table 9 for projected net interest income percentage changes under other rate change scenarios. We seek to minimize this interest rate risk exposure in part by maintaining the fixed rate period of wholesale funding longer than the average term for local deposit funding. Wholesale funding is approximately 10% of total assets and carried an approximately 27 month weighted average fixed rate remaining term as of December 31, 2014.

 

The Dodd-Frank Wall Street Reform Act of 2010 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 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.

 

2013 compared to 2012

 

Tax adjusted net interest income totaled $22,273 during 2013 compared to $21,028 in 2012, an increase of $1,245, or 5.9%, from a 7.1% increase in average earning assets during 2013, which offset a decline in net interest margin from 3.41% during 2012 to 3.38% during 2013. Compared to 2012, loan yield declined from 5.12% to 4.59% (53 basis points) while the tax adjusted investment security yield declined from 3.26% to 3.21% (5 basis points). Securities yields were supported by a greater allocation in higher yielding tax exempt securities in 2013 compared to 2012 although yield on these tax exempt securities declined from 4.68% in 2012 to 4.27% in 2013. Continued low overall interest rate levels and very low investment security reinvestment rates caused yield on earning assets to decline 35 basis points during 2013, which was offset by a 35 basis point decline in the cost of interest bearing liabilities, allowing the rate spread to remain at 3.21% during both 2013 and 2012. However, because average earning assets grew 7.1% while average interest bearing liabilities grew 4.4%, net yield on earning assets (net margin) declined 3 basis points during 2013 as a greater amount of assets experienced declining yields than the amount of liabilities that experienced declining costs. The increase in 2013 average earning assets was due in part to a full year of ownership of the assets purchased with Marathon State Bank on June 1, 2012 (approximately 20% of the 2013 earnings asset growth), and in part from net organic loan growth (approximately 80% of the 2013 earning asset growth).

 

During 2013, net interest margin benefited from interest rate floors on certain commercial-related loans and retail residential home equity lines of credit. The coupon rate on approximately $71 million, or 13.7%, of gross loans at December 31, 2013 was supported by an average interest rate floor approximately 114 basis points greater than the normal adjustable rate. If current interest rate levels were assumed to remain the same, the annualized increase to net interest income and net interest margin was approximately $807 and .12%, respectively, based on those existing loan floors and average total earning assets during the year ended December 31, 2013.

 

2012 compared to 2011

 

Tax adjusted net interest income totaled $21,028 during 2012 compared to $20,297 in 2011, an increase of $731, or 3.6%, from a 7.7% increase in average earning assets during 2012 which offset a decline in net interest margin from 3.55% during 2011 to 3.41% during 2012. The increase in 2012 average earnings assets was the result of the acquisition of Marathon on June 1, 2012. Compared to 2011, loan yield declined from 5.55% to 5.12% (43 basis points) while the tax adjusted investment security yield declined from 3.87% to 3.26% (61 basis points). Continued low overall interest rate levels and very low investment security reinvestment rates caused yield on earning assets to decline as did the cost of paying liabilities, which declined from 1.77% to 1.35% (42 basis points). The long-term market rate decline first seen in the national economy during the 2008-2009 recession continued during 2012, and loans, securities, and funding continued to reprice to lower levels.

 

During 2012, net interest margin benefited from interest rate floors on certain commercial-related loans and retail residential home equity lines of credit. The coupon rate on approximately $85 million, or 17.5%, of gross loans at December 31, 2012 was supported by an average interest rate floor approximately 129 basis points greater than the normal adjustable rate. If current interest rate levels were assumed to remain the same, the annualized increase to net interest income and net interest margin was approximately $1,095 and .18%, respectively, based on those existing loan floors and average total earning assets during the year ended December 31, 2012.

 

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Interest Rate Sensitivity

 

We incur market risk primarily from interest-rate risk inherent in our lending and deposit taking activities. Market risk is the risk of loss from adverse changes in market prices and rates. We actively monitor and manage our interest-rate risk exposure. The measurement of the market risk associated with financial instruments (such as loans and deposits) is meaningful only when all related and offsetting on- and off-balance sheet transactions are aggregated, and the resulting net positions are identified. Disclosures about the fair value of financial instruments that reflect changes in market prices and rates can be found in Item 8, Note 23 of the Notes to Consolidated Financial Statements.

 

Our primary objective in managing interest-rate risk is to minimize the adverse impact of changes in interest rates on net interest income and capital, while adjusting the asset-liability structure to obtain the maximum yield-cost spread on that structure. We rely primarily on our asset-liability structure reflected on the Consolidated Balance Sheets to control interest-rate risk. In general, longer-term earning assets are funded by shorter-term funding sources allowing us to earn net interest income on both the credit risk taken on assets and the yield curve of market interest rates. However, a sudden and substantial change in interest rates may adversely impact earnings, to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. We do not engage in significant trading activities to enhance earnings or for hedging purposes.

 

Our overall strategy is to coordinate the volume of rate sensitive assets and liabilities to minimize the impact of interest rate movement on the net interest margin. Table 7 represents our earnings sensitivity to changes in interest rates at December 31, 2014. It is a static indicator which does not reflect various repricing characteristics and may not indicate the sensitivity of net interest income in a changing interest rate environment, particularly during periods when the interest yield curve is flattening or steepening. The following repricing methodologies should be noted:

 

1.Public or government fund MMDA and NOW accounts are considered fully repriced within 60 days. Higher yielding retail and non-governmental money market and NOW deposit accounts are considered fully repriced within 90 days. Rewards Checking NOW accounts and lower rate money market deposit accounts are considered fully repriced within one year. Other NOW and savings accounts are considered “core” deposits as they are generally insensitive to interest rate changes. These core deposits are generally considered to reprice beyond five years.
2.Nonaccrual loans are considered to reprice beyond 5 years.
3.Assets and liabilities with contractual calls or prepayment options are repriced according to the likelihood of the call or prepayment being exercised in the current interest rate environment.
4.Measurements taking into account the impact of rising or falling interest rates are based on a parallel yield curve change that is fully implemented within a 12-month time horizon.
5.Bank owned life insurance is considered to reprice beyond 5 years.

 

Table 7 reflects a liability sensitive (“negative”) gap position during as of December 31, 2014, with a cumulative one-year gap ratio of 98.2% compared to a “negative” gap (liability sensitive position) of 85.4% at December 31, 2013. In general, a current negative gap position would be favorable in a falling rate environment, but unfavorable in a rising rate environment. However, net interest income is impacted not only by the timing of product repricing, but the extent of the change in pricing which could be severely limited from local competitive pressures. This factor can result in changes to net interest income from changing interest rates different than expected from review of the gap table.

 

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Table 7: Interest Rate Sensitivity Analysis

 

   December 31, 2014 
(dollars in thousands)  0-90
Days
   91-180 days   181-365 days   1-2 yrs.   Beyond.
2-5 yrs.
   Beyond
5 yrs.
   Total 
                             
Earning assets:                            
Loans  $182,741   $42,500   $67,859   $84,770   $117,632   $36,590   $532,092 
Securities   9,604    6,228    9,995    22,317    51,267    44,746    144,157 
FHLB stock                            2,556    2,556 
CSV bank-owned life insurance                            13,230    13,230 
Other earning assets   8,225    496    1,736                   10,457 
                                    
Total  $200,570   $49,224   $79,590   $107,087   $168,899   $97,122   $702,492 
Cumulative rate sensitive assets  $200,570   $249,794   $329,384   $436,471   $605,370   $702,492      
                                    
Interest-bearing liabilities                                   
Interest-bearing deposits  $96,547   $25,399   $198,627   $26,977   $60,473   $100,125   $508,148 
FHLB advances   10,000                   10,271         20,271 
Other borrowings   4,824                   5,500         10,324 
Senior subordinated notes                       4,000         4,000 
Junior subordinated debentures                       7,732         7,732 
                                    
Total  $111,371   $25,399   $198,627   $26,977   $87,976   $100,125   $550,475 
Cumulative interest sensitive liabilities  $111,371   $136,770   $335,397   $362,374   $450,350   $550,475      
                                    
Interest sensitivity gap for the individual period  $89,199   $23,825   $(119,037)  $80,110   $80,923   $(3,003)     
Ratio of rate sensitive assets to rate sensitive liabilities for the individual period   180.1%   193.8%   40.1%   397.0%   192.0%   97.0%     
                                    
Cumulative interest sensitivity gap  $89,199   $113,024   $(6,013)  $74,097   $155,020   $152,017      
Cumulative ratio of rate sensitive assets to rate sensitive liabilities   180.1%   182.6%   98.2%   120.4%   134.4%   127.6%     

 

We use financial modeling policies and techniques to measure interest rate risk. These policies are intended to limit exposure of earnings at risk. A formal liquidity contingency plan exists that directs management to the least expensive liquidity sources to fund sudden and unanticipated liquidity needs (Refer to the section labeled “Asset Growth and Liquidity” contained in this Annual Report on Form 10-K). We also use various policy measures to assess interest rate risk as described below.

 

36
 

Interest Rate Risk Limits

 

We balance the need for liquidity with the opportunity for increased net interest income available from longer term loans held for investment and securities. To measure the impact on net interest income from interest rate changes, we model interest rate simulations on a quarterly basis. Our policy is that projected net interest income over the next 12 months will not be reduced by more than 15% given a change in interest rates of up to 200 basis points. Table 8 presents the projected impact to net interest income by certain rate change scenarios and the change to the one year cumulative ratio of rate sensitive assets to rate sensitive liabilities.

 

Table 8: Net Interest Margin Rate Simulation Impacts

 

As of December 31:  2014   2013   2012 
             
Cumulative 1 year gap ratio            
Base   98%   85%   94%
Up 200   95%   82%   89%
Down 200   100%   87%   95%
                
Change in Net Interest Income – Year 1               
Up 200 during the year   -4.2%   -2.8%   -1.4%
Down 200 during the year   -0.4%   -0.1%   0.4%
                
Change in Net Interest Income – Year 2               
No rate change (base case)   -1.0%   0.8%   -2.5%
Following up 200 in year 1   -3.0%   -0.2%   -2.8%
Following down 200 in year 1   -5.1%   -2.4%   -3.8%

 

Note: Simulations reflect net interest income changes from a down 100 basis point scenario, rather than a down 200 basis point scenario, reflecting functional interest floors in the current low rate environment.

 

To assess whether interest rate sensitivity beyond one year helps mitigate or exacerbate the short-term rate sensitive position, a quarterly measure of core funding utilization is made. Core funding is defined as liabilities with a maturity in excess of 60 months and capital. Core deposits including DDA, NOW, and non-maturity savings accounts (except high yield NOW such as Rewards Checking deposits and money market accounts) are also considered core long-term funding sources. The core funding utilization ratio is defined as assets that reprice in excess of 60 months divided by core funding. Our target for the core funding utilization ratio is to remain at 80% or below given the same 200 basis point changes in rates that apply to the guidelines for interest rate risk limits exposure described previously. Our core funding utilization ratio after a projected 200 basis point increase in rates was 50.8% at December 31, 2014 compared to 53.8% and 60.5% at December 31, 2013 and 2012, respectively.

 

At December 31, 2014, internal interest rate simulations that project the impact of interest rate on our net interest income estimated that income is projected to decline in both rising and falling rate scenarios. Changes that maintain the current shape of the yield curve (often referred to as “parallel yield curve shifts”) estimated relatively modest projected reductions to future years’ net interest income. The impact of various rate simulations on projected “base” net interest income are shown in Table 9 below. However, if interest rates were to increase more quickly than anticipated and if the yield curve flattened at the same time, such as in a “flat up 500 basis point” change occurring during year 1, net interest income would decline during the first two years of the simulation in amounts ranging from 4.9% in year 1 to a decline of 7.0% in year 2 of the base simulation’s net interest income ($1,116 in year 1 and $1,588 in year 2). When the yield curve flattens, repriced short-term funding cost, such as for terms of one year or less increases, while maturing fixed rate balloon loans, such as with terms from 3 to 5 years, increase much less. During flattening periods, assets and liabilities may reprice at the same time but to a much different extent. At December 31, 2013, similar “flat up 500 basis point” projections indicated net interest income would decline during the first two years of the simulation in amounts ranging from 6.0% in year 1 to 12.7% in year 2 of the base simulation’s net interest income.

 

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Although the flat up 500 basis points simulation is projected to negatively impact net interest income during the first two years of the simulation, we also have risk to a prolonged period of low or falling rates in the already low rate environment beginning in year 2 of a falling rate scenario. In this situation, loan and security yields continue to decline while funding costs reach effective lows, reducing net interest margin, particularly if average credit spreads were to decline in response to heighted market competition for new borrowers.

 

Table 9: Projected Changes To Net Interest Income Under Various Rate Change Simulations

 

   During next 12M   During next 24M   During next 24M   During next 24M 
   Down
100 bp
   Flat up
200 bp
   Parallel up 400 bp   Flat up
500 bp
 
                 
Year 1  -0.4%  -4.6%  -3.9%  -4.9%
Year 2   -4.1%   -4.5%   -4.8%   -7.0%
Year 3   -7.7%   -0.6%   1.4%   -0.4%
Year 4   -10.5%   5.2%   15.7%   15.0%
Year 5   -12.0%   8.6%   30.5%   31.7%

 

Consistent with market expectations, we believe short-term interest rates will begin to increase during the second half of 2015 in response to Federal Reserve actions to increase their discount rate. However, rate increases are expected to be measured and modest, approximating the “flat up 200 bp” scenario shown in Table 9 above. We consider a falling rate scenario such as that shown above for “down 100 bp” to be unlikely.

 

Noninterest Income

 

Table 10 presents a common size income statement showing the changing mix of income and expense relative to traditional loan and deposit product net interest income (before tax adjustment) for the five years ending December 31, 2014. This analysis highlights the reliance on, or diversification of, noninterest or fee income to net interest income.

 

Table 10: Summary of Earnings as a Percent of Net Interest Income

 

   2014   2013   2012   2011   2010 
                     
Net interest income   100.0%   100.0%   100.0%   100.0%   100.0%
Provision for loan losses   2.5%   18.8%   3.9%   7.1%   9.4%
                          
Net interest income after loan loss provision   97.5%   81.2%   96.1%   92.9%   90.6%
Total noninterest income   25.7%   26.4%   32.6%   27.3%   28.1%
Total noninterest expenses   81.0%   77.5%   86.3%   80.7%   83.4%
                          
Net income before income taxes   42.2%   30.1%   42.4%   39.5%   35.3%
Provision for income taxes   13.1%   7.8%   12.6%   12.4%   10.4%
                          
Net income   29.1%   22.3%   29.8%   27.1%   24.9%

 

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Table 11 presents a breakdown of the components of noninterest income during the three years ended December 31.

 

Table 11: Noninterest Income

 

   2014   2013   2012 
       % of pre-tax       % of pre-tax       % of pre-tax 
Years Ended December 31,  Amount   Income   Amount   Income   Amount   Income 
                         
Service fees  $1,656    17.72%  $1,580    24.66%  $1,648    19.29%
Mortgage banking income   1,373    14.69%   1,591    24.83%   1,795    21.01%
Merchant and debit card interchange fee income   1,044    11.17%   859    13.40%   851    9.96%
Retail investment sales commissions   932    9.97%   927    14.47%   712    8.34%
Increase in cash surrender value of life insurance   404    4.32%   402    6.27%   407    4.76%
Other operating income   325    3.48%   266    4.15%   283    3.31%
Insurance annuity sales commissions   14    0.15%   17    0.27%   24    0.28%
Net gain on sale of securities   3    0.03%   12    0.19%       0.00%
Gain on bargain purchase       0.00%       0.00%   851    9.96%
Loss on sale of credit card loan principal       0.00%   (31)   -0.48%       0.00%
Loss on sale of premises and equipment   (57)   -0.61%       0.00%   (3)   -0.03%
                               
Total noninterest income  $5,694    60.92%  $5,623    87.76%  $6,568    76.87%

 

2014 compared to 2013

 

Total noninterest income for the year ended December 31, 2014 was $5,694 compared to $5,623 during 2013, up $71, or 1.3%, despite a decline in residential mortgage banking of $218, or 13.7%. Fewer mortgage loan originations led the decline in mortgage banking revenue on significantly lower residential loan refinance activity due to an increase in long term interest rates in response to expected actions by the Federal Reserve. Offsetting the year to date mortgage banking decline were higher service fees, up $76, and higher debit and credit card interchange income, up $185. During December 2013, PSB sold its credit card loan principal portfolio in exchange for greater interchange fee income on those retained credit card customers, accounting for 62% of the increased interchange income during the year ended December 31, 2014. Prior to the sale of the credit card portfolio, card income was categorized as loan interest income.

 

During 2015, we expect to see an increase in mortgage banking income from increased home sale activity as well as increased retail investment sales commissions from an additional investment advisor salesperson. Separate from other gains (losses) on property sales, noninterest income is expected to increase 4% to 6%.

 

2013 compared to 2012

 

Total noninterest income for the year ended December 31, 2013 was $5,623 compared $6,568 during 2012, a decline of $945, or 14.4%. However, the prior year period included an $851 nonrecurring gain on purchase of Marathon. Excluding this special gain, noninterest income would have been $5,623 and $5,717 in 2013 and 2012, respectively, a decrease of $94, or 1.6%, including a $204 decrease in mortgage banking (down 11.4%) offset by a $208 increase in retail investment and annuity sales commissions (up 28.3%). Service fees declined $68, or 4.1%, on lower overdraft fee income.

 

Due the increase in long term U.S. Treasury rates during 2013, residential mortgage refinance activity declined significantly after several years of consistently falling rates which prompted customers to refinance, causing mortgage banking to decline during 2013.

 

2012 compared to 2011

 

Total noninterest income during 2012 was $6,568 compared to $5,337 in 2011, an increase of $1,231, or 23.1%. However, 2012 included an $851 gain on purchase of Marathon State Bank, which is a nonrecurring item. Excluding the purchase gain, noninterest income increased $380, or 7.1% from a $422 (30.7%) increase in mortgage banking. After significant long-term rate declines during 2011 and 2010, residential mortgage fixed rates declined further in 2012, prompting a new wave of customer refinancing activity, which increased mortgage banking income. Other operating income declined $192 during 2012 from a reduction in commissions earned on the sale of interest rate swaps to floating rate commercial loan customers after introducing the product during 2011.

 

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Noninterest Expense

 

Table 12 outlines the components of noninterest expenses for the three years ending December 31.

 

Table 12: Noninterest Expense

 

Years Ended December 31,  2014   2013   2012 
       % of net       % of net       % of net 
       margin &       margin &       margin & 
   Amount   other income*   Amount   other income*   Amount   other income* 
                         
Wages, except incentive compensation  $7,318    25.45%  $7,026    25.19%  $6,684    24.22%
Health and dental insurance   925    3.22%   1,130    4.05%   1,078    3.91%
Incentive compensation   650    2.26%   295    1.06%   657    2.38%
Payroll taxes and other employee benefits   761    2.65%   694    2.49%   631    2.29%
Profit sharing and retirement plan expense   521    1.81%   446    1.60%   509    1.84%
Deferred compensation plan expense   220    0.77%   160    0.57%   178    0.65%
Restricted stock plan vesting expense   166    0.58%   145    0.52%   105    0.38%
Deferred loan origination costs   (682)   -2.37%   (827)   -2.96%   (673)   -2.44%
                               
Total salaries and employee benefits   9,879    34.37%   9,069    32.52%   9,169    33.23%
Data processing other office operations   2,224    7.74%   1,862    6.67%   2,296    8.32%
Occupancy expense   1,828    6.36%   1,762    6.32%   1,622    5.88%
FDIC insurance expense   523    1.82%   452    1.62%   464    1.68%
Debit card processing and losses expense   519    1.81%   394    1.41%   387    1.40%
Legal and professional expenses   393    1.37%   295    1.06%   567    2.05%
Advertising and promotion   376    1.31%   335    1.20%   327    1.18%
Directors fees and benefits   356    1.24%   354    1.27%   384    1.39%
Loss on foreclosed assets   233    0.81%   428    1.53%   573    2.08%
Other expenses   1,589    5.50%   1,555    5.57%   1,603    5.81%
                               
Total noninterest expense  $17,920    62.33%  $16,506    59.17%  $17,392    63.02%

 

* Net interest income (net margin) is calculated on a tax equivalent basis using a tax rate of 34%.

 

2014 compared to 2013

 

During the year ended December 31, 2014, noninterest expense totaled $17,920 compared to $16,506 during 2013. However, both periods included special items including $371 of nonrecurring Northwoods Rhinelander merger and conversion costs during 2014 and a $458 reduction in employee incentive costs during 2013 due to recognition of the large grain loan loss. Excluding the pro-forma impact of these items as well as the loss on foreclosed assets, noninterest expense during the year ended December 31, 2014 would have been $17,316 compared to $16,536 during 2013, an increase of $780, or 4.7%. Approximately $317 of the increase was from recurring Northwoods branch wage and other direct operating costs following the acquisition. Separate from Northwoods wage costs, pro-forma salaries and employee benefits increased an additional $244, or 2.6%. Data processing and office operations costs increased $130 (excluding the Northwoods branch acquisition conversion and operating costs), up 7.0%, and FDIC insurance premiums increased $71 related to the grain loan charge-off and increased deposits. All other net operating expense increases totaled $18.

 

During 2015, we expect salaries and benefits to lead the growth in expense due to a full year of operations of the Northwoods Rhinelander branch as well additional staff to support commercial product sales growth. However, we expect to see savings in professional fees and data processing costs in 2015 compared to 2014 which include those merger and conversion costs. Professional fees are also expected to decline in response to our November 25, 2014 election to deregister from the SEC under the JOBS Act of 2012, eliminating our reporting to the SEC and related audit and legal costs. Considering all items, we expect total 2015 noninterest expense to increase an inflationary amount over 2014.

 

40
 

 

2013 compared to 2012

 

Noninterest expenses totaled $16,506 during the year ended December 31, 2013 compared to $17,392 during 2012. Both years included special items including a $458 reduction in employee incentive costs during 2013 on recognition of the large grain charge-off, $45 of grain loss legal expense during 2013, and $674 of acquisition and conversion expenses associated with the purchase of Marathon during 2012. Excluding the proforma effect of the grain loss wage reduction and legal expense in 2013, the special 2012 Marathon items, and loss on foreclosed assets, noninterest expense would have been $16,491 during 2013 and $16,145 during 2012, an increase of $346, or 2.1%. The majority of the increase in proforma noninterest expense during 2013 would have been due to a $359 increase in wage expense, primarily from performance incentives that would have existed prior to recognition of the large 2013 grain loan loss and charge-off.

 

2012 compared to 2011

 

Noninterest expenses totaled $17,392 during the year ended December 31, 2012 compared to $15,778 during 2011, up $1,614. Excluding the loss on foreclosed assets for both periods, $438 in Marathon data conversion costs, and $233 in Marathon merger professional fees, 2012 expenses would have been $16,148 compared to $14,581 during 2011, an increase of $1,567, or 10.7%.

 

Marathon operating expenses, primarily wages and monthly data processing costs, added approximately $535 in normal recurring operating expenses following the acquisition by PSB. Separate from Marathon, other increases to wages and benefits included higher health and dental insurance costs, up $226, or 26.5%, due to higher claims experience under our self insured plan, and higher incentive plan, profit sharing, and other incentive benefit plan costs, up $176, or 13.8%. Excluding Marathon related expenses, our data processing and other office operations increased $350, or 23.6%, over 2011 due to higher costs associated with our outsourced information processing system as vendor monthly discounts previously in place following the 2010 original data conversion expired during the September 2011 quarter.

 

Income Taxes

 

The effective tax rate was 31.1% during 2014 compared to 26.0% during 2013 and 30.0% during 2012. The 2013 effective rate declined compared to the other years as the percentage of tax-exempt income from securities and bank owned life insurance increased while total pre-tax income declined from the large grain credit loss. During 2012, the effective income tax rate recorded with the gain on purchase of Marathon was 14.7% due to the large gain recognized on purchase of their tax exempt securities portfolio. Excluding the after tax gain on purchase of Marathon, the 2012 effective tax rate would have been 31.3%, the same as seen during 2011. Refer to Item 8, Note 17 of the Notes to Consolidated Financial Statements for additional tax information. We expect the 2015 effective tax rate to approximate the 31.1% seen during 2014.

 

41
 

 

Credit Quality and Provision for Loan Losses

 

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. An allowance for loan losses is maintained for incurred losses inherent but yet unidentified in the loan portfolio due to past conditions, as well as specific allowances for loss related to individual problem loans. The allowance for loan losses represents our estimate of an amount adequate to provide for probable credit losses in the loan portfolio based on current economic conditions and past events that will result in future losses. Provisions to the allowance for loan losses are recorded as a reduction to income. Actual loan loss charge offs are charged against the allowance for loan losses when incurred.

 

The adequacy of the allowance for loan losses is assessed via ongoing credit quality review and grading of the loan portfolio, past loan loss experience, trends in past due and nonperforming loans, existing economic conditions, loss exposure by loan category, results of independent and internal loan reviews, and estimated future losses on specifically identified problem loans. We have an internal risk analysis and review staff that continuously reviews loan quality. Accordingly, the amount charged to expense is based on our multi-factor evaluation of the loan portfolio. It is our policy that when available information confirms that specific loans, or portions thereof, including impaired loans, are uncollectible, these amounts are promptly charged off against the allowance. In addition to coverage from the allowance for loan losses, nonperforming loans are secured by various collateral including business, real estate and consumer collateral. Loans charged off are subject to ongoing review and specific efforts are taken to maximize recovery of principal, accrued interest, and related expenses.

 

The allocation of the year-end allowance for loan losses for each of the past five years based on our estimate of loss exposure by category of loans is shown in Table 13. Our allocation methodology focuses on changes in the size and character of the loan portfolio, current economic conditions, the geographic and industry mix of the loan portfolio, and historical losses by category. The total allowance is available to absorb losses from any segment of the portfolio. Management allocates the allowance for loan losses by pools of risk and by loan type. We combine estimates of the allowance needed for loans analyzed individually and loans analyzed on a pool basis. The determination of allocated reserves for larger commercial loans involves a review of individual higher-risk transactions, focused on loan grading, and assessment of projected cash flows and possible resolutions of problem credits. While we use available information to recognize losses on loans, future adjustments may be necessary based on changes in economic conditions and future impacts to specific borrowers.

 

Table 13: Allocation of Allowance for Loan Losses

 

As of December 31,  2014   2013   2012   2011   2010 
       % of       % of       % of       % of       % of 
   Dollar   principal   Dollar   principal   Dollar   principal   Dollar   principal   Dollar   principal 
                                         
Commercial, industrial,                                        
municipal, and agricultural  $925    0.74%  $1,661    1.36%  $1,687    1.32%  $1,743    1.44%  $2,736    2.14%
Commercial real estate mortgage   1,783    0.78%   1,958    0.89%   2,129    1.02%   2,290    1.17%   3,304    1.72%
Residential real estate mortgage   1,366    0.84%   995    0.62%   1,104    0.79%   627    0.56%   211    0.19%
Consumer and individual   77    2.14%   61    1.72%   77    1.64%   103    2.81%   213    5.42%
Impaired loans   2,258    11.79%   2,108    13.36%   2,434    19.57%   3,178    18.46%   1,496    13.10%
                                                   
Totals  $6,409    1.20%  $6,783    1.31%  $7,431    1.53%  $7,941    1.78%  $7,960    1.81%

 

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The following table presents our allowance for loan loss activity by loan category during the five years ended December 31, 2014.

 

Table 14: Loan Loss Experience

 

Years ended December 31  2014   2013   2012   2011   2010 
                     
Average balance of loans for period  $523,712   $508,454   $462,237   $443,709   $443,293 
                          
Allowance for loan losses at beginning of year  $6,783   $7,431   $7,941   $7,960   $7,611 
                          
Loans charged off:                         
                          
Commercial, industrial, municipal, and agricultural   215    3,650    128    867    454 
Commercial real estate mortgage   41    174    518    236    448 
Residential real estate mortgage   694    850    629    367    462 
Consumer and individual   19    69    57    117    101 
                          
Total charge-offs   969    4,743    1,332    1,587    1,465 
                          
Recoveries on loans previously charged-off:                         
                          
Commercial, industrial, municipal, and agricultural   4    29    6    166    7 
Commercial real estate mortgage   3    33    4    6     
Residential real estate mortgage   19    6    21        8 
Consumer and individual   9    12    6    6    4 
                          
Total recoveries   35    80    37    178    19 
                          
Net loans charged-off   934    4,663    1,295    1,409    1,446 
Provision for loan losses   560    4,015    785    1,390    1,795 
                          
Allowance for loan losses at end of year  $6,409   $6,783   $7,431   $7,941   $7,960 
                          
Ratio of net charge-offs during the year to average loans   0.18%   0.92%   0.28%   0.32%   0.33%
                          
Ratio of allowance for loan losses to loans receivable at end of year   1.20%   1.31%   1.53%   1.78%   1.81%

 

2014 compared to 2013

 

Provision for estimated loan losses was $560 during 2014 compared to $4,015 during 2013, which included $3,340 provision for the large grain credit loss. Excluding this provision from 2013, provision for loan losses declined $115, or 17.0%, during 2014 compared to proforma 2013. The loss on foreclosed assets during 2014 was $233 compared to $428 in 2013, a decline of $195, or 45.6%, on a $236 decline in loss on sale of foreclosed assets and partial charge-offs from declines in market value during 2014. Taken together 2014 total credit losses were $793 in 2014 compared to $1,103 in 2013 (excluding the $3,340 large grain loss), a decline of $310, or 28.1%. Refer to Note 6 of the Notes to Consolidated Financial Statements for a summary of activity in foreclosed assets during the three years ended December 31, 2014. Improving general credit trends within our portfolio and a slowly improving local economy contributed to the decline in credit costs during 2014.

 

Net charge-offs of loan principal were $934 during 2014 compared to $4,663 ($1,323 excluding the large grain loss). The most significant charge-off during 2014 included a $497 partial charge-off (equal to 46% of loan principal) of a jumbo single family residential mortgage loan to reflect net realizable value pending potential foreclosure reflecting market value decline. Net loan charge-offs as a percentage of average total loans was .18% during 2014 compared to .92% during 2013 (.26% excluding the large grain loan charge-off). The largest 2013 charge-off was the $3,340 grain loan, which was 72% of total charge-offs. We continue to pursue all available channels for recovery of a portion of the grain credit loss and are cautiously optimistic concerning some amount of significant future recovery, although the timing and amount of such recovery are still uncertain. At December 31, 2014, the allowance for loan losses was $6,409, or 1.20% of total loans (50% of nonperforming loans), compared to $6,783, or 1.31% of total loans (79% of nonperforming loans) at December 31, 2013.

 

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Allowance for inherent loan losses provided for performing loans collectively evaluated for impairment was .80% of loan principal outstanding at December 31, 2014, compared to .92% at December 31, 2013. Required reserves declined during 2014 as losses on commercial related loans, representing 69% of total gross loans declined, as well as continuing a trend of lower net charge-offs in those commercial types, which form the basis for estimated loss needs. In addition, no significant commercial related problem loans were newly identified. However, inherent losses on residential real estate loans increased from .62% of loan principal at December 31, 2013 to .84% of loan principal at December 31, 2014, reflecting a trend of higher loss rates. The loan loss provision during 2015 is expected to increase slightly from the $560 recorded during 2014 on increased organic loan growth during 2015 compared to 2014. However, future provisions could be impacted by loan competition, which could reduce reserve needs, and the actual amount of impaired and other problem loans identified by internal procedures or regulatory agencies, which could increase reserve needs.

 

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. Nonperforming assets aggregating to $500 or more, measured by gross principal outstanding per credit relationship, included six relationships at December 31, 2014 totaling $6,227, compared to three relationships at December 31, 2013 totaling $2,031. The majority of the increase during 2014 in large problem relationships was due to the restructuring of the $2,775, municipal loan. Specific reserves maintained on these large problem loans were $802 at December 31, 2014 and $462 at December 31, 2013.

 

We maintain our headquarters and one branch location in the City of Wausau, Wisconsin, and maintain the majority of our deposits (including five of our nine locations), and loan customers in Marathon County, Wisconsin. The significant majority of our customers and borrowers live and work in Marathon, Oneida, and Vilas Counties, Wisconsin, in which we have branch locations. The unemployment rate (not seasonally adjusted) in the Wausau-Marathon County, Wisconsin MSA was 4.5% at December 2014 compared to 5.7% at December 2013. The unemployment rate in Oneida County, Wisconsin was 8.3% at December 2014 compared to 8.6% at December 2013. The unemployment rate in Vilas County, Wisconsin was 9.4% at December 2014 compared to 10.7% at December 2013. The unemployment rate for all of Wisconsin (not seasonally adjusted) was 5.0% at December 2014 compared to 5.8% at December 2013.

 

A local economic outlook survey of business owners recently published by the Chamber of Commerce for our market area points to expectations of continued slow improvement in the local economy but with modest local capital expansion by businesses. The greatest limitation to growth according to local business owners is the inability to find well trained or qualified labor, and economic expansion is expected to occur later in 2015. While the general credit quality of our loan portfolio and the level of identified problem loans continues to improve, the local economic conditions are fragile with slower growth in central and northern Wisconsin compared to many areas in the United States. During 2012, large local employers in the paper manufacturing, window manufacturing, and insurance claim processing industries announced plant closures, job reductions, or loss of key customer contracts. Our market area has a higher than typical allocation of resources in the manufacturing sector, although the greatest economic growth for many years has been in health and education services. The local paper and wood industries have, and continue to experience, a long-term production decline. The local retail sales environment also declined during 2013 as J.C. Penney Company, Inc., Gap, Inc., and Abercrombie & Fitch, Co. brand Hollister announced store closures within our primary markets.

 

2013 compared to 2012

 

Provision for estimated loan losses increased significantly to $4,015 during 2013 compared to $785 in 2012, up 3,230, or 411%. We recorded a $3,340 provision for loan losses during the September 2013 quarter due to the write down of a loan to a grain commodities dealer who was discovered to have misrepresented inventory collateral, financial statements, inventory records, and federal warehouse receipts taken as collateral which impacted several banks. The borrower and its operations remain under investigation by the authorities. Separate from the large grain loss, we recorded a $675 provision for loan losses during 2013 compared to a provision of $785 during 2012, a decline of $110, or 14.0%. The loss on foreclosed assets was $428 during 2013 compared to $573 during 2012, a decline of $145, or 25.3%. Taken together, 2013 credit costs excluding the large grain loss were $1,103 compared to $1,358 in 2012, a decline of $255, or 18.8%.

 

Net charge-offs of loan principal were $4,663 during 2013 ($1,323 if the large grain charge-off is excluded) compared to $1,295 during 2012. The most significant loan charge-offs during 2013 included the large $3,340 grain charge-off (outlined in detail below and equal to 100% of the unpaid loan principal at time of charge-off), $143 related to a residential 2nd mortgage used to fund a plumbing contractor (85% of loan principal), $125 related to business financing for a beautician (74% of loan principal), and $105 related to financing mobile home park rental real estate (51% of loan principal), which together represented 80% of all 2013 net charge-offs. The most significant loan charge-offs during 2012 were $282 (equal to 40% of the unpaid loan principal at time of charge-off) related to a restaurant operation including its owner occupied commercial real estate, $147 (83% of loan principal) related to a property owner and manager of non-owner occupied low cost 1 to 4 family rental housing, and $125 (73% of loan principal) related to a retail power equipment sales operation including its owner occupied commercial real estate. These three foreclosures represented 43% of all 2012 net charge-offs.

 

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Allowance for inherent loan losses provided for performing loans collectively evaluated for impairment was .92% of loan principal outstanding at December 31, 2013, compared to 1.04% at December 31, 2012. Required reserves declined during 2013 as nonperforming loans declined 16.6% and no significant new problem loans were identified. Net loan charge-offs as a percentage of average loans outstanding were .92% during 2013 (.26% excluding the large grain loan charge-off) compared to .28% during 2012.

 

The $3,340 commercial line of credit loss recorded in 2013 resulted from a customer fraud associated with pledges of single party grain inventory represented by federal warehouse receipts or other inventory records to multiple parties as collateral and misrepresented inventory records and financial statements. We had a lending relationship with the borrower for several years, dating back to 2008.  Our monitoring of the loan relationship included weekly debtor’s certificates demonstrating weekly collateral position of the Bank’s loans.  In addition, as grain was sold and proceeds came to reduce the Bank’s loan balance, we normally would re-advance on the revolving lines of credit based on new collateral pledged (federal warehouse receipts and contracts for sale of grain pledged to the Bank). The loans had performed as required from the origination date until August 2013 when the misrepresentation was uncovered. Three other unrelated banks were also involved in the collateral based financing arrangement. One of the parties was a loan participant with us, and the other two parties operated independently from all the other banks in the arrangement. Our loan participant held an inventory line of credit outstanding of $2.0 million at the time the problem was uncovered, and the other two banks held approximately $5.0 million and $3.7 million, respectively. In total, including our $3.3 million of loan principal, there was $14.0 million in debt financing the collateral operations at the time the misrepresentation was uncovered. Based on information provided to us by others, the borrower also owed an additional $15.2 million on real estate mortgage debt outstanding at the time the collateral misrepresentation was uncovered, none of which was held by us or our loan participant.

 

In addition, recovery of our value from remaining collateral was hurt by poorly worded inter-creditor agreements related to the collateral and its cash proceeds as well as procedural problems related to lien perfections. To identify if similar risks remain with other borrowers in our loan portfolio, we considered which factors were most significant in allowing the current large credit loss to occur. The primary factors contributing to the loss included:

 

Multiple inventory and line of credit financing lenders in the relationship, none of which were considered to be the clearly stated lead lender.

 

Failure to maintain an interbank creditor agreement with all line of credit lenders that allowed completed inventory collateral audits to be concurrently reconciled to inventory records and financial statements provided to all lenders at the time of the inventory audit.

 

Failure to require audited year-end financial statements rather than relying on reviewed year-end financial statements.

 

Failure to identify counterfeit federal warehouse grain receipts not normally taken by us as collateral.

 

Based on these heightened risk factors, we reviewed our existing loan portfolio to identify individual notes with a principal balance or outstanding principal commitment of at least $500 in which a significant collateral type in the borrowing relationship included one of the following collateral types:

 

Fungible inventory (i.e., commodities such as fuel, agricultural products, timber, etc.)

 

Readily saleable retail inventory units (i.e., vehicles, boats, etc.)

 

Accounts receivable

 

Other nontraditional collateral types

 

From this population, we selected all loans having at least one of the following characteristics for in-depth credit review:

 

Borrower is not required to provide audited year-end financial statements.

 

Existence of multiple unrelated lenders involved in the aggregated borrower relationship.

 

Independent collateral audits are not regularly performed, or those that are performed are not also concurrently reconciled back to the borrower’s financial statements taking into account the debt positions with all lenders involved in the relationship.

 

Based on these selection criteria conducted during the December 2013 quarter, we identified 44 individual notes with $53,493 in outstanding total principal (representing 10.2% of company-wide gross loans receivable) and $23,876 in additional unused commitments at September 30, 2013. Included in this total were 16 notes with $24,795 in outstanding principal (and $14,215 in unused commitments) for which either an audited financial statement or a periodic collateral field audit are currently obtained, but not both. Separate from these 44 notes, there were an additional 15 individual lines of credit with no outstanding principal outstanding but unused commitments of $11,188 at September 30, 2013. The financial statement attestation level, credit documentation, and collateral arrangements for each borrower included in this selection were reviewed to determine if areas of unidentified credit risk existed, and whether they could be reduced by eliminating or mitigating these risk factors.

 

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The review of these specific credits did reveal 4 total borrowers (including 6 total notes) with outstanding aggregate principal of $16,054 and unused commitments of $7,546 that required follow-up to increase the level of financial statement attestation or conduct a current audit of collateral. The detailed credit reviews of all 59 loans noted above having similar risk characteristics to the large 2013 grain loss did not identify any significant unknown elevated risk factors that would require the credit to be classified as an impaired loan. In addition, the results of this credit review over the selected loans resulted in no increase to the provision for loan losses during 2013.

 

In addition to actions with the specific borrowers noted above, we implemented lending policy changes as outlined below. Many of these procedures were already utilized on most of our credits as needed but had not yet been incorporated as part of the written loan policy requirements until now.

 

Requirement for independent document and credit review upon origination for loans above a certain principal commitment, and, for loans of any significant size, whenever a relationship is being downgraded from a performing loan grade (grades 1 through 4) to the watch grade or lower (grades 5 through 7).

 

Require borrowers to which we make a large loan principal commitment over a certain dollar amount to provide audited financial statements, or, in the case of loans secured by inventory or accounts receivable, periodic collateral audits in lieu of an audited year-end financial statement if appropriate.

 

In the case of multiple unrelated lenders providing credit secured by inventory or accounts receivable, require all lenders to agree to a combined inter-creditor agreement to coordinate collateral audit activities, loan servicing, and other management functions.

 

We continue to seek recovery of principal associated with the large grain loss although the intended grain commodity collateral represented by federal warehouse receipts was liquidated under the administration of the United States Department of Agriculture for the payment of debts to farmers who had consigned grain to our loan customer and had not yet been paid. In addition, the remaining operating cash from accounts receivable on sale of grain is being sought by several independent banks with competing claims of various documentation quality. Owners and principals of our customer are not expected to have significant remaining personal assets available to their creditors for collection. We have also filed a claim under our fidelity insurance policy for loss reimbursement, although it is not yet known whether loss coverage will be extended, and if extended, the extent of coverage available. Due to these challenges, extended recovery timeline, and unknowns associated with principal recovery, the entire loan balance of $3,340 was charged off against the allowance for loan losses during 2013. Any future recovery of principal would be recorded as an increase to the allowance for loan losses, which would likely result in increased income from a reduction to the regular provision for loan losses expense.

 

2012 compared to 2011

 

Provision for estimated loan losses declined to $785 in 2012 from $1,390 in 2011, down 43.5%. The provision for loan losses decreased during 2012 as fewer new problem loans were identified and some large existing problem loans were favorably resolved or resolved within projected loss parameters using existing reserves expensed in prior years. During 2012, approximately $3.8 million of new loans were added to nonperforming loans, down 57% from approximately $8.9 million in loans added to nonperforming loans during 2011. In addition, losses on foreclosed assets declined $624, or 52.1%, to $573 during 2012 compared to $1,197 during 2011. The decline was due to a decrease in partial write-downs of foreclosed assets as local real estate values stabilized. During 2012, provision for partial write-downs charged to loss on foreclosed assets was $485 compared $992 during 2011, down $507. Total credit costs as represented by the provision for loan losses and loss on foreclosed assets were $1,358 during 2012 and $2,587 during 2011, down $1,229, or 47.5%.

 

Net charge-offs of loan principal were $1,295 during 2012 compared to $1,409 during 2011, a decline of $114, or 8.1%. The most significant loan charge-offs during 2012 were $282 (equal to 40% of the unpaid loan principal at time of charge-off) related to a restaurant operation including its owner occupied commercial real estate, $147 (83% of loan principal) related to a property owner and manager of non-owner occupied low cost 1 to 4 family rental housing, and $125 (73% of loan principal) related to a retail power equipment sales operation including its owner occupied commercial real estate. These three foreclosures represented 43% of all 2012 net charge-offs. The next six largest 2012 charge-off relationships incurred $380 in aggregate charge-offs, averaging $63 per relationship. Therefore, the nine largest charge-off relationships totaled $934, or 72% of all 2012 net charge-offs. The majority of gross loan charge-offs during 2011 were related to six borrowers totaling $1,143, or 72% of all charge-offs, with the largest charge off of $700 related to a line of credit to a building supply company.

 

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Nonperforming 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 15 presents nonperforming loans and assets by category for the five years ended December 31.

 

Table 15: Nonperforming Loans and Foreclosed Assets

 

As of December 31,  2014   2013   2012   2011   2010 
                     
Nonaccrual loans (excluding restructured loans)  $3,983   $3,704   $6,491   $5,893   $7,127 
Nonaccrual restructured loans   4,388    3,636    1,224    2,081    1,912 
Restructured loans not on nonaccrual   4,391    1,299    2,965    6,220    2,383 
Accruing loans past due 90 days or more                    
                          
Total nonperforming loans   12,762    8,639    10,680    14,194    11,422 
Nonaccrual trust preferred investment security               750     
Foreclosed assets   1,661    1,750    1,774    2,939    4,967 
                          
Total nonperforming assets  $14,423   $10,389   $12,454   $17,883   $16,389 
Impaired loans considered to be performing  $6,386   $7,136   $1,969   $3,026   $6,398 
                          
Total nonperforming loans as a percent of gross loans   2.40%   1.67%   2.20%   3.19%   2.60%
Total nonperforming assets as a percent of total assets   1.96%   1.46%   1.75%   2.87%   2.64%

 

Loans are placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments. Previously accrued and uncollected interest on such loans is reversed, and future payments received are applied in full to reduce remaining loan principal. No income is accrued or recorded on future payments until the loan is returned to accrual status. 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.

 

Upon return to accrual status, the interest portion of past payments that were applied to reduce nonaccrual principal is taken back into income. The interest that would have been reported in 2014 if all such loans had been current throughout the year in accordance with their original terms was approximately $487 in comparison to $32 actually recorded in income. The interest that would have been reported in 2013 if all such loans had been current throughout the year in accordance with their original terms was approximately $505 in comparison to $108 actually recorded in income. The interest that would have been reported in 2012 if all such loans had been current throughout the year in accordance with their original terms was approximately $564 in comparison to $125 actually recorded in income.

 

Troubled debt restructured loans (“TDR”) are also included in nonperforming loans. Restructured loans involve the granting of concessions to the borrower involving the modification of terms of the loan, such as changes in payment schedule or interest rate, or capitalization of unpaid real estate taxes or unpaid interest that the lender would not normally grant. The majority of restructured loans represent conversion of amortizing commercial purpose loans to interest only loans for a temporary period to increase the problem borrower’s cash flow. The remaining restructured loans granted a lower interest rate to borrowers for a temporary period to increase borrower operating cash flow. Such loans are subject to management review and ongoing monitoring and are made in cases where the borrower’s delinquency is considered short-term from circumstances the borrower is believed able to overcome or which would reduce our estimated total credit loss on the relationship. All restructured loans, both nonaccrual and accrual status, remain classified as nonperforming loans. Therefore, some borrowers continue to make substantially all required payments while maintained as nonperforming loans.

 

Substantially all of our residential mortgage loans originated for and held in our loan portfolio were based on conventional and long standing underwriting criteria and are secured by first mortgages on homes in our local markets. We were never an originator of higher risk loans such as option ARM products, high loan-to-value ratio mortgages, interest only loans, subprime loans, or loans with initial teaser rates that can have a greater risk of non-collection than other loans. At December 31, 2014, approximately $898 of loans receivable were 1 – 4 family home equity or junior lien mortgage loans in which the maximum commitment amount of the line of credit plus existing senior liens is greater than 100% of the underlying real estate value, or the loan was in a 3rd mortgage position or lower, compared to $760 at December 31, 2013, and $1,554 at December 31, 2012. Such loans were not originated as part of a program to add higher yielding loans to our portfolio but were loans made on a case by case basis and individually underwritten based on the credit quality of the individual borrower. We do not maintain a formal residential mortgage modification program for delinquent residential mortgage borrowers.

 

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2014 compared to 2013

 

Total nonperforming assets increased $4,034, or 38.3%, to $14,423 at December 31, 2014 compared $10,389 at December 31, 2013. The increase in nonperforming assets includes a $2,775 municipal development loan restructured during 2014, representing 69% of the total increase in nonperforming assets during 2014. At December 31, 2014, the allowance for loan losses was $6,409, or 1.20% of total loans (50% of nonperforming loans), compared to $6,783, or 1.31% of total loans (79% of nonperforming loans) at December 31, 2013. Approximately 43% of total nonperforming assets are made up of six individual nonperforming relationships greater than $500 at December 31, 2014 compared to 20% (three relationships) of nonperforming assets at December 31, 2013 and 11% (two relationships) of nonperforming assets at December 31, 2012. Total nonperforming assets as a percentage of tangible common equity including the allowance for loan losses (the “Texas Ratio”) as shown in Table 35 was 21.90% at December 31, 2014 compared to 16.80% at December 31, 2013 and 20.54% at December 31, 2012. For the purpose of this measurement, tangible common equity is equal to total common stockholders’ equity less mortgage servicing right assets.

 

Approximately 43% of total nonperforming assets were represented by the following aggregate credits or foreclosed properties greater than $500 at December 31, 2014:

 

Table 16: Largest Nonperforming Assets at December 31, 2014 ($000s)

 

Collateral Description  Asset Type  Gross Principal   Specific Reserves 
            
Municipal tax incremental financing district (TID) debt issue  Accrual TDR  $2,775   $ 
Timber byproduct processing equipment and receivables  Nonaccrual   905    316 
Non-owner occupied light manufacturing facility real estate  Nonaccrual   682    135 
Owner occupied commercial office and residential rentals  Nonaccrual   671    123 
Owner occupied multi-use, multi-tenant professional building  Nonaccrual   610    77 
Single family residential home first mortgage  Nonaccrual   584    151 
              
Total listed nonperforming assets     $6,227   $802 
Total bank wide nonperforming assets     $14,423   $2,067 
Listed assets as a percent of total nonperforming assets      43%   39%

 

The following Table 17 presents the following aggregate credits greater than $500 considered to be impaired but performing loans at December 31, 2014. In general, loans not classified as nonaccrual or restructured may be classified as impaired due to elevated potential credit risk but still be considered performing. Such loans are not included in nonperforming assets in Table 16 above.

 

Table 17: Largest Performing, but Impaired Loans at December 31, 2014 ($000s)

 

Collateral Description  Asset Type  Gross Principal   Specific Reserves 
              
Timber byproduct processing real estate and transportation equipment  Impaired  $2,477   $18 
Owner occupied light manufacturing facility and equipment  Impaired   1,678     
Owner occupied cabinetry contractor real estate and equipment  Impaired   716     
              
Total listed performing, but impaired loans     $4,871   $18 
Total performing, but impaired loans     $6,386   $191 
Listed assets as a percent of total performing, but impaired loans      76%   9%

 

The following section summarizes activity associated with the three large nonperforming loans shown in Table 18 as of December 31, 2013 and their activity during 2014 as well as three new nonperforming loans added to Table 16 during 2014.

 

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Prior to 2012, we financed a municipal water utility project and other developmental costs within a local tax incremental financing district (TID), in part to bring water to a large paper manufacturing factory within the small village. During 2012, the factory announced it was ceasing production, laying off all employees and shuttering the factory. While the water utility and the residential housing improvements continued to provide some real estate tax cash flow from within the TID, the cash flow was not sufficient to repay the debt according to the original amortization schedule. Therefore, the TID gained permission from the State of Wisconsin during 2014 to extend the life of the TID as “distressed” and we restructured the amortization schedule of the municipal debt. The municipality also made $315 of scheduled principal payments during 2014. Current cash flow on the existing projects within the TID is expected to be able to fully service the debt under the new terms, and the $2,775 remaining principal as shown in Table 16 was classified as an accruing troubled debt restructured loan at December 31, 2014 with no specific allowance reserves for loss.

 

During 2013, our commercial borrower in the timber byproduct processing industry lost a major customer and experienced significantly reduced cash flow. Loan payments later become delinquent and some of the loans were reclassified to nonaccrual status. We have a traditional commercial lending relationship with this company in addition to a large loan with an 80% guarantee by the United States Department of Agriculture. To assist our borrower in the short term, we consolidated the traditional commercial loans into one loan for a 1 year term with interest only payments while the terms of the USDA guaranteed loan were unchanged. Although the borrower has remained current on the restructured interest only note, a significant collateral shortfall would exist upon foreclosure, so the $905 restructured loan as shown in Table 16 remained on nonaccrual status at December 31, 2014 with a specific loss allowance of $316. Although the borrower appears to be experiencing a recovery with increasing cash flows, we are unable to predict the final timing or resolution of this problem loan relationship. The related USDA guaranteed loan has remained current on its payments since origination and is well collateralized. Therefore, the $2,477 guaranteed loan remains on accrual status as an impaired loan at December 31, 2014 as shown in Table 17.

 

During 2010, we restructured the loan terms on $754 of loan principal to lower the interest rate on existing debt with a borrower in the cabinetry contracting industry to increase cash flow during a large decline in customer sales. During 2011, the borrower sold the business to a competitor but retained a mortgage on the production facility which was leased to the new business owner. At December 31, 2012 and 2013, this loan was classified as a performing restructured loan with outstanding principal of $752 (Table 20) and $731 (Table 18), respectively. During 2013, the original lessee ceased to use the production facility which sat idle at December 31, 2013. In response, the remaining principal balance was reclassified as a nonaccrual loan at December 31, 2013. The borrower was able to rent the facility to another manufacturer during 2014 and, although the loan remains on nonaccrual status, regular principal payments are being received. The remaining principal balance was $682 at December 31, 2014 as shown in Table 16. The specific allowance associated with this loan increased from $87 at December 31, 2012 to $304 at December 2013 to reflect non-usage of the building, a lower appraisal value, and the likelihood of bank foreclosure and liquidation of the collateral. During 2014, a new appraisal was obtained, which reflected improving commercial real estate fair values, which when combined with the lower principal balance, lowered specific allowances on this loan to $135 at December 31, 2014.

 

During 2013, we downgraded one borrower’s various non-owner occupied commercial real estate loans totaling $642 to nonaccrual status. The credit extension originally financed the purchase of real estate for rental purposes as well as for equipment and working capital needs for a related new restaurant. During 2013, the restaurant closed and cash flows were negatively impacted by tenant payment delinquencies and the need for building capital improvements which resulted in the borrower falling behind in property tax payments. During 2014, the loan was restructured to pay past due property taxes, resulting in unpaid principal of $671 at December 31, 2014 as shown in Table 16. The customer continues to make payments under the terms of the new note, although the loan is maintained on nonaccrual status and we cannot predict the final timing or resolution of this problem loan. Specific loss allowances on these loans were $123 at December 31, 2014 compared to $51 at December 31, 2013 based on property liquidation values in the potential event of bank foreclosure and liquidation.

 

During 2011, we restructured an owner occupied commercial real estate loan with an insurance agency. The building was constructed during 2008 and included additional space to rent to unrelated service businesses. The debt was restructured to extend the amortization period to support declining borrower cash flow as portions of the building remained vacant. The restructured loan of $664 was maintained on accrual status as reflected in Table 20 at December 31, 2012 with a specific allowance of $182, and was reflected in Table 18 with restructured principal of $658 and a specific allowance of $107 at December 31, 2013. Customer financial performance deteriorated during 2013 and we reclassified the $658 loan to nonaccrual status due to the increased likelihood of bank foreclosure and liquidation. After reducing the remaining principal balance to $610 as shown in Table 16, the borrower ceased payments during 2014 and foreclosure of the property appears likely. The specific allowance associated with the loan totaled $77 at December 31, 2014, down from $107 at December 31, 2013 on payments of principal, which decreased from $182 at December 31, 2012 from an updated favorable property appraisal obtained during 2013.

 

During 2014, a $1,075 single family residential jumbo first mortgage loan became delinquent as the borrower is disputing a potential change in ownership of the home via divorce proceedings and ceased payments, causing us to classify the loan as nonaccrual. The mortgage is significantly under collateralized in today’s real estate market although the borrower continues income levels sufficient to service the required debt payments. During 2014, we recorded a $497 partial charge-off of the loan reflecting the collateral shortfall and retain $584 in gross principal as shown in Table 16. We further maintained a $151 specific allowance for loss at December 31, 2014 due to the uncertainty surrounding the resolution of the loan.

 

49
 

 

2013 compared to 2012

 

Total nonperforming assets decreased $2,065, or 16.6%, to $10,389 at December 31, 2013 compared to $12,454 at December 31, 2012. At December 31, 2013, the allowance for loan losses was $6,783, or 1.31% of total loans (79% of nonperforming loans), compared to $7,431, or 1.53% of total loans (70% of nonperforming loans) at December 31, 2012. Approximately 20% of total nonperforming assets are made up of three individual nonperforming relationships greater than $500 at December 31, 2013 compared to 11% (two relationships) of nonperforming assets at December 31, 2012 and 52% (nine relationships) at December 31, 2011.

 

Approximately 20% of total nonperforming assets were represented by the following aggregate credits or foreclosed properties greater than $500 at December 31, 2013:

 

Table 18: Largest Nonperforming Assets at December 31, 2013 ($000s)

 

Collateral Description  Asset Type  Gross Principal   Specific Reserves 
            
Owner occupied cabinetry contractor real estate and equipment  Nonaccrual  $731   $304 
Owner occupied multi use, multi-tenant real estate  Nonaccrual   658    107 
Owner occupied commercial office and residential rentals  Nonaccrual   642    51 
              
Total listed nonperforming assets     $2,031   $462 
Total bank wide nonperforming assets     $10,389   $1,936 
Listed assets as a percent of total nonperforming assets      20%   24%

 

The following Table 19 presents the following aggregate credits greater than $500 considered to be impaired but performing loans at December 31, 2013. In general, loans not classified as nonaccrual or restructured may be classified as impaired due to elevated potential credit risk but still be considered performing. Such loans are not included in nonperforming assets in Table 18 above.

 

Table 19: Largest Performing, but Impaired Loans at December 31, 2013 ($000s)

 

Collateral Description  Asset Type