NOTE 4 – LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES

Loans

Loans that management has the intent to hold for the foreseeable future or until maturity or pay-off are generally reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest on loans is credited to income as earned. Interest income is not accrued on loans where management has determined collection of such interest is doubtful or those loans which are past due 90 days or more as to principal or interest payments. When a loan is placed on nonaccrual status, previously accrued but unpaid interest deemed uncollectible is reversed and charged against current income. After being placed on nonaccrual status, additional income is recorded only to the extent that payments are received and the collection of principal becomes reasonably assured. Interest income recognition on loans considered to be impaired is consistent with the recognition on all other loans. Loan origination fees and certain direct loan origination costs are deferred and recognized as an adjustment of the related loan yield using the interest method.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely.

Management maintains the allowance for loan losses at a level to cover probable credit losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. In accordance with current accounting standards, the allowance is provided for losses that have been incurred based on events that have occurred as of the balance sheet date. The allowance is based on past events and current economic conditions and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions.

The allowance for loan losses includes specific allowances related to loans which have been judged to be impaired. A loan is impaired when, based on current information, it is probable that PSB will not collect all amounts due in accordance with the contractual terms of the loan agreement. Management has determined that impaired loans include nonaccrual loans, loans identified as restructurings of troubled debt, and loans accruing interest with elevated risk of default in the near term based on a variety of credit factors. Specific allowances on impaired loans are based on discounted cash flows of expected future payments using the loan's initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.

In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require PSB to make additions to the allowance for loan losses based on their judgments of collectability resulting from information available to them at the time of their examination.

The composition of loans at period-end, categorized by the type of the loan, is as follows:

	September 30, 2011			December 31, 2010

Commercial, industrial, and municipal	$	132,258		$	129,063
Commercial real estate mortgage		180,605			180,937
Construction and development		27,336			35,310
Residential real estate mortgage		74,819			71,675
Residential real estate home equity		23,913			23,774
Consumer and individual		3,584			3,929

Subtotals – Gross loans		442,515			444,688
Loans in process of disbursement		(1,948	)		(5,177	)

Subtotals – Disbursed loans		440,567			439,511
Net deferred loan costs		210			250
Allowance for loan losses		(8,019	)		(7,960	)

Net loans receivable	$	432,758		$	431,801

The following is a summary of information pertaining to impaired loans:

	September 30, 2011		December 31, 2010

Impaired loans without a valuation allowance	$	3,787	$	8,773
Impaired loans with a valuation allowance		13,746		2,643

Total impaired loans before valuation allowances		17,533		11,416
Valuation allowance related to impaired loans		3,468		1,496

Net impaired loans	$	14,065	$	9,920

Activity in the allowance for loan losses during the nine months ended September 30, 2011, follows:

Allowance for loan losses:	Commercial			Commercial Real Estate			Residential Real Estate			Consumer			Unallocated		Total

Beginning balance	$	3,862		$	3,674		$	211		$	213		$	–	$	7,960
Provision		604			(468	)		1,016			(2	)		–		1,150
Recoveries		166			6			–			5			–		177
Charge offs		(808	)		(132	)		(224	)		(104	)		–		(1,268	)

Ending balance	$	3,824		$	3,080		$	1,003		$	112		$	–	$	8,019
Individually evaluated for impairment	$	2,020		$	970		$	456		$	22		$	–	$	3,468
Collectively evaluated for impairment	$	1,804		$	2,110		$	547		$	90		$	–	$	4,551

Loans receivable (gross):

Individually evaluated for impairment	$	6,947		$	8,418		$	2,093		$	75		$	–	$	17,533
Collectively evaluated for impairment	$	125,311		$	188,029		$	108,133		$	3,509		$	–	$	424,982

The commercial credit exposure based on internally assigned credit grade at September 30, 2011 and at December 31, 2010, follows:

			Commercial		Construction &
At September 30, 2011	Commercial		Real Estate		Development		Agricultural		Government		Total

High quality (risk rating 1)	$	68	$	–	$	–	$	–	$	–	$	68
Minimal risk (2)		12,522		20,959		451		648		1,750		36,330
Average risk (3)		53,767		108,210		8,779		1,773		5,248		177,777
Acceptable risk (4)		41,809		34,236		2,149		307		–		78,501
Watch risk (5)		6,970		8,453		3,822		–		–		19,245
Substandard risk (6)		449		970		–		–		–		1,419
Impaired loans (7)		6,919		7,777		641		28		–		15,365

Total	$	122,504	$	180,605	$	15,842	$	2,756	$	6,998	$	328,705

			Commercial		Construction &
At December 31, 2010	Commercial		Real Estate		Development		Agricultural		Government		Total

High quality (credit risk rating 1)	$	83	$	–	$	–	$	–	$	–	$	83
Minimal risk (2)		3,854		27,792		1,055		664		1,922		35,287
Average risk (3)		57,667		107,639		7,865		1,507		6,024		180,702
Acceptable risk (4)		37,373		33,482		12,594		293		–		83,742
Watch risk (5)		10,303		6,560		145		–		–		17,008
Substandard risk (6)		4,797		3,010		237		–		–		8,044
Impaired loans (7)		4,218		2,454		345		358		–		7,375

Total	$	118,295	$	180,937	$	22,241	$	2,822	$	7,946	$	332,241

The consumer credit exposure based on payment activity at September 30, 2011 and at December 31, 2010, follows:

	Residential –		Residential –		Construction &
At September 30, 2011	Prime		HELOC		Development		Consumer		Total

Performing	$	73,307	$	23,817	$	11,416	$	3,524	$	112,064
Nonperforming		1,512		96		78		60		1,746

Total	$	74,819	$	23,913	$	11,494	$	3,584	$	113,810


	Residential –		Residential –		Construction &
At December 31, 2010	Prime		HELOC		Development		Consumer		Total

Performing	$	70,242	$	23,632	$	12,928	$	3,851	$	110,653
Nonperforming		1,433		142		141		78		1,794

Total	$	71,675	$	23,774	$	13,069	$	3,929	$	112,447

The payment age analysis of loans receivable disbursed at September 30, 2011 follows:

	30-59		60-89		90+		Total				Total		90+ and
Loan Class	Days		Days		Days		Past Due		Current		Loans		Accruing

Commercial:

Commercial and industrial	$	34	$	118	$	1,890	$	2,042	$	120,462	$	122,504	$	–
Agricultural		–		28		–		28		2,728		2,756		–
Government		–		–		–		–		6,998		6,998		–

Commercial real estate:

Commercial real estate		55		625		912		1,592		179,013		180,605		–
Commercial construction and development		–		–		204		204		14,879		15,083		–

Residential real estate:

Residential – prime		426		229		1,280		1,935		72,884		74,819		–
Residential – HELOC		39		22		49		110		23,803		23,913		–
Residential – construction and development		–		–		78		78		10,227		10,305		–

Consumer		69		4		7		80		3,504		3,584		–

Total	$	623	$	1,026	$	4,420	$	6,069	$	434,498	$	440,567	$	–

The payment age analysis of loans receivable disbursed at December 31, 2010 follows:

	30-59		60-89		90+		Total				Total		90+ and
Loan Class	Days		Days		Days		Past Due		Current		Loans		Accruing

Commercial:

Commercial and industrial	$	2,235	$	694	$	2,305	$	5,234	$	113,061	$	118,295	$	–
Agricultural		–		–		72		72		2,750		2,822		–
Government		–		–		–		–		7,946		7,946		–

Commercial real estate:

Commercial real estate		178		355		1,545		2,078		178,859		180,937		–
Commercial construction and development		–		145		448		593		17,930		18,523		–

Residential real estate:

Residential – prime		649		267		758		1,674		70,001		71,675		–
Residential – HELOC		26		35		78		139		23,635		23,774		–
Residential – construction and development		17		–		99		116		11,494		11,610		–

Consumer		8		3		78		89		3,840		3,929		–

Total	$	3,113	$	1,499	$	5,383	$	9,995	$	429,516	$	439,511	$	–

Impaired loans at September 30, 2011, and during the nine months then ended, by loan class, follows:

	Unpaid						Average		Interest
	Principal		Related		Recorded		Recorded		Income
	Balance		Allowance		Investment		Investment		Recognized

With no related allowance recorded:

Commercial & industrial	$	1,601	$	–	$	1,601	$	2,407	$	33
Commercial real estate		2,030		–		2,030		3,677		84
Commercial construction & development		–		–		–		120		–
Agricultural		–		–		–		150		–
Residential – prime		47		–		47		338		1
Residential – HELOC		109		–		109		77		6
Residential construction & development		–		–		–		12		–
Consumer		–		–		–		11		–

With an allowance recorded:

Commercial & industrial	$	5,318	$	1,992	$	3,326	$	2,105	$	87
Commercial real estate		5,747		730		5,017		2,639		194
Commercial construction & development		641		240		401		357		16
Agricultural		28		28		–		5		1
Residential – prime		1,733		342		1,391		946		20
Residential – HELOC		104		85		19		40		–
Residential construction & development		100		29		71		55		2
Consumer		75		22		53		36		1

Totals:

Commercial & industrial	$	6,919	$	1,992	$	4,927	$	4,512	$	120
Commercial real estate		7,777		730		7,047		6,316		278
Commercial construction & development		641		240		401		477		16
Agricultural		28		28		–		155		1
Residential – prime		1,780		342		1,438		1,284		21
Residential – HELOC		213		85		128		117		6
Residential construction & development		100		29		71		67		2
Consumer		75		22		53		47		1

Loans on nonaccrual status at period-end, follows:

	September 30, 2011		December 31, 2010

Commercial:

Commercial and industrial	$	4,311	$	4,546
Agricultural		–		72

Commercial real estate:

Commercial real estate		1,763		2,119
Commercial construction and development		209		508

Residential real estate:

Residential – prime		1,512		1,433
Residential – HELOC		96		142
Residential construction and development		78		141

Consumer		60		78

Total	$	8,029	$	9,039

The following table presents information concerning modifications of troubled debt made during the three months ended September 30, 2011. The contract identified below was modified to convert from amortizing principal payments to interest only payments. All modified or restructured loans are classified as impaired loans. Recorded investment as presented in the tables concerning modified loans below represents principal outstanding before specific reserves. Specific loan reserves maintained in connection with this impaired loan totaled $12 at September 30, 2011.

			Pre-modification		Post-modification
			outstanding		outstanding
	Number of		recorded		recorded
As of September 30, 2011 ($000s)	contracts		investment		investment

Commercial real estate		1	$	89	$	89

The following table presents information concerning modifications of troubled debt made during the nine months ended September 30, 2011:

			Post-modification			Pre-modification
			outstanding			outstanding
	Number of		recorded			recorded
As of September 30, 2011 ($000s)	contracts		investment			investment

Commercial & industrial		6		$	1,157		$	1,123
Commercial real estate		7			4,371			4,363
Commercial construction & development		1			74			73

During the nine months ended September 30, 2011, approximately $4,748, or 85%, of the modified loan principal was restructured to convert the payments from amortizing principal payments to interest only payments. The remaining modified principal of $854 was modified to extend amortization periods or to lower the existing interest rate. No loan principal was charged off or forgiven in connection with the modifications. At September 30, 2011, specific loan loss reserves maintained on loans modified or restructured during the nine months ended September 30, 2011 totaled $526.

The following table outlines past troubled debt restructurings that subsequently defaulted within twelve months of the last restructuring date. For purposes of this table, default is defined as 90 days or more past due on restructured payments.

Default during the three months and nine months ended September 30, 2011 ($000s)	Number of contracts		Recorded investment

Commercial real estate		2	$	267

The contracts noted above were originally restructured to extend principal amortization, capitalize real estate taxes or past due interest, or to convert payments to interest only. Collateral supporting the modified loans was in the process of foreclosure at period-end. Specific loan loss reserves of $76 were maintained on these impaired loans at September 30, 2011.