FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)
T	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR

 £ 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.

(Exact name of registrant as specified in charter)

WISCONSIN
(State of incorporation) 39-1804877
(I.R.S. Employer Identification Number)

1905 West Stewart Avenue

Wausau, Wisconsin 54401

(Address of principal executive office)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No o

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	o	Accelerated filer	o
Non-accelerated filer	o	Smaller reporting company	x
(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 o No x

The number of common shares outstanding at August 13, 2012 was 1,663,472.

 PSB HOLDINGS, INC.

FORM 10-Q

Quarter Ended June 30, 2012

			Page No.
PART I.	FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Consolidated Balance Sheets June 30, 2012 (unaudited) and December 31, 2011 (derived from audited financial statements)	1
		Consolidated Statements of Income Three Months and Six Months Ended June 30, 2012 and 2011 (unaudited)	2
		Consolidated Statements of Comprehensive Income Three Months and Six Months Ended June 30, 2012 and 2011 (unaudited)	3
		Consolidated Statement of Changes in Stockholders’ Equity Six Months Ended June 30, 2012 (unaudited)	3
		Consolidated Statements of Cash Flows Six Months Ended June 30, 2012 and 2011 (unaudited)	4
		Notes to Consolidated Financial Statements	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	56
	Item 4.	Controls and Procedures	56
PART II.	OTHER INFORMATION
	Item 1A.	Risk Factors	57
	Item 6.	Exhibits	57

i

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PSB Holdings, Inc.

Consolidated Balance Sheets

June 30, 2012 unaudited, December 31, 2011 derived from audited financial statements

	June 30,			December 31,
(dollars in thousands, except per share data)	2012			2011
Assets
Cash and due from banks	$	33,248		$	14,805
Interest-bearing deposits and money market funds		1,210			1,829
Federal funds sold		5,293			21,571
Cash and cash equivalents		39,751			38,205
Securities available for sale (at fair value)		93,565			59,383
Securities held to maturity (fair value of $72,563 and $50,751, respectively)		70,443			49,294
Bank certificates of deposit		2,484			2,484
Loans held for sale		452			39
Loans receivable, net		466,330			437,557
Accrued interest receivable		2,366			2,068
Foreclosed assets		2,642			2,939
Premises and equipment, net		10,191			9,928
Mortgage servicing rights, net		1,110			1,205
Federal Home Loan Bank stock (at cost)		2,761			3,250
Cash surrender value of bank-owned life insurance		11,608			11,406
Other assets		5,321			5,109
TOTAL ASSETS	$	709,024		$	622,867
Liabilities
Non-interest-bearing deposits	$	82,909		$	75,298
Interest-bearing deposits		474,498			406,211
Total deposits		557,407			481,509
Federal Home Loan Bank advances		55,124			50,124
Other borrowings		18,086			19,691
Senior subordinated notes		7,000			7,000
Junior subordinated debentures		7,732			7,732
Accrued expenses and other liabilities		11,043			6,449
Total liabilities		656,392			572,505
Stockholders’ equity
Preferred stock – no par value:
Authorized – 30,000 shares; no shares issued or outstanding		—			—
Common stock – no par value with a stated value of $1 per share:
Authorized – 3,000,000 shares; Issued – 1,751,431 shares
Outstanding – 1,584,637 and 1,575,804 shares, respectively		1,751			1,751
Common stock dividend distributable – 78,835 shares		79			—
Additional paid-in capital		6,967			5,323
Retained earnings		46,698			46,111
Accumulated other comprehensive income, net of tax		1,654			1,934
Treasury stock, at cost – 166,794 and 175,627 shares, respectively		(4,517	)		(4,757	)
Total stockholders’ equity		52,632			50,362
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	709,024		$	622,867

-1-

PSB Holdings, Inc.

Consolidated Statements of Income

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(dollars in thousands, except per share data – unaudited)	2012		2011		2012		2011
Interest and dividend income:
Loans, including fees	$	5,785	$	6,112	$	11,626	$	12,156
Securities:
Taxable		575		705		1,147		1,383
Tax-exempt		299		281		562		578
Other interest and dividends		20		15		39		39
Total interest and dividend income		6,679		7,113		13,374		14,156
Interest expense:
Deposits		1,070		1,396		2,222		2,825
FHLB advances		353		459		705		916
Other borrowings		149		165		297		332
Senior subordinated notes		142		141		284		283
Junior subordinated debentures		85		86		170		170
Total interest expense		1,799		2,247		3,678		4,526
Net interest income		4,880		4,866		9,696		9,630
Provision for loan losses		165		430		325		790
Net interest income after provision for loan losses		4,715		4,436		9,371		8,840
Noninterest income:
Service fees		413		408		815		787
Mortgage banking		439		281		751		706
Investment and insurance sales commissions		238		142		376		272
Increase in cash surrender value of life insurance		101		102		202		208
Gain on bargain purchase		851		—		851		—
Other noninterest income		281		264		570		621
Total noninterest income		2,323		1,197		3,565		2,594
Noninterest expense:
Salaries and employee benefits		2,217		1,991		4,380		4,101
Occupancy and facilities		396		412		802		865
Loss on foreclosed assets, net		4		278		237		573
Data processing and other office operations		428		313		832		626
Advertising and promotion		106		54		164		115
FDIC insurance premiums		105		149		212		338
Other noninterest expenses		808		672		1,556		1,204
Total noninterest expense		4,064		3,869		8,183		7,822
Income before provision for income taxes		2,974		1,764		4,753		3,612
Provision for income taxes		1,056		538		1,655		1,101
Net income	$	1,918	$	1,226	$	3,098	$	2,511
Basic earnings per share	$	1.15	$	0.74	$	1.86	$	1.52
Diluted earnings per share	$	1.15	$	0.74	$	1.86	$	1.51

-2-

PSB Holdings, Inc.

Consolidated Statements of Comprehensive Income

	Three Months Ended						Six Months Ended
	June 30,						June 30,
(dollars in thousands – unaudited)	2012			2011			2012			2011
Net income	$	1,918		$	1,226		$	3,098		$	2,511
Other comprehensive income, net of tax:
Unrealized gain (loss) on securities available for sale		(76	)		337			(74	)		284
Amortization of unrealized gain on securities available for sale transferred to securities held to maturity included in net income		(73	)		(77	)		(144	)		(163	)
Unrealized loss on interest rate swap		(103	)		(155	)		(113	)		(129	)
Reclassification adjustment of interest rate swap settlements included in earnings		26			28			51			55
Comprehensive income	$	1,692		$	1,359		$	2,818		$	2,558

PSB Holdings, Inc.

Consolidated Statement of Changes in Stockholders’ Equity

Six months ended June 30, 2012

									Accumulated
									Other
			Additional						Comprehensive
	Common		Paid-in			Retained			Income			Treasury
(dollars in thousands – unaudited)	Stock		Capital			Earnings			(Loss)			Stock			Totals
Balance January 1, 2012	$	1,751	$	5,323		$	46,111		$	1,934		$	(4,757	)	$	50,362
Comprehensive income:
Net income							3,098									3,098
Unrealized loss on securities available for sale, net of tax										(74	)					(74	)
Amortization of unrealized gain on securities available for sale transferred to securities held to maturity included in net income, net of tax										(144	)					(144	)
Unrealized loss on interest rate swap, net of tax										(113	)					(113	)
Reclassification of interest rate swap settlements included in earnings, net of tax										51						51
Total comprehensive income																2,818
Purchase of treasury stock													(5	)		(5	)
Exercise of stock options				(6	)								15			9
Issuance of new restricted stock grants				(230	)								230			—
Vesting of existing restricted stock grants				63												63
Stock dividend declared – 5% of shares		79		1,817			(1,906	)								(10	)
Cash dividends declared $.36 per share							(591	)								(591	)
Cash dividends declared on unvested restricted stock grants							(14	)								(14	)
Balance June 30, 2012	$	1,830	$	6,967		$	46,698		$	1,654		$	(4,517	)	$	52,632

-3-

PSB Holdings, Inc.

Consolidated Statements of Cash Flows

Six months ended June 30, 2012 and 2011

(dollars in thousands – unaudited)	2012			2011
Cash flows from operating activities:
Net income	$	3,098		$	2,511
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for depreciation and net amortization		1,330			1,069
Provision for loan losses		325			790
Deferred net loan origination costs		(221	)		(156	)
Gain on sale of loans		(803	)		(401	)
Provision for (recovery of) servicing right valuation allowance		133			(145	)
Loss on sale of foreclosed assets		157			433
Increase in cash surrender value of life insurance		(202	)		(208	)
Gain on bargain purchase		(851	)		—
Changes in operating assets and liabilities:
Accrued interest receivable		104			166
Other assets		199			131
Other liabilities		(395	)		(556	)
Net cash provided by operating activities		2,874			3,634
Cash flows from investing activities:
Proceeds from sale and maturities of:
Securities available for sale		13,704			7,930
Securities held to maturity		5,403			2,230
Payment for purchase of:
Securities available for sale		(14,320	)		(13,941	)
Securities held to maturity		(6,599	)		(831	)
Cash acquired on purchase of Marathon State Bank		19,640			—
Redemption of FHLB stock		489			—
Net (increase) decrease in loans		2,297			(6,500	)
Capital expenditures		(187	)		(102	)
Proceeds from sale of foreclosed assets		408			330
Purchase of bank-owned life insurance		—			(92	)
Net cash provided by (used in) investing activities		20,835			(10,976	)

-4-

PSB Holdings, Inc.

Consolidated Statements of Cash Flows

Six months ended June 30, 2012 and 2011

(continued)

(dollars in thousands – unaudited)	2012			2011
Cash flows from financing activities:
Net decrease in non-interest-bearing deposits		(16,812	)		(2,472	)
Net decrease in interest-bearing deposits		(8,135	)		(14,118	)
Net increase in FHLB advances		5,000			1,690
Net decrease in other borrowings		(1,605	)		(6,372	)
Dividends declared		(615	)		(586	)
Proceeds from exercise of stock options		9			24
Purchase of treasury stock		(5	)		—
Net cash used in financing activities		(22,163	)		(21,834	)
Net increase (decrease) in cash and cash equivalents		1,546			(29,176	)
Cash and cash equivalents at beginning		38,205			40,331
Cash and cash equivalents at end	$	39,751		$	11,155
Supplemental cash flow information:
Cash paid during the period for:
Interest	$	3,735		$	4,591
Income taxes		1,169			1,025
Noncash investing and financing activities:
Loans charged off	$	631		$	1,083
Loans transferred to foreclosed assets		414			135
Loans originated on sale of foreclosed assets		140			—
Issuance of unvested restricted stock grants at fair value		200			200
Vesting of restricted stock grants		63			45

-5-

 PSB Holdings, Inc.

Notes to Consolidated Financial Statements

NOTE 1 – GENERAL 

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly PSB Holdings, Inc.’s (“PSB”) financial position, results of its operations, and cash flows for the periods presented, and all such adjustments are of a normal recurring nature. The consolidated financial statements include the accounts of all subsidiaries. All material intercompany transactions and balances are eliminated. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. Any reference to “PSB” refers to the consolidated or individual operations of PSB Holdings, Inc. and its subsidiary Peoples State Bank and, where applicable, its subsidiary Marathon State Bank, which, as described in Note 2 below, was acquired by PSB on June 14, 2012. Dollar amounts are in thousands, except per share amounts.

These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles have been omitted or abbreviated. The information contained in the consolidated financial statements and footnotes in PSB’s Annual Report on Form 10-K for the year ended December 31, 2011 should be referred to in connection with the reading of these unaudited interim financial statements.

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing right assets, and the valuation of investment securities.

NOTE 2 – PSB HOLDINGS, INC. ACQUISITION OF MARATHON STATE BANK

On June 14, 2012, PSB completed its purchase of Marathon State Bank, a privately owned bank with $107 million in total assets located in the Village of Marathon City, Wisconsin (“Marathon”). Under the terms of the agreement, PSB paid $5,505 in cash, which was equal to 100% of Marathon’s tangible net book value following a special dividend by Marathon to its shareholders to reduce its book equity ratio to 6% of total assets. The following table outlines the fair value of Marathon assets and liabilities acquired including determination of the gain on bargain purchase using an accounting date of June 1, 2012. A core deposit intangible was not recorded on the purchase as the fair value calculation determined it was insignificant.

Cash purchase price	$	5,505
Fair value of assets acquired:
Cash and due from banks		20,392
Securities		50,547
Loans receivable		23,760
Short-term commercial paper and bankers’ acceptances		11,713
Foreclosed assets		—
Premises and equipment		402
Core deposit intangible		—
Accrued interest receivable and other assets		550
Total fair value of assets acquired		107,364
Fair value of liabilities assumed:
Non-interest bearing deposits		23,255
Interest-bearing deposits		77,611
Accrued interest payable and other liabilities		142
Total fair value of liabilities assumed		101,008
Fair value of net assets acquired		6,356
Gain on bargain purchase	$	851

-6-

PSB recorded a total credit mark down of $490 on Marathon’s loan portfolio on the purchase date, or 1.52% of purchased loan principal (including non-rated commercial paper and bankers’ acceptances). Purchased impaired loan principal totaled $310 on which a $21 credit write-down was recorded. Due to the insignificant amount of total purchased impaired loans, the entire $490 credit mark down will be accreted to income as a yield adjustment based on contractual cash flows over the remaining life of the purchased loans. 

Pro forma combined results of operations as if the combination occurred at the beginning of the quarterly and year to date periods ended June 30, 2012:

	Quarter ended June 30, 2012 (pro forma combined at beginning of period)
		Net interest		Noninterest		Net		Earnings
($000s)		income		income		income		per share
PSB Holdings, Inc.	$	4,747	$	1,469	$	1,364	$	0.82
Marathon State Bank		382		860		523		0.31
Pro forma Totals	$	5,129	$	2,329	$	1,887	$	1.13
		Six months ended June 30, 2012 (pro forma combined at beginning of period)
		Net interest		Noninterest		Net		Earnings
($000s)		income		income		income		per share
PSB Holdings, Inc.	$	9,563	$	2,711	$	2,544	$	1.53
Marathon State Bank		808		872		600		0.36
Pro forma Totals	$	10,371	$	3,583	$	3,144	$	1.89

Pro forma combined results of operations as if the combination occurred at the beginning of the quarterly and year to date periods ended June 30, 2011:

	Quarter ended June 30, 2011 (pro forma combined at beginning of period)
		Net interest		Noninterest		Net		Earnings
($000s)		income		income		income		per share
PSB Holdings, Inc.	$	4,866	$	1,197	$	1,226	$	0.74
Marathon State Bank		443		10		151		0.09
Pro forma Totals	$	5,309	$	1,207	$	1,377	$	0.83
	Six months ended June 30, 2011 (pro forma combined at beginning of period)
		Net interest		Noninterest		Net		Earnings
($000s)		income		income		income		per share
PSB Holdings, Inc.	$	9,630	$	2,594	$	2,511	$	1.51
Marathon State Bank		879		26		289		0.18
Pro forma Totals	$	10,509	$	2,620	$	2,800	$	1.69

-7-

NOTE 3 – SECURITIES

The amortized cost and estimated fair value of investment securities are as follows:

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
June 30, 2012	Cost		Gains		Losses		Value
Securities available for sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	32,519	$	33	$	2	$	32,550
U.S. agency issued residential mortgage-backed securities		17,194		982		—		18,176
U.S. agency issued residential collateralized mortgage obligations		41,755		784		40		42,499
Privately issued residential collateralized mortgage obligations		284		9		—		293
Other equity securities		47		—		—		47
Totals	$	91,799	$	1,808	$	42	$	93,565
Securities held to maturity
Obligations of states and political subdivisions	$	66,125	$	2,206	$	18	$	68,313
Nonrated trust preferred securities		1,496		35		105		1,426
Nonrated senior subordinated notes		403		2		—		405
Bankers’ acceptances		2,419		—		—		2,419
Totals	$	70,443	$	2,243	$	123	$	72,563

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
December 31, 2011	Cost		Gains		Losses		Value
Securities available for sale
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	501	$	17	$	—	$	518
U.S. agency issued residential mortgage-backed securities		18,754		1,068		6		19,816
U.S. agency issued residential collateralized mortgage obligations		37,774		806		7		38,573
Privately issued residential collateralized mortgage obligations		418		11		—		429
Other equity securities		47		—		—		47
Totals	$	57,494	$	1,902	$	13	$	59,383
Securities held to maturity
Obligations of states and political subdivisions	$	47,404	$	1,636	$	30	$	49,010
Nonrated trust preferred securities		1,487		40		195		1,332
Nonrated senior subordinated notes		403		6		—		409
Totals	$	49,294	$	1,682	$	225	$	50,751

Securities with a fair value of $48,506 and $56,659 at June 30, 2012 and December 31, 2011, respectively, were pledged to secure public deposits, other borrowings, and for other purposes required by law.

-8-

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, categorized by the type of the loan, is as follows:

	June 30, 2012			December 31, 2011
Commercial, industrial, and municipal	$	137,827		$	127,192
Commercial real estate mortgage		179,186			184,360
Commercial construction and development		21,337			20,078
Residential real estate mortgage		98,025			78,114
Residential construction and development		13,084			13,419
Residential real estate home equity		23,607			23,193
Consumer and individual		5,566			3,732
Subtotals – Gross loans		478,632			450,088
Loans in process of disbursement		(4,867	)		(4,787	)
Subtotals – Disbursed loans		473,765			445,301
Net deferred loan costs		213			197
Allowance for loan losses		(7,648	)		(7,941	)
Net loans receivable	$	466,330		$	437,557

-9-

The following is a summary of information pertaining to impaired loans at period-end: 

	June 30, 2012		December 31, 2011
Impaired loans without a valuation allowance	$	7,425	$	5,474
Impaired loans with a valuation allowance		9,150		11,745
Total impaired loans before valuation allowances		16,575		17,219
Valuation allowance related to impaired loans		2,570		3,178
Net impaired loans	$	14,005	$	14,041

Activity in the allowance for loans losses during the six months ended June 30, 2012 follows:

Allowance for loan losses:		Commercial			Commercial Real Estate			Residential Real Estate			Consumer			Unallocated		Total
Beginning Balance	$	3,406		$	3,175		$	1,242		$	118		$	—	$	7,941
Provision		(390	)		(15	)		717			13			—		325
Recoveries		6			3			2			2			—		13
Charge offs		(105	)		(115	)		(388	)		(23	)		—		(631	)
Ending balance	$	2,917		$	3,048		$	1,573		$	110		$	—	$	7,648
Individually evaluated for impairment	$	1,244		$	815		$	495		$	16		$	—	$	2,570
Collectively evaluated for impairment	$	1,673		$	2,233		$	1,078		$	94		$	—	$	5,078
Loans receivable (gross):
Individually evaluated for impairment	$	5,770		$	8,216		$	2,518		$	71		$	—	$	16,575
Collectively evaluated for impairment	$	132,057		$	192,307		$	132,198		$	5,495		$	—	$	462,057

Activity in the allowance for loans losses during the six months ended June 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		579			(653	)		932			(68	)		—		790
Recoveries		139			6			—			5			—		150
Charge offs		(766	)		(132	)		(102	)		(83	)		—		(1,083	)
Ending balance	$	3,814		$	2,895		$	1,041		$	67		$	—	$	7,817
Individually evaluated for impairment	$	1,943		$	882		$	542		$	20		$	—	$	3,387
Collectively evaluated for impairment	$	1,871		$	2,013		$	499		$	47		$	—	$	4,430
Loans receivable (gross):
Individually evaluated for impairment	$	7,338		$	7,688		$	2,163		$	78		$	—	$	17,267
Collectively evaluated for impairment	$	123,409		$	192,238		$	111,323		$	3,667		$	—	$	430,637

-10-

PSB maintains an independent credit administration staff that continually monitors aggregate commercial loan portfolio and individual borrower credit quality trends. All commercial purpose loans are assigned a credit grade upon origination, and credit grades for nonproblem borrowers with aggregate credit in excess of $500 are reviewed annually. In addition, all past due, restructured, or identified problem loans, both commercial and consumer purpose, are reviewed and assigned an up-to-date credit grade quarterly.

PSB uses a seven point grading scale to estimate credit risk with risk rating 1, representing the high credit quality, and risk rating 7, representing the lowest credit quality. The assigned credit grade takes into account several credit quality components which are assigned a weight and blended into the composite grade. The factors considered and their assigned weight for the final composite grade is as follows:

Cash flow (30% weight) – Considers earnings trends and debt service coverage levels.

Collateral (25% weight) – Considers loan to value and other measures of collateral coverage.

Leverage (15% weight) – Considers balance sheet debt and capital ratios compared to Robert Morris & Associates (RMA) industry medians.

Liquidity (10% weight) – Considers balance sheet current, quick, and other working capital ratios compared to RMA industry medians.

Management (5% weight) – Considers the past performance, character, and depth of borrower management.

Guarantor (5% weight) – Considers the existence of a guarantor along with a bank’s past experience with the guarantor and his related liquidity and credit score.

Financial reporting (5% weight) – Considers the relative level of independent financial review obtained by the borrower on its financial statements, from audited financial statements down to existence of only tax returns or potentially unreliable financial information.

Industry (5% weight) – Considers the borrower’s industry and whether it is stable or subject to cyclical or seasonal factors.

Nonclassified loans are assigned a risk rating of 1 to 4 and have credit quality that ranges from well above average to some inherent industry weaknesses that may present higher than average risk due to conditions affecting the borrower, the borrower’s industry, or economic development.

Special mention and watch loans are assigned a risk rating of 5 when potential weaknesses exist that deserve management’s close attention. If left uncorrected, the potential weaknesses may result in deterioration of repayment prospects or in credit position at some future date. Substandard loans are assigned a risk rating of 6 and are inadequately protected by the current worth and borrowing capacity of the borrower. Well-defined weaknesses exist that may jeopardize the liquidation of the debt. There is a possibility of some loss if the deficiencies are not corrected. At this point, the loan may still be performing and accruing interest.

Impaired and other doubtful loans assigned a risk rating of 7 have all of the weaknesses of a substandard credit plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of current facts, conditions, and collateral values highly questionable and improbable. Impaired loans include all nonaccrual loans and all restructured loans including restructured loans performing according to the restructured terms. In special situations, an impaired loan with a risk rating of 7 could still be maintained on accrual status such as in the case of restructured loans performing according to restructured terms.

-11-

The commercial credit exposure based on internally assigned credit grade at June 30, 2012, follows:

	Commercial		Commercial Real Estate		Construction & Development		Agricultural		Government		Total
High quality (risk rating 1)	$	44	$	—	$	—	$	—	$	—	$	44
Minimal risk (2)		14,800		22,022		155		523		1,644		39,144
Average risk (3)		64,681		99,031		14,762		1,975		12,343		192,792
Acceptable risk (4)		27,403		40,870		2,368		347		—		70,988
Watch risk (5)		7,616		7,940		1,875		—		—		17,431
Substandard risk (6)		681		1,736		1,548		—		—		3,965
Impaired loans (7)		5,742		7,587		629		28		—		13,986
Total	$	120,967	$	179,186	$	21,337	$	2,873	$	13,987	$	338,350

The commercial credit exposure based on internally assigned credit grade at December 31, 2011, follows:
	Commercial		Commercial  Real Estate		Construction & Development		Agricultural		Government		Total
High quality (risk rating 1)	$	65	$	—	$	—	$	—	$	—	$	65
Minimal risk (2)		10,404		21,922		205		534		1,660		34,725
Average risk (3)		54,387		103,614		12,981		1,088		6,153		178,223
Acceptable risk (4)		38,381		42,435		2,401		307		—		83,524
Watch risk (5)		7,054		7,972		2,903		—		—		17,929
Substandard risk (6)		675		1,005		937		—		—		2,617
Impaired loans (7)		6,456		7,412		651		28		—		14,547
Total	$	117,422	$	184,360	$	20,078	$	1,957	$	7,813	$	331,630

The consumer credit exposure based on payment activity at June 30, 2012, follows:

	Residential-		Residential-		Construction and
	Prime		HELOC		Development		Consumer		Total
Performing	$	96,026	$	23,410	$	13,006	$	5,509	$	137,951
Nonperforming		1,999		197		78		57		2,331
Total	$	98,025	$	23,607	$	13,084	$	5,566	$	140,282

The consumer credit exposure based on payment activity at December 31, 2011, follows:
		Residential-		Residential-		Construction and
		Prime		HELOC		Development		Consumer		Total
Performing	$	76,474	$	23,034	$	13,341	$	3,677	$	116,526
Nonperforming		1,640		159		78		55		1,932
Total	$	78,114	$	23,193	$	13,419	$	3,732	$	118,458

-12-

The payment age analysis of loans receivable disbursed at June 30, 2012, follows:

	30-59		60-89		90+		Total				Total		90+ and
Loan Class	Days		Days		Days		Past Due		Current		Loans		Accruing
Commercial:
Commercial and industrial	$	1,215	$	67	$	1,105	$	2,387	$	118,580	$	120,967	$	—
Agricultural		—		28		—		28		2,845		2,873		—
Government		—		—		—		—		13,987		13,987		—
Commercial real estate:
Commercial real estate		564		—		1,117		1,681		177,505		179,186		—
Commercial construction and development		3		—		127		130		18,549		18,679		—
Residential real estate:
Residential – Prime		274		425		1,198		1,897		96,128		98,025		—
Residential – HELOC		79		59		113		251		23,356		23,607		—
Residential – construction and development		48		—		78		126		10,749		10,875		—
Consumer		5		1		56		62		5,504		5,566		—
Total	$	2,188	$	580	$	3,794	$	6,562	$	467,203	$	473,765	$	—

The payment age analysis of loans receivable disbursed at December 31, 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	$	670	$	25	$	2,041	$	2,736	$	114,686	$	117,422	$	—
Agricultural		—		—		—		—		1,957		1,957		—
Government		—		—		—		—		7,813		7,813		—
Commercial real estate:
Commercial real estate		542		—		1,229		1,771		182,589		184,360		—
Commercial construction and development		—		—		145		145		17,195		17,340		—
Residential real estate:
Residential – prime		1,127		173		1,144		2,444		75,670		78,114		—
Residential – HELOC		255		5		129		389		22,804		23,193		—
Residential – construction and development		—		35		77		112		11,258		11,370		—
Consumer		11		—		54		65		3,667		3,732		—
Total	$	2,605	$	238	$	4,819	$	7,662	$	437,639	$	445,301	$	—

-13-

Impaired loans as of June 30, 2012, and during the six 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	$	2,127	$	—	$	2,127	$	1,867	$	38
Commercial real estate		4,457		—		4,457		4,082		130
Commercial construction & development		127		—		127		64		—
Residential – prime		679		—		679		421		5
Residential – HELOC		35		—		35		18		2
With an allowance recorded:
Commercial & industrial	$	3,615	$	1,217	$	2,398	$	2,807	$	28
Commercial real estate		3,130		602		2,528		2,770		47
Commercial construction & development		502		213		289		375		14
Agricultural		28		27		1		1		—
Residential – prime		1,498		326		1,172		1,377		3
Residential – HELOC		208		128		80		109		—
Residential construction & development		98		41		57		83		1
Consumer		71		16		55		55		1
Totals:
Commercial & industrial	$	5,742		1,217	$	4,525	$	4,674	$	66
Commercial real estate		7,587		602		6,985		6,852		177
Commercial construction & development		629		213		416		439		14
Agricultural		28		27		1		1		—
Residential – prime		2,177		326		1,851		1,798		8
Residential – HELOC		243		128		115		127		2
Residential construction & development		98		41		57		83		1
Consumer		71		16		55		55		1

-14-

The impaired loans at December 31, 2011, and during the year 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 and industrial	$	1,606	$	—	$	1,606	$	2,409	$	51
Commercial real estate		3,706		—		3,706		4,515		204
Commercial construction and development		—		—		—		120		—
Agricultural		—		—		—		150		—
Residential – Prime		162		—		162		396		1
Residential – HELOC		—		—		—		23		—
Residential construction and development		—		—		—		12		—
Consumer		—		—		—		11		—
With an allowance recorded:
Commercial and industrial	$	4,850	$	1,635	$	3,215	$	2,050	$	93
Commercial real estate		3,706		694		3,012		1,637		154
Commercial construction and development		651		191		460		386		23
Agricultural		28		28		—		5		2
Residential – Prime		2,029		448		1,581		1,041		53
Residential – HELOC		268		131		137		99		9
Residential construction and development		144		36		108		74		5
Consumer		69		15		54		37		2
Totals:
Commercial and industrial	$	6,456	$	1,635	$	4,821	$	4,459	$	144
Commercial real estate		7,412		694		6,718		6,152		358
Commercial construction and development		651		191		460		506		23
Agricultural		28		28		—		155		2
Residential – Prime		2,191		448		1,743		1,437		54
Residential – HELOC		268		131		137		122		9
Residential construction and development		144		36		108		86		5
Consumer		69		15		54		48		2

-15-

Loans on nonaccrual status at period-end, follows:

	June 30, 2012		December 31, 2011
Commercial:
Commercial and industrial	$	3,863	$	4,309
Commercial real estate:
Commercial real estate		1,783		1,585
Commercial construction and development		130		148
Residential real estate:
Residential – prime		1,999		1,640
Residential – HELOC		197		159
Residential construction and development		78		78
Consumer		57		55
Total	$	8,107	$	7,974

During the quarter and six months ended June 30, 2012, the commercial related contracts identified below were modified to convert from amortizing principal payments to interest only payments or to capitalize unpaid property taxes and were therefore categorized as troubled debt restructurings. During the quarter and six months ended June 30, 2011, the commercial related contracts identified below were modified to defer principal payments due or lower the interest rate. Specific loan reserves maintained in connection with loans restructured during the year to date period totaled $62 at June 30, 2012 and $515 at June 30, 2011. All modified or restructured loans are classified as impaired loans. Recorded investment as presented in the tables below concerning modified loans represents principal outstanding before specific reserves.

The following table presents information concerning modifications of troubled debt made during the quarter ended June 30, 2012:

As of June 30, 2012 ($000s)	Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment at period-end
Commercial real estate		1	$	148	$	144

The following table presents information concerning modifications of troubled debt made during the six months ended June 30, 2012: 

As of June 30, 2012 ($000s)	Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment at period-end
Commercial and industrial		3	$	180	$	173
Commercial real estate		2	$	527	$	516

-16-

The following table presents information concerning modifications of troubled debt made during the quarter ended June 30, 2011:

As of June 30, 2011 ($000s)	Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment at period-end
Commercial and industrial		5	$	1,132	$	1,132
Commercial real estate		6	$	4,282	$	4,282
Commercial construction and development		1	$	74	$	74

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

As of June 30, 2011 ($000s)	Number of contracts		Pre-modification outstanding recorded investment		Post-modification outstanding recorded investment at period-end
Commercial and industrial		6	$	1,157	$	1,123
Commercial real estate		6	$	4,282	$	4,274
Commercial construction and development		1	$	74	$	73

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 quarter and six months ended	Number of	Recorded
June 30, 2012 ($000s)	contracts	investment
Commercial and industrial	1	$        23

No troubled debt restructurings defaulted during the six months ended June 30, 2011 that had defaulted within twelve months of the last restructuring date.

NOTE 5 – FORECLOSED ASSETS

Real estate and other property acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value (after deducting estimated costs to sell) at the date of foreclosure, establishing a new cost basis. Costs related to development and improvement of property are capitalized, whereas costs related to holding property are expensed. After foreclosure, valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Revenue and expenses from operations of foreclosed assets and changes in any valuation allowance are included in loss on foreclosed assets.

A summary of activity in foreclosed assets is as follows:

	Three months ended						Six months ended
	June 30,						June 30,
	2012			2011			2012			2011
Balance at beginning of period	$	3,108		$	4,828		$	2,939		$	4,967
Transfer of loans at net realizable value to foreclosed assets		50			—			408			135
Sale proceeds		(408	)		(256	)		(408	)		(330	)
Loans made on sale of foreclosed assets		(140	)		—			(140	)		—
Net gain from sale of foreclosed assets		48			—			48			24
Provision for write-down charged to operations		(16	)		(233	)		(205	)		(457	)
Balance at end of period	$	2,642		$	4,339		$	2,642		$	4,339

-17-

NOTE 6 – DEPOSITS

The distribution of deposits at period end is as follows:

	June 30, 2012		December 31, 2011
Non-interest bearing demand	$	82,909	$	75,298
Interest bearing demand (NOWs)		118,469		108,894
Savings		50,981		28,056
Money market		108,712		102,993
Retail and local time		126,904		91,702
Broker and national time		69,432		74,566
Total deposits	$	557,407	$	481,509

NOTE 7 – OTHER BORROWINGS

Other borrowings consist of the following obligations at June 30, 2012, and December 31, 2011:

	June 30, 2012		December 31, 2011
Short-term repurchase agreements	$	4,586	$	6,191
Wholesale structured repurchase agreements		13,500		13,500
Total other borrowings	$	18,086	$	19,691

PSB pledges various securities available for sale as collateral for repurchase agreements. The fair value of securities pledged for repurchase agreements totaled $23,096 at June 30, 2012 and $22,977 at December 31, 2011.

The following information relates to securities sold under repurchase agreements and other borrowings:

	Three months ended						Six months ended
	June 30,						June 30,
	2012			2011			2012			2011
As of end of period - weighted average rate		3.23	%		2.61	%		3.23	%		2.61	%
For the period:
Highest month-end balance	$	19,934		$	27,279		$	19,934		$	32,644
Daily average balance	$	19,705		$	26,154		$	19,388		$	28,421
Weighted average rate		3.04	%		2.53	%		3.08	%		2.36	%

NOTE 8 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

PSB is exposed to certain risks relating to its ongoing business operations. The primary risk managed by using derivative instruments is interest rate risk. Interest rate swaps are entered into to manage interest rate risk associated with PSB’s variable rate junior subordinated debentures. Accounting standards require PSB to recognize all derivative instruments as either assets or liabilities at fair value in the balance sheet. PSB designates its interest rate swap associated with the junior subordinated debentures as a cash flow hedge of variable-rate debt. For derivative financial instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative instrument representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.

-18-

From time to time, PSB will also enter into fixed interest rate swaps with customers in connection with their floating rate loans to PSB. When fixed rate swaps are originated with customers, an identical offsetting swap is also entered into by PSB with a correspondent bank. These swap arrangements are intended to offset each other as “back to back” swaps and allow PSB’s loan customer to obtain fixed rate loan financing via the swap while PSB exchanges these fixed payments with a correspondent bank. In these arrangements, PSB’s net cash flows and interest income are equal to the floating rate loan originated in connection with the swap. These customer swaps are not designated as hedging instruments and are accounted for at fair value with changes in fair value recognized in the income statement during the current period.

PSB is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. PSB controls the credit risk of its financial contracts through credit approvals, limits, and monitoring procedures, and does not expect any counterparties to fail their obligations. PSB swaps originated with correspondent banks are over-the-counter (OTC) contracts. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreement terms, including the underlying instrument, amounts, exercise prices, and maturity.

At period end, the following interest rate swaps to hedge variable-rate debt were outstanding:

	June 30, 2012		December 31, 2011
Notional amount		$ 7,500		$ 7,500
Pay fixed rate		2.72%		2.72%
Receive variable rate		0.47%		0.55%
Maturity	September 2017		September 2017
Unrealized gain (loss) fair value		$ (678)		$ (576)

This agreement provides for PSB to receive payments at a variable rate determined by the three-month LIBOR in exchange for making payments at a fixed rate. Actual maturities may differ from scheduled maturities due to call options and/or early termination provisions. No interest rate swap agreements were terminated prior to maturity during the six months ended June 30, 2012 or 2011. Risk management results for the six months ended June 30, 2012 related to the balance sheet hedging of variable rate debt indicates that the hedge was 100% effective, and no component of the derivative instrument’s gain or loss was excluded from the assessment of hedge effectiveness.

As of June 30, 2012, approximately $170 of losses ($103 after tax impacts) reported in other comprehensive income related to the interest rate swap are expected to be reclassified into interest expense as a yield adjustment of the hedged borrowings during the 12-month period ending June 30, 2013. The interest rate swap agreement was secured by cash and cash equivalents of $750 at June 30, 2012, and by $680 at December 31, 2011.

PSB maintains outstanding interest rate swaps with customers and correspondent banks associated with its lending activities that are not designated as hedges. At period end, the following floating interest rate swaps were outstanding with customers:

	June 30, 2012		December 31, 2011
Notional amount		$ 15,298		$14,324
Receive fixed rate (average)		1.99%		2.05%
Pay variable rate (average)		0.24%		0.29%
Maturity	March 2015 – Oct. 2021		March 2015 – Oct. 2021
Weighted average remaining term		4.4 years		4.9 years
Unrealized gain (loss) fair value		$702		$555

At period end, the following offsetting fixed interest rate swaps were outstanding with correspondent banks:

	June 30, 2012		December 31, 2011
Notional amount		$ 15,298		$ 14,324
Pay fixed rate (average)		1.99%		2.05%
Receive variable rate (average)		0.24%		0.29%
Maturity	March 2015 – Oct. 2021		March 2015 – Oct. 2021
Weighted average remaining term		4.4 years		4.9 years
Unrealized gain (loss) fair value		$ (702)		$ (555)

-19-

NOTE 9 – INCOME TAX EFFECTS ON ITEMS OF COMPREHENSIVE INCOME (LOSS)

	Three Months Ended						Six Months Ended
	June 30, 2012						June 30, 2012
Periods ended June 30, 2012	Pre-tax			Income Tax			Pre-tax			Income Tax
(dollars in thousands)	Inc. (Exp.)			Exp. (Credit)			Inc. (Exp.)			Exp. (Credit)
Unrealized loss on securities available for sale	$	(126	)	$	(50	)	$	(130	)	$	(56	)
Amortization of unrealized gain on securities available for sale transferred to securities held to maturity included in net income		(119	)		(46	)		(236	)		(92	)
Unrealized loss on interest rate swap		(170	)		(67	)		(186	)		(73	)
Reclassification adjustment of interest rate swap settlements included in earnings		43			17			84			33
Totals	$	(372	)	$	(146	)	$	(468	)	$	(188	)

	Three Months Ended  June 30, 2011						Six Months Ended June 30, 2011
Periods ended June 30, 2011	Pre-tax			Income Tax			Pre-tax			Income Tax
(dollars in thousands)	Inc. (Exp.)			Exp. (Credit)			Inc. (Exp.)			Exp. (Credit)
Unrealized gain on securities available for sale	$	556		$	219		$	469		$	185
Amortization of unrealized gain on securities available for sale transferred to securities held to maturity included in net income		(127	)		(50	)		(269	)		(106	)
Unrealized loss on interest rate swap		(256	)		(101	)		(213	)		(84	)
Reclassification adjustment of interest rate swap settlements included in earnings		46			18			91			36
Totals	$	219		$	86		$	78		$	31

NOTE 10 – STOCK-BASED COMPENSATION

Under the terms of an incentive stock option plan adopted during 2001, shares of unissued common stock were reserved for options to officers and key employees at prices not less than the fair market value of the shares at the date of the grant. No additional shares of common stock remain reserved for future grants under the option plan approved by the shareholders, and the last outstanding option shares were exercised during the quarter ended June 30, 2012. As of December 31, 2011, 588 options were outstanding and eligible to be exercised at a price of $16.03 per share which were exercised during the quarter ended June 30, 2012. During the six months ended June 30, 2011, 1,537 options were exercised at $15.08 per share.

PSB granted restricted stock to certain employees having an initial market value of $200 during the three months ended March 31, 2012 and 2011. Restricted shares vest to employees based on continued PSB service over a six-year period and are recognized as compensation expense over the vesting period. Cash dividends are paid on unvested shares at the same time and amount as paid to PSB common shareholders. Cash dividends paid on unvested restricted stock shares are charged to retained earnings as significantly all restricted shares are expected to vest to employees. Unvested shares are subject to forfeiture upon employee termination. During the six months ended June 30, compensation expense recorded from amortization of restricted shares expected to vest to employees was $53 and $39 during 2012 and 2011, respectively.

-20-

The following tables summarize information regarding restricted stock outstanding at June 30, 2012 and 2011 including activity during the six months then ended.

				Weighted
				Average
	Shares			Grant Price
January 1, 2011		19,452		$	15.68
Restricted stock granted		9,130			21.90
Restricted stock legally vested		(3,010	)		(16.62	)
June 30, 2011		25,572		$	17.79
January 1, 2012		25,572		$	17.79
Restricted stock granted		8,895			22.48
Restricted stock legally vested		(4,058	)		(16.08	)
June 30, 2012		30,409		$	19.39

Scheduled compensation expense per calendar year assuming all restricted shares eventually vest to employees would be as follows:

2012	$	105
2013		125
2014		125
2015		95
2016		80
Thereafter		40
Totals	$	570

NOTE 11– EARNINGS PER SHARE

Basic earnings per share of common stock are based on the weighted average number of common shares outstanding during the period. Unvested but issued restricted shares are considered to be outstanding shares and used to calculate the weighted average number of shares outstanding and determine net book value per share. Diluted earnings per share is calculated by dividing net income by the weighted average number of shares adjusted for the dilutive effect of outstanding stock options. On June 19, 2012, the Company declared a 5% stock dividend to shareholders of record July 16, 2012, which was paid in the form of additional common stock on July 30, 2012. All references in the accompanying consolidated financial statements and footnotes to the number of common shares and per share amounts have been restated to reflect the 5% stock dividend.

Presented below are the calculations for basic and diluted earnings per share:

	Three months ended				Six months ended
	June 30,				June 30,
(dollars in thousands, except per share data – unaudited)	2012		2011		2012		2011
Net income	$	1,918	$	1,226	$	3,098	$	2,511
Weighted average shares outstanding		1,663,410		1,652,652		1,663,093		1,652,063
Effect of dilutive stock options outstanding		23		973		109		1,132
Diluted weighted average shares outstanding		1,663,433		1,653,625		1,663,202		1,653,195
Basic earnings per share	$	1.15	$	0.74	$	1.86	$	1.52
Diluted earnings per share	$	1.15	$	0.74	$	1.86	$	1.51

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NOTE 12 – CONTINGENCIES

In the normal course of business, PSB is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the consolidated financial statements.

NOTE 13 – FAIR VALUE MEASUREMENTS

Certain assets and liabilities are recorded or disclosed at fair value to provide financial statement users additional insight into PSB’s quality of earnings. Under current accounting guidance, PSB groups assets and liabilities which are recorded at fair value in three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). All transfers between levels are recognized as occurring at the end of the reporting period.

Following is a brief description of each level of the fair value hierarchy:

Level 1 – Fair value measurement is based on quoted prices for identical assets or liabilities in active markets.

Level 2 – Fair value measurement is based on (1) quoted prices for similar assets or liabilities in active markets; (2) quoted prices for identical or similar assets or liabilities in markets that are not active; or (3) valuation models and methodologies for which all significant assumptions are or can be corroborated by observable market data.

Level 3 – Fair value measurement is based on valuation models and methodologies that incorporate at least one significant assumption that cannot be corroborated by observable market data. Level 3 measurements reflect PSB’s estimates about assumptions market participants would use in measuring fair value of the asset or liability.

Some assets and liabilities, such as securities available for sale, loans held for sale, mortgage rate lock commitments, and interest rate swaps, are measured at fair value on a recurring basis under GAAP. Other assets and liabilities, such as impaired loans, foreclosed assets, and mortgage servicing rights are measured at fair value on a nonrecurring basis.

Following is a description of the valuation methodology used for each asset and liability measured at fair value on a recurring or nonrecurring basis, as well as the classification of the asset or liability within the fair value hierarchy.

Securities available for sale – Securities available for sale may be classified as Level 1, Level 2, or Level 3 measurements within the fair value hierarchy and are measured on a recurring basis. Level 1 securities include equity securities traded on a national exchange. The fair value measurement of a Level 1 security is based on the quoted price of the security. Level 2 securities include U.S. government and agency securities, obligations of states and political subdivisions, corporate debt securities, and mortgage-related securities. The fair value measurement of a Level 2 security is obtained from an independent pricing service and is based on recent sales of similar securities and other observable market data and represents a market approach to fair value.

At June 30, 2012 and December 31, 2011, Level 3 securities include a common stock investment in Bankers’ Bank, Madison, Wisconsin that is not traded on an active market. Historical cost of the common stock is assumed to approximate fair value of this investment.

Loans held for sale – Loans held for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value and are measured on a recurring basis. The fair value measurement of a loan held for sale is based on current secondary market prices for similar loans, which is considered a Level 2 measurement and represents a market approach to fair value.

Impaired loans – Loans are not measured at fair value on a recurring basis. Carrying value of impaired loans that are not collateral dependent are based on the present value of expected future cash flows discounted at the applicable effective interest rate and, thus, are not fair value measurements. However, impaired loans considered to be collateral dependent are measured at fair value on a nonrecurring basis. The fair value measurement of an impaired loan that is collateral dependent is based on the fair value of the underlying collateral. Fair value measurements of underlying collateral that utilize observable market data, such as independent appraisals reflecting recent comparable sales, are considered Level 2 measurements. Other fair value measurements that incorporate internal collateral appraisals or broker price opinions, net of selling costs, or estimated assumptions market participants would use to measure fair value, such as discounted cash flow measurements, are considered Level 3 measurements and represent a market approach to fair value.

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In the absence of a recent independent appraisal, collateral dependent impaired loans are valued based on a recent broker price opinion generally discounted by 10% plus estimated selling costs. In the absence of a broker price opinion, collateral dependent impaired loans are valued at the lower of last appraisal value or the current real estate tax value discounted by 20% to 50%, depending on internal judgments on the condition of the property, plus estimated selling costs. Property values are impacted by many macroeconomic factors. In general, a declining economy or rising interest rates would be expected to lower fair value of collateral dependent impaired loans while an improving economy or falling interest rates would be expected to increase fair value of collateral dependent impaired loans.

Foreclosed assets – Real estate and other property acquired through, or in lieu of, loan foreclosure are not measured at fair value on a recurring basis. Initially, foreclosed assets are recorded at fair value less estimated costs to sell at the date of foreclosure. Valuations are periodically performed by management, and the real estate or other property is carried at the lower of carrying amount or fair value less estimated costs to sell. Fair value measurements are based on current formal or informal appraisals of property value compared to recent comparable sales of similar property. Independent appraisals reflecting comparable sales are considered Level 2 measurements, while internal assessments of appraised value based on current market activity, including broker price opinions, are considered Level 3 measurements and represent a market approach to fair value. Property values are impacted by many macroeconomic factors. In general, a declining economy or rising interest rates would be expected to lower fair value of foreclosed assets while an improving economy or falling interest rates would be expected to increase fair value of foreclosed assets.

Mortgage servicing rights – Mortgage servicing rights are not measured at fair value on a recurring basis. However, mortgage servicing rights that are impaired are measured at fair value on a nonrecurring basis. Serviced loan pools are stratified by year of origination and term of the loan, and a valuation model is used to calculate the present value of expected future cash flows for each stratum. When the carrying value of a stratum exceeds its fair value, the stratum is measured at fair value. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, custodial earnings rate, ancillary income, default rates and losses, and prepayment speeds. Although some of these assumptions are based on observable market data, other assumptions are based on unobservable estimates of what market participants would use to measure fair value. As a result, the fair value measurement of mortgage servicing rights is considered a Level 3 measurement and represents an income approach to fair value. When market mortgage rates decline, borrowers may have the opportunity to refinance their existing mortgage loans at lower rates, increasing the risk of prepayment of loans on which we maintain mortgage servicing rights. Therefore, declining long term interest rates would decrease the fair value of mortgage servicing rights. Significant unobservable inputs at June 30, 2012 used to measure fair value included:

Direct annual servicing cost per loan	$	50
Direct annual servicing cost per loan in process of foreclosure	$	500
Weighted average prepayment speed: CPR		1.32	%
Weighted average prepayment speed: PSA		276	%
Weighted average discount rate		9.30	%
Asset reinvestment rate		4.00	%
Short-term cost of funds		0.25	%
Escrow inflation adjustment		1.00	%
Servicing cost inflation adjustment		1.00	%

Mortgage rate lock commitments – The fair value of mortgage rate lock commitments is measured on a recurring basis. Fair value is based on current secondary market pricing for delivery of similar loans and the value of originated mortgage servicing rights on loans expected to be delivered, which is considered a Level 2 fair value measurement.

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Interest rate swap agreements – Fair values for interest rate swap agreements are based on the amounts required to settle the contracts based on valuations provided by third-party dealers in the contracts, which is considered a Level 2 fair value measurement, and are measured on a recurring basis.

			Recurring Fair Value Measurements Using
			Quoted Prices in Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(dollars in thousands)			(Level 1)		(Level 2)		(Level 3)
Assets measured at fair value on a recurring basis at June 30, 2012:
Securities available for sale:
U.S. Treasury and agency debentures	$	32,550	$	—	$	32,550	$	—
U.S. agency issued residential MBS and CMO		60,675		—		60,675		—
Privately issued residential MBS and CMO		293		—		293		—
Other equity securities		47		—		—		47
Total securities available for sale		93,565		—		93,518		47
Loans held for sale		452		—		452		—
Mortgage rate lock commitments		143		—		143		—
Interest rate swap agreements		702		—		702		—
Total assets	$	94,862	$	—	$	94,815	$	47
Liabilities – Interest rate swap agreements	$	1,381	$	—	$	1,381	$	—
Assets measured at fair value on a recurring basis at December 31, 2011:
Securities available for sale:
U.S. Treasury and agency debentures	$	518	$	—	$	518	$	—
U.S. agency issued residential MBS and CMO		58,389		—		58,389		—
Privately issued residential MBS and CMO		429		—		429		—
Other equity securities		47		—		—		47
Total securities available for sale		59,383		—		59,336		47
Loans held for sale		39		—		39		—
Mortgage rate lock commitments		60		—		60		—
Interest rate swap agreements		555		—		555		—
Total assets	$	60,037	$	—	$	59,990	$	47
Liabilities – Interest rate swap agreements	$	1,131	$	—	$	1,131	$	—

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Reconciliation of fair value measurements using significant unobservable inputs:

	Securities
	Available
(dollars in thousands)	For Sale
Balance at January 1, 2011:	$	51
Total realized/unrealized gains and (losses):
Included in earnings		—
Included in other comprehensive income		—
Purchases, maturities, and sales		—
Transferred from Level 2 to Level 3		—
Transferred to held to maturity classification		—
Balance at June 30, 2011	$	51
Total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2011	$	—
Balance at January 1, 2012	$	47
Total realized/unrealized gains and (losses):
Included in earnings		—
Included in other comprehensive income		—
Purchases, maturities, and sales		—
Transferred from Level 2 to Level 3		—
Transferred to held to maturity classification		—
Balance at December 31, 2012	$	47
Total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2012	$	—

			Nonrecurring Fair Value Measurements Using
			Quoted Prices in
			Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	($000s)		(Level 1)		(Level 2)		(Level 3)
Assets measured at fair value on a nonrecurring basis at June 30, 2012:
Impaired loans	$	2,907	$	—	$	—	$	2,907
Foreclosed assets		2,642		—		450		2,192
Mortgage servicing rights		1,110		—		—		1,110
Total assets	$	6,659	$	—	$	450	$	6,209
Assets measured at fair value on a nonrecurring basis at December 31, 2011:
Impaired loans	$	4,086	$	—	$	—	$	4,086
Foreclosed assets		2,939		—		587		2,352
Mortgage servicing rights		1,205		—		—		1,205
Total assets	$	8,230	$	—	$	587	$	7,643

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At June 30, 2012, loans with a carrying amount of $3,516 were considered impaired and were written down to their estimated fair value of $2,907 net of a valuation allowance of $609. At December 31, 2011, loans with a carrying amount of $5,306 were considered impaired and were written down to their estimated fair value of $4,086, net of a valuation allowance of $1,220. Changes in the valuation allowances are reflected through earnings as a component of the provision for loan losses or as a charge-off against the allowance for loan losses.

At June 30, 2012, mortgage servicing rights with a carrying amount of $1,325 were considered impaired and were written down to their estimated fair value of $1,110, resulting in an impairment allowance of $215. At December 31, 2011, mortgage servicing rights with a carrying amount of $1,286 were considered impaired and were written down to their estimated fair value of $1,205, resulting in an impairment allowance of $81. Changes in the impairment allowances are reflected through earnings as a component of mortgage banking income.

PSB estimates fair value of all financial instruments regardless of whether such instruments are measured at fair value. The following methods and assumptions were used by PSB to estimate fair value of financial instruments not previously discussed.

Cash and cash equivalents – Fair value reflects the carrying value of cash, which is a Level 1 measurement.

Securities held to maturity – Fair value of securities held to maturity is based on dealer quotations on similar securities near period-end, which is considered a Level 2 measurement. Certain debt issued by banks or bank holding companies purchased by PSB as securities held to maturity is valued on a cash flow basis discounted using market rates reflecting credit risk of the borrower, which is considered a Level 3 measurement.

Bank certificates of deposit – Fair value of fixed rate certificates of deposit included in other investments is estimated by discounting future cash flows using current rates at which similar certificates could be purchased, which is a Level 3 measurement.

Loans – Fair value of variable rate loans that reprice frequently are based on carrying values. Loans with an active sale market, such as one- to four-family residential mortgage loans, estimate fair value based on sales of loans with similar structure and credit quality. Fair value of other loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings. Fair value of impaired and other nonperforming loans are estimated using discounted expected future cash flows or the fair value of underlying collateral, if applicable. Except for collateral dependent impaired loans valued using an independent appraisal of collateral value, reflecting a Level 2 fair value measurement, fair value of loans is considered to be a Level 3 measurement due to internally developed discounted cash flow measurements.

Federal Home Loan Bank stock – Fair value is the redeemable (carrying) value based on the redemption provisions of the Federal Home Loan Bank, which is considered a Level 3 fair value measurement.

Accrued interest receivable and payable – Fair value approximates the carrying value, which is considered a Level 3 fair value measurement.

Cash value of life insurance – Fair value is based on reported values of the assets by the issuer which are redeemable to the insured, which is considered a Level 1 fair value measurement.

Deposits – Fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, by definition, is the amount payable on demand on the reporting date. Fair value of fixed rate time deposits is estimated using discounted cash flows applying interest rates currently offered on issue of similar time deposits. Use of internal discounted cash flows provides a Level 3 fair value measurement.

FHLB advances and other borrowings – Fair value of fixed rate, fixed term borrowings is estimated by discounting future cash flows using the current rates at which similar borrowings would be made as calculated by the lender or correspondent. Fair value of borrowings with variable rates or maturing within 90 days approximates the carrying value of these borrowings. Fair values based on lender provided settlement provisions are considered a Level 2 fair value measurement. Other borrowings with local customers in the form of repurchase agreements are estimated using internal assessments of discounted future cash flows, which is a Level 3 measurement.

Senior subordinated notes and junior subordinated debentures – Fair value of fixed rate, fixed term notes and debentures are estimated internally by discounting future cash flows using the current rates at which similar borrowings would be made, which is a Level 3 fair value measurement.

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The carrying amounts and fair values of PSB’s financial instruments consisted of the following:

	June 30, 2012
	Carrying		Estimated		Fair Value Hierarchy Level
	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets ($000s):
Cash and cash equivalents	$	39,751	$	39,751	$	39,751	$	—	$	—
Securities		164,008		166,129		—		164,251		1,878
Bank certificates of deposit		2,484		2,556		—		—		2,556
Net loans receivable and loans held for sale		466,782		472,642		—		897		471,745
Accrued interest receivable		2,366		2,366		—		—		2,366
Mortgage servicing rights		1,110		1,110		—		—		1,110
Mortgage rate lock commitments		143		143		—		143		—
FHLB stock		2,761		2,761		—		—		2,761
Cash surrender value of life insurance		11,608		11,608		11,608		—		—
Interest rate swap agreements		702		702		—		702		—
Financial liabilities ($000s):
Deposits	$	557,407	$	560,131	$	—	$	—	$	560,131
FHLB advances		55,124		57,074		—		57,074		—
Other borrowings		18,086		19,608		—		15,022		4,586
Senior subordinated notes		7,000		7,234		—		—		7,234
Junior subordinated debentures		7,732		4,961		—		—		4,961
Interest rate swap agreements		1,381		1,381		—		1,381		—
Accrued interest payable		640		640		—		—		640

The carrying amounts and fair values of PSB’s financial instruments consisted of the following at December 31, 2011:

	December 31, 2011
	Carrying		Estimated		Fair Value Hierarchy Level
	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets ($000s):
Cash and cash equivalents	$	38,205	$	38,205	$	38,205	$	—	$	—
Securities		108,677		110,134		—		108,346		1,788
Bank certificates of deposit		2,484		2,577		—		—		2,577
Net loans receivable and loans held for sale		437,596		444,799		—		39		444,760
Accrued interest receivable		2,068		2,068		—		—		2,068
Mortgage servicing rights		1,205		1,205		—		—		1,205
Mortgage rate lock commitments		60		60		—		60		—
FHLB stock		3,250		3,250		—		—		3,250
Cash surrender value of life insurance		11,406		11,406		11,406		—		—
Interest rate swap agreements		555		555		—		555		—
Financial liabilities ($000s):
Deposits	$	481,509	$	484,640	$	—	$	—	$	484,640
FHLB advances		50,124		52,547		—		52,547		—
Other borrowings		19,691		21,454		—		15,163		6,291
Senior subordinated notes		7,000		7,120		—		—		7,120
Junior subordinated debentures		7,732		4,849		—		—		4,849
Interest rate swap agreements		1,131		1,131		—		1,131		—
Accrued interest payable		623		623		—		—		623

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NOTE 14 – CURRENT YEAR AND COMPARABLE PRIOR YEAR PERIOD ACCOUNTING CHANGES

FASB ASC Topic 220, “Comprehensive Income.” In June 2011, new authoritative accounting guidance was approved that required changes to the presentation of comprehensive net income. Effective during the quarter ended March 31, 2012, PSB began to present comprehensive income as a separate financial statement directly after the basic income statement. Adoption of the new presentation standards for comprehensive income did not have any financial impact to PSB’s financial results or operations. The requirements to disclose on the face of the income statement on a line by line basis the impact to current net income on reclassification of items coming out of comprehensive net income was deferred.

FASB ASC Topic 820, “Fair Value Measurements.” In May 2011, new authoritative accounting guidance concerning fair value measurements was issued. Significant provisions of the new guidance now require both domestic and international companies to follow existing United States guidance in measuring fair value. In addition, certain Level 3 unobservable inputs and impacts to fair value from sensitivity of these inputs to changes must be disclosed. Lastly, the level of fair value hierarchy used to estimate fair value of financial instruments not accounted for at fair value on the balance sheet (such as loans receivable and deposits) must be disclosed. These new disclosures were adopted during the quarter ended March 31, 2012 and did not have a significant impact to PSB financial reporting or operations.

FASB ASC Topic 310, “Receivables.” New authoritative accounting guidance issued in July 2010 under ASC Topic 310, “Receivables,” required extensive new disclosures surrounding the allowance for loan losses although it did not change any credit loss recognition or measurement rules. The new rules require disclosures to include a breakdown of allowance for loan loss activity by portfolio segment as well as problem loan disclosures by detailed class of loan. In addition, disclosures on internal credit grading metrics and information on impaired, nonaccrual, and restructured loans are also required. The period-end disclosures were effective for financial periods ending December 31, 2010 but deferred presentation of loan loss allowance by loan portfolio segment until the quarter ended March 31, 2011. PSB adopted the rules for loan loss allowance disclosures by loan segment effective March 31, 2011.

NOTE 15 – FUTURE ACCOUNTING CHANGES

FASB ASC Topic 210, “Balance Sheet.” In December 2011, new authoritative accounting guidance concerning disclosure of information about offsetting and related arrangements associated with derivative instruments was issued. New requirements will require additional disclosures associated with offsetting and collateral arrangements with derivative instruments to enable users of PSB’s financial statements to understand the effect of those arrangements on its financial position. These new disclosures are effective during the quarter ended March 31, 2013 and are not expected to have significant impact to PSB’s financial results or operations upon adoption.

NOTE 16 – SUBSEQUENT EVENTS

Management has reviewed PSB’s operations for potential disclosure of information or financial statement impacts related to events occurring after June 30, 2012 but prior to the release of these financial statements. Based on the results of this review, no subsequent event disclosures or financial statement impacts to the recently completed quarter are required as of the release date.

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Item 2. 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 as of June 30, 2012 compared to December 31, 2011 and results of our operations for the three months and six months ended June 30, 2012 compared to the results of operations for the three months and six months ended June 30, 2011. The following MD&A concerning our operations is intended to satisfy three principal objectives:

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

• Enhance the overall financial disclosure and provide the context within which our financial information should be analyzed.

• Provide information about the quality of, and potential variability of, our earnings and cash flow, so that investors can ascertain the likelihood that past performance is, or is not, indicative of future performance.

Management’s discussion and analysis, like other portions of this Quarterly Report on Form 10-Q, includes forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, our anticipated future financial performance involves risks and uncertainties that may cause actual results to differ materially from those described in our forward-looking statements. A cautionary statement regarding forward-looking statements is set forth under the caption “Forward-Looking Statements” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011, and, from time to time, in our other filings with the Securities Exchange Commission. We do not intend to update forward-looking statements. This discussion and analysis should be considered in light of that cautionary statement. Additional risk factors relating to an investment in our common stock are also described under Item 1A of the 2011 Annual Report on Form 10-K.

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

EXECUTIVE OVERVIEW

Results of Operations

June 2012 quarterly earnings were $1,918, or $1.15 per diluted share, compared to $1,226, or $.74 per diluted share during the June 2011 quarter. Year to date earnings for the six months ended June 30, 2012 were $3,098, or $1.86 per diluted share, compared to $2,511, or $1.51 per diluted share during the six months ended June 30, 2011. The June 2012 quarter included a special non-recurring gain on bargain purchase of Marathon State Bank (“Marathon”) of $515 (after tax impacts of $336), which increased June 2012 quarterly and year to date earnings by $.31 per share. Separate from the bargain purchase, we also incurred $75 of merger expenses (after tax benefits) during the June 2012 quarter (which decreased net income by $.05 per share) after $117 of merger expenses (after tax benefits) during the March 2012 quarter ($.07 per share). Excluding the special gain on bargain purchase and related merger expenses, diluted earnings per share would have been $.89 and $.74 during the quarters ended June 30, 2012 and 2011, respectively. Similarly, diluted earnings per share would have been $1.67 and $1.51, during the six months ended June 30, 2012 and 2011, respectively.

Separate from the merger related items, increased earnings were propelled by a decrease in credit costs, defined as the provision for loan losses plus loss on foreclosed assets, which offset an increase in operating expenses. Credit costs totaled $169 during the June 2012 quarter and $708 during the June 2011 quarter, a decrease of $539, or 76%. Similarly, these expenses totaled $562 during the six months ended June 30, 2012 and $1,363 during the six months ended June 30, 2011, a decrease of $801, or 59%. Considered before credit costs, income from continuing operations would have been $1,580 and $1,655 during the quarter ended June 30, 2012 and 2011, respectively. Similarly, income from continuing operations would have been $3,116 and $3,337 during the six months ended June 30, 2012 and 2011, respectively. Future quarterly period net income growth is likely dependent on declining credit costs as net interest margin will be pressured to decline and operating costs remain at similar levels.

During the remainder of 2012, PSB expects to incur substantial additional merger costs up to $600 before income tax benefits related to the data conversion of Marathon customer information. While a portion of the cost is expected to be capitalized as premises and equipment, the majority of the cost will be recorded as additional expense. Integration costs may also include a loss on disposal of the existing Peoples Marathon branch location later in 2012 if market and sale conditions for the real estate decline. The remaining premises and equipment investment in the Peoples’ Marathon branch is approximately $190. Integration of Peoples’ existing Marathon branch with Marathon State Bank later in 2012 is expected to generate annual run-rate expense savings of approximately $250 to be fully phased in by the end of 2013. Marathon State Bank will become a branch of Peoples State Bank later in 2012. During all of 2012, our acquisition of Marathon is expected to increase 2012 earnings by 0% to 5%, net of all merger related items including the June 2012 gain on bargain purchase and data conversion expenses.

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Total nonperforming assets of $17,360 at June 30, 2012 decreased $523, or 2.9%, since December 31, 2011 due to a decrease in restructuring of troubled debt maintained on accrual status and a decrease in foreclosed assets, totaling $656. Total nonperforming assets were 2.45% and 2.87% of total assets at June 30, 2012 and December 31, 2011, respectively. At June 30, 2012, the allowance for loan losses was $7,648, or 1.61% of total loans (55% of nonperforming loans), compared to $7,941, or 1.78% of total loans (56% of nonperforming loans) at December 31, 2011. Restructured loans maintained on accrual status and performing according to terms were 34% and 35% of total nonperforming assets at June 30, 2012 and December 31, 2011, respectively. Looking ahead, we continue to face the likelihood of restructuring certain problem commercial related loans to minimize potential credit losses, which may increase nonperforming assets in future quarters even if restructured loans perform according to their new terms.

Liquidity

Total assets were $709,024 at June 30, 2012, up $86,157, or 13.8% compared to $622,867 at December 31, 2011. The increase in total assets was due to the acquisition of Marathon State Bank during the June 2012 quarter, which added $107,364 of total assets at the acquisition date. However, total asset growth since December 31, 2011 was also impacted by a $20,464 decline in cash and cash equivalents held by our Peoples State Bank subsidiary during the six months ended June 30, 2012 caused by a $20,007 decline in total deposits, primarily seasonal deposits, including municipal and commercial demand deposits. Wholesale funding, including brokered and national certificates of deposits, FHLB advances, and other borrowings, were $142,642 at June 30, 2012, compared to $144,381 at December 31, 2011, down $1,739, or 1.2%. Wholesale funding was 20.1% of total assets at June 30, 2012 compared to 23.2% of total assets at December 31, 2011.

We regularly maintain access to wholesale markets to fund loan originations and manage local depositor needs. At June 30, 2012, unused (but available) wholesale funding was approximately $254 million, or 36% of total assets, compared to $238 million, or 38% of total assets at December 31, 2011. Unused wholesale funding sources include federal funds purchased lines of credit, Federal Reserve Discount Window advances, FHLB advances, brokered and national certificates of deposit, and a holding company correspondent bank line of credit. Our ability to borrow funds on a short-term basis from the Federal Reserve Discount Window is an important part of our liquidity analysis and represented 34% and 42% of unused but available liquidity at June 30, 2012 and December 31, 2011, respectively.

Capital Resources

During the six months ended June 30, 2012, stockholders’ equity increased $2,270 primarily from $2,483 in retained net income net of $615 of cash dividends paid. Net book value per share at June 30, 2012 was $31.64 compared to $30.44 at December 31, 2011. Net book value and other references to per share information reflect the impact of PSB’s 5% dividend paid in common stock declared June 19, 2012 and paid July 30, 2012. Common stockholders’ equity was 7.42% of total assets at June 30, 2012 compared to 8.09% at December 31, 2011. The stockholders’ equity ratio declined since December 31, 2011 due to the cash purchase of Marathon which increased total assets without a new issue of common stock.

For regulatory purposes, the $7 million 8% senior subordinated notes maturing July 2019 and $7.7 million junior subordinated debentures maturing September 2035 reflected as debt on the Consolidated Balance Sheet are reclassified as Tier 2 and Tier 1 regulatory equity capital, respectively. We were considered “well capitalized” under banking regulations at June 30, 2012 with a leverage capital ratio of 9.18% and a total risk adjusted capital ratio of 14.53% compared to a leverage ratio of 9.27% and a total risk adjusted capital ratio of 14.99% at December 31, 2011. As with the book stockholders’ equity ratio, regulatory capital ratios declined as a result of the increased assets recorded with the Marathon acquisition. PSB retains the ability to prepay its $7 million in 8% senior subordinated notes on a monthly basis beginning July 1, 2012. After considering total regulatory capital needs for loan growth, regulatory changes impacting capital minimums, and merger and acquisition activities, we may prepay some or all of the 8% notes during 2012. Repayment of these debentures in their entirety would reduce interest expense by approximately $140 per quarter.

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Approximately 20% of our total regulatory capital at June 30, 2012 is comprised of debt instruments including junior and senior debentures and notes which, unlike common stock, require quarterly payments of interest aggregating $223 (before tax benefits). Therefore, although no current plans exist, future capital needs during the next several years would likely be met by issuance of our authorized common or preferred stock as needed. Due to relatively high cost of capital options, the cash purchase acquisition of Marathon State Bank, and potential future merger and acquisition activities requiring capital, we do not expect to buy back significant treasury stock shares during 2012, although we do expect to continue to pay our traditional semi-annual cash dividend assuming continued profitable operations and projections of adequate future capital levels for growth.

During the June 2012 quarter, the banking regulatory agencies, including the Board of Governors of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), issued two new regulatory capital proposals that are likely to have a significant impact on our regulatory capital needs if finalized. Among other significant changes, the proposal would phase out our current $7.7 million of junior subordinated debentures from Tier 1 capital and move them to Tier 2 capital classification over a 10 year period beginning in 2013. This change would reduce our leverage capital ratio and our Tier 1 risk adjusted capital ratio. Separately, proposed changes to the calculation of risk weighted assets would increase the denominator of risk adjusted capital ratios, including the Tier 1 capital and Tier 2 (“Total”) capital ratio, which would reduce our risk adjusted capital ratios. The regulatory agencies have estimated that industry wide total risk adjusted assets are likely to increase an average of 20% due to the proposed changes. Lastly, under the proposal, minimum capital ratios to be considered well capitalized, including the impact of the proposed “capital buffer,” would be 6.50% for the leverage ratio, 8.50% for the Tier 1 to risk adjusted capital ratio, and 10.50% for the total risk adjusted capital ratio, up from 5.00%, 6.00%, and 10.00%, respectively.

Following the passage of the Dodd-Frank Wall Street Reform Act of 2010, which grandfathered existing junior subordinated debentures as Tier 1 capital for banks with less than $15 billion in total assets, the community banking industry had believed the proposed disallowance of junior subordinated debentures would apply only to large international banks, and the extent of the Federal Reserve’s recent actions was unexpected. We continue to internally review the timing and extent of the proposed changes on our regulatory capital position. As a reference for this discussion, assuming the immediate loss of junior subordinated debentures as Tier 1 capital and a 20% increase in total risk adjusted assets, our pro forma June 30, 2012 leverage ratio would have been 7.17% instead of 9.18%, our Tier 1 risk adjusted capital ratio would have been 8.61% instead of 11.85%, and our total risk adjusted capital ratio would have been 12.31% instead of 14.53%.

Off Balance –Sheet Arrangements and Contractual Obligations

Our largest volume off-balance sheet activity involves our servicing of payments and related collection activities on approximately $258 million of residential 1 to 4 family mortgages sold to FHLB and FNMA at June 30, 2012. At June 30, 2012, we provided a credit enhancement against FHLB loss under five separate “master commitments” associated with 16% of the total serviced principal (down from 20% at December 31, 2011), up to a maximum guarantee of $1.9 million in the aggregate. However, we would incur such loss only if the FHLB first lost $1.9 million on this remaining loan pool of approximately $42 million as part of their “First Loss Account” (discussed here in the aggregate, although the guarantee is applied on an individual master commitment basis). Since inception of our guarantees to the FHLB beginning in 2000, only $0.3 million of $425 million of loans originated with guarantees have incurred a principal loss, all of which has been borne by the FHLB within their First Loss Account. No loans have been sold by us to the FHLB with our Credit Enhancement Guarantee of principal since October 2008 and we do not intend to originate future loans with the guarantee.

We also utilize interest rate swaps to hedge costs associated with certain variable rate debt (notional amount of $7,500 at June 30, 2012) and as a tool for our customers to obtain long-term fixed rate commercial loan financing (offsetting notional amounts of $15,298). These arrangements and related off balance sheet commitments are outlined in Note 8 in the Notes to Consolidated Financial Statements. Aggregate net unrealized losses on fair value of all interest rate swaps were $678 and $576 at June 30, 2012 and December 31, 2011, respectively before tax benefits.

We provide various commitments to extend credit for both commercial and consumer purposes totaling approximately $94 million at June 30, 2012 compared to $99 million at December 31, 2011. These lending commitments are a traditional and customary part of lending operations and many of the commitments are expected to expire without being drawn upon.

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RESULTS OF OPERATIONS

Earnings

Quarter and six months ended June 30, 2012 compared to June 30, 2011

June 2012 quarterly earnings were $1,918, or $1.15 per diluted share compared to $1,226, or $.74 per diluted share during June 2011, an increase of $692, or $.41 per share, up 55.4%. The increase was due primarily to a $515 gain on bargain purchase of Marathon State Bank (net of $336 in income tax expense), or $.31 per share, during the June 2012 quarter. Refer to Note 2 of the Notes to Consolidated Financial Statements for the calculation of the bargain purchase and the assets and liabilities acquired with the Marathon purchase. Year to date earnings for the six months ended June 30, 2012 were $3,098, or $1.86 per diluted share compared to $2,511, or $1.51 per diluted share during 2011, an increase of $587, or $.35 per share, up 23.2%. Excluding the gain on bargain purchase and merger related expenses, June 2012 quarterly earnings were $.89 per share compared to $.74 per share in June 2011, up 20.2%. Similarly, earnings for the six months ended June 30, 2012 were $1.66 per share compared to $1.51 per share in June 2011, up 9.9%. Increased earnings before the special merger impacts were due to lower credit related costs, defined as provision for loan losses and loss on foreclosed assets, which offset increases in other operating expenses during 2012 compared to 2011. Table 1 below outlines the merger related adjustments and the impact of declining credit costs by comparing net income from continuing operations before credit costs to net income as reported.

Table 1: Impact of Special Income and Expense Items on Continuing Operations (a non-GAAP measure)

	Quarter ended June 30,						Six months ended June 30,
($000s, net of income tax effects)	2012			2011			2012			2011
Net income from continuing operations before credit costs	$	1,580		$	1,655		$	3,116		$	3,337
Less: Credit costs		(102	)		(429	)		(341	)		(826	)
Net income from continuing operations after credit costs		1,478			1,226			2,775			2,511
Add: Gain on bargain purchase		515			—			515			—
Less: Merger related expenses		(75	)		—			(192	)		—
Net income	$	1,918		$	1,226		$	3,098		$	2,511

	Quarter ended June 30,						Six months ended June 30,
(per diluted share, net of income tax effects)	2012			2011			2012			2011
Net income from continuing operations before credit costs	$	0.95		$	1.00		$	1.87		$	2.01
Less: Credit costs		(0.06	)		(0.26	)		(0.21	)		(0.50	)
Net income from continuing operations after credit costs		0.89			0.74			1.66			1.51
Add: Gain on bargain purchase		0.31			—			0.31			—
Less: Merger related expenses		(0.05	)		—			(0.11	)		—
Net income	$	1.15		$	0.74		$	1.86		$	1.51

Return on average assets was 1.21% (.93% before the Marathon merger related items) and .82% during the quarters ended June 30, 2012 and 2011, respectively. Return on average stockholders’ equity was 14.60% (11.22% before the merger items) and 10.04% during the quarters ended June 30, 2012 and 2011, respectively.

Return on average assets was 1.00% (.89% before the Marathon merger related items) and .83% during the six months ended June 30, 2012 and 2011, respectively. Return on average stockholders’ equity was 11.99% (10.74% before the merger items) and 10.50% during the six months ended June 30, 2012 and 2011, respectively.

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The following Table 2 presents PSB’s consolidated quarterly summary financial data.

Table 2: Financial Summary

(dollars in thousands, except per share data)	Quarter ended
	June 30,			March 31,			December 31,			September 30,			June 30,
	2012			2012			2012			2011			2011
Earnings and dividends:
Net interest income	$	4,880		$	4,816		$	5,060		$	4,867		$	4,866
Provision for loan losses	$	165		$	160		$	240		$	360		$	430
Other noninterest income	$	2,323		$	1,242		$	1,376		$	1,367		$	1,197
Other noninterest expense	$	4,064		$	4,119		$	4,121		$	3,835		$	3,869
Net income	$	1,918		$	1,180		$	1,400		$	1,394		$	1,226
Basic earnings per share(3)	$	1.15		$	0.70		$	0.85		$	0.85		$	0.74
Diluted earnings per share(3)	$	1.15		$	0.70		$	0.85		$	0.84		$	0.74
Dividends declared per share(3)	$	0.36		$	—		$	0.35		$	—		$	0.35
Net book value per share	$	31.64		$	30.96		$	30.44		$	30.10		$	29.48
Semi-annual dividend payout ratio		19.44	%		n/a			20.86	%		n/a			23.33	%
Average common shares outstanding		1,663,410			1,663,138			1,654,111			1,653,179			1,652,652
Balance sheet – average balances:
Loans receivable, net of allowances for loss	$	447,886		$	436,907		$	440,737		$	434,031		$	437,314
Assets	$	639,404		$	607,917		$	604,216		$	602,088		$	601,978
Deposits	$	493,349		$	466,121		$	457,916		$	452,225		$	451,214
Stockholders’ equity	$	52,835		$	51,016		$	50,910		$	49,369		$	48,978
Performance ratios:
Return on average assets(1)		1.21	%		0.78	%		0.92	%		0.92	%		0.82	%
Return on average stockholders’ equity(1)		14.60	%		9.30	%		10.91	%		11.20	%		10.04	%
Average stockholders’ equity less accumulated other comprehensive income (loss) to average assets		8.01	%		8.10	%		8.11	%		7.84	%		7.75	%
Net loan charge-offs to average loans(1)		0.24	%		0.31	%		0.28	%		0.14	%		-0.01	%
Nonperforming loans to gross loans		2.95	%		3.38	%		3.19	%		3.26	%		3.21	%
Allowance for loan losses to gross loans		1.61	%		1.75	%		1.78	%		1.82	%		1.75	%
Nonperforming assets to tangible equity plus the allowance for loan losses(4)		29.34	%		32.44	%		31.32	%		32.82	%		35.03	%
Net interest rate margin(1)(2)		3.42	%		3.50	%		3.64	%		3.53	%		3.57	%
Net interest rate spread(1)(2)		3.20	%		3.27	%		3.38	%		3.28	%		3.34	%
Service fee revenue as a percent of average demand deposits(1)		2.41	%		2.66	%		2.49	%		2.95	%		3.05	%
Noninterest income as a percent of gross revenue		25.81	%		15.65	%		16.31	%		16.15	%		14.40	%
Efficiency ratio(2)		54.85	%		66.04	%		62.34	%		59.75	%		61.92	%
Noninterest expenses to average assets(1)		2.56	%		2.73	%		2.71	%		2.53	%		2.58	%
Stock price information:
High	$	26.67		$	24.76		$	23.57		$	23.81		$	24.76
Low	$	21.81		$	21.86		$	22.43		$	22.05		$	22.86
Last trade value at quarter-end	$	25.24		$	24.76		$	22.48		$	22.62		$	23.10

⁽¹⁾Annualized

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

⁽³⁾Due to rounding, cumulative quarterly per share performance may not equal annual per share totals.

⁽⁴⁾Tangible stockholders’ equity excludes intangible assets and any preferred stock capital elements.

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Balance Sheet Changes and Analysis

At June 30, 2012, total assets were $709,024, compared to $606,788 at March 31, 2012, and $622,867 at December 31, 2011, an increase of $102,236 (16.8%) and $86,157 (13.8%), respectively. The increase in total assets was due to the acquisition of Marathon State Bank during the June 2012 quarter, which added $107,364 in total assets at the acquisition date. Changes in assets during the three months and six months ended June 30, 2012 consisted of:

Table 3: Change in Balance Sheet Assets Composition

	Three months ended					Six months ended
Increase (decrease) in assets ($000s)	June 30, 2012					June 30, 2012
		$		%			$		%
Investment securities	$	51,371		45.6	%	$	55,331		50.9	%
Cash and cash equivalents		20,035		101.6	%		1,546		4.0	%
Residential real estate mortgage and home equity loans		18,974		16.6	%		20,244		18.0	%
Commercial, industrial and agricultural loans		7,272		5.6	%		10,634		8.4	%
Other assets (various categories)		3,032		15.9	%		2,317		11.7	%
Commercial real estate mortgage loans		1,918		1.0	%		(3,820	)	-1.9	%
Bank-owned life insurance		101		0.9	%		202		1.8	%
Foreclosed assets		(467	)	-15.0	%		(297	)	-10.1	%
Total increase in assets	$	102,236		16.8	%	$	86,157		13.8	%

Marathon’s largest asset classes were agency and municipal investment securities ($50,547 at the acquisition date), loans receivable ($23,760), and cash and due from banks ($20,392) which made up 88% of total fair value of assets acquired and contributed to the increases categorized in Table 3 for the three months ended June 30, 2012.

Changes in net assets during the three months and six months ended June 30, 2012 impacted funding sources as follows:

Table 4: Change in Balance Sheet Liabilities and Equity Composition

Increase (decrease) in liabilities and equity ($000s)	Three months ended June 30, 2012						Six months ended June 30, 2012
	$			%			$			%
Core deposits (including MMDA)	$	78,883			22.4	%	$	69,498			19.3	%
Retail certificates of deposit > $100		11,464			24.9	%		11,534			25.0	%
Other liabilities and debt (various categories)		6,063			30.8	%		4,594			21.7	%
FHLB advances		5,000			10.0	%		5,000			10.0	%
Stockholders’ equity		1,130			2.2	%		2,270			4.5	%
Wholesale and national deposits		554			0.8	%		(5,134	)		-6.9	%
Other borrowings		(858	)		-4.5	%		(1,605	)		-8.2	%
Total increase in liabilities and stockholders’ equity	$	102,236			16.8	%	$	86,157			13.8	%

Marathon contributed $100,866 of deposits on the acquisition date, which included $1,559 of brokered certificates of deposit. These new deposits contributed to the increase in core deposits and certificates seen during the three months ended June 30, 2012.

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Loans Receivable and Credit Quality

Table 5: Period-End Loan Composition

	June 30,				June 30,						December 31, 2011
	Dollars		Dollars		Percentage of total								Percentage
(dollars in thousands)	2012		2011		2012			2011			Dollars		of total
Commercial, industrial and agricultural	$	137,825	$	130,747		29.0	%		29.3	%	$	127,191		28.5	%
Commercial real estate mortgage		198,078		199,484		41.7	%		44.8	%		201,898		45.4	%
Residential real estate mortgage		108,901		86,610		23.0	%		19.4	%		89,484		20.1	%
Residential real estate loans held for sale		452		319		0.1	%		0.1	%		39		0.0	%
Consumer home equity		23,607		24,976		5.0	%		5.6	%		23,193		5.2	%
Consumer and installment		5,567		3,745		1.2	%		0.8	%		3,732		0.8	%
Totals	$	474,430	$	445,881		100.0	%		100.0	%	$	445,537		100.0	%

Loans held for investment continue to consist primarily of commercial related loans, including commercial and industrial and commercial real estate loans, representing 71% of total loans at June 30, 2012 and 74% of total loans at December 31, 2011. Loans for the purpose of construction, land development, and other land loans (including residential construction and development) were $34,421 at June 30, 2012 and $33,497 at December 31, 2011 (including loan principal in process of disbursement) and represented just 7% of total gross loans. Our markets have traditionally supplied opportunities for loan growth and loan participations purchased were just $12,464 and $12,196 at June 30, 2012 and December 31, 2011, respectively. The majority of loan participations purchased are arrangements with other community banks in Wisconsin that work together to meet the credit needs of each other’s largest credit customers and are underwritten in the same manner as loans originated solely for our own portfolio. At June 30, 2012, only $554 of loan participations were purchased from sources other than traditional banks with substantial operations in Wisconsin.

Since 2010, local loan growth opportunities have been limited resulting in sporadic net loan growth and periodic quarter to quarter loan declines. Competition from larger banks in our markets is becoming stronger as such banks with higher capital levels and substantial deposit growth look to lending for higher yielding assets as investment security returns remain very low. Banks including BMO Harris Bank (the acquirer of M&I Bank and the bank having the largest deposit market share in our markets), U.S. Bank, Associated Bank, and Chase Bank appear to have relaxed credit terms for high credit quality borrowers and lowered lending interest rate spreads in an effort to aggressively increase their loan market share. We expect strong competition to continue through 2012 which could impact the pace of 2012 loan growth and could negatively impact net interest margin and net interest income. We could experience a small decrease in our loans outstanding during the remainder of 2012 compared to loans receivable held at June 30, 2012.

To support loan growth and invest deposits previously held in low yielding overnight funds, we maintained a temporary program to originate 15-year fully amortizing fixed rate residential first mortgage loans and retain those loans on our balance sheet rather than selling them to secondary market investors as is our normal practice. The loans were fully underwritten and conforming to secondary market standards. However, if the property was located in a rural area in which an adequate number of recent comparable sales were not available, some of the mortgages may not have been underwritten with a qualifying secondary market appraisal, although a current appraisal was obtained on each loan. The program originated approximately $10.1 million in residential mortgage loans at a 3.17% weighted average interest rate during the six months ended June 30, 2012 which contributed to the increase in residential mortgage loans in Table 5 above. If commercial related loan growth does not reinvest liquidity obtained from the Marathon State Bank acquisition, this 15 year fixed rate residential mortgage origination program is likely to be utilized in a similar manner during the remainder of 2012 to support loan and net interest income growth.

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The loan portfolio is our primary asset subject to credit risk. Our process for monitoring credit risk includes quarterly analysis of loan quality, delinquencies, nonperforming assets, and potential problem loans. Loans are placed on a nonaccrual status when they become contractually past due 90 days or more as to interest or principal payments. All interest accrued but not collected for loans (including applicable impaired loans) that are placed on nonaccrual status or charged off is reversed against interest income. Nonaccrual loans and restructured loans maintained on accrual status remain classified as nonperforming loans until the uncertainty surrounding the credit is eliminated. In general, uncertainty surrounding the credit is eliminated when the borrower has displayed a history of regular loan payments using a market interest rate that is expected to continue as if a typical performing loan. Some borrowers continue to make loan payments while maintained on non-accrual status. We apply all payments received on nonaccrual loans to principal until the loan is returned to accrual status or repaid. Total nonperforming assets as a percentage of total tangible common equity including the allowance for loan losses was 29.34%, 31.32%, and 35.03% at June 30, 2012, December 31, 2011, and June 30, 2011, respectively (refer to Table 24). For the purpose of this measurement, tangible common equity is equal to total common stockholders’ equity less mortgage servicing right assets.

Nonperforming assets include: (1) loans that are either contractually past due 90 days or more as to interest or principal payments, on a nonaccrual status, or the terms of which have been renegotiated to provide a reduction or deferral of interest or principal (restructured loans), (2) investment securities in default as to principal or interest, and (3) foreclosed assets.

Table 6: Nonperforming Assets

	June 30,						December 31,
(dollars in thousands)	2012			2011			2011
Nonaccrual loans (excluding restructured loans)	$	5,760		$	5,928		$	5,893
Nonaccrual restructured loans		2,347			1,905			2,081
Restructured loans not on nonaccrual		5,861			6,456			6,220
Accruing loans past due 90 days or more		—			—			—
Total nonperforming loans		13,968			14,289			14,194
Nonaccrual trust preferred investment security		750			750			750
Foreclosed assets		2,642			4,339			2,939
Total nonperforming assets	$	17,360		$	19,378		$	17,883
Nonperforming loans as a % of gross loans receivable		2.95	%		3.21	%		3.19	%
Total nonperforming assets as a % of total assets		2.45	%		3.22	%		2.87	%

Total nonperforming assets decreased $523, or 2.9% since December 31, 2011 from a $359 decrease in restructured loans maintained on accrual status and a $297 decrease in foreclosed assets. In certain situations, particularly for loans supported by collateral with depressed valuations or with borrowers undergoing what could be temporary financial difficulties, we will consider restructuring existing debt in an attempt to protect as much of our loan principal as possible. Typical restructured terms will convert a loan from amortizing payments to interest only payments, or lower the interest rate to a level less than market rates for the borrower’s risk profile. Existing restructurings have not forgiven borrower loan principal and have been associated with commercial related loans, not residential mortgage loans. At June 30, 2012, 71% of restructured loan principal shown in the table above remained on accrual status.

While we believe the most significant declines in general credit quality and the economy in our local markets have occurred, some borrowers continue to manage fragile cash flows and debt servicing ability as the economy has yet to sustain a meaningful recovery. Such conditions are seen in the level of problem borrowers with restructured loan terms. The longer significant recovery is delayed, the more difficult it will be for some borrowers to continue scheduled debt payments as previously unencumbered collateral is pledged for new working capital and balance sheet equity is drawn down, potentially increasing future provisions for loan losses. In light of these conditions, we expect to see an increase in borrowers requiring restructured loan terms which would increase our level of nonperforming loans. Foreclosed assets may also increase during the next several quarters as we work through ongoing collection and foreclosure actions. A continued slow local economy impacts the value of collateral and foreclosed assets, potentially increasing losses on foreclosed borrowers and properties during the coming quarters.

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At June 30, 2012, all nonperforming assets aggregating to $500 or more measured by gross principal outstanding per credit relationship are summarized in the following table and represented 43% of all nonperforming assets compared to 52% of nonperforming assets at December 31, 2011. In the table, loans presented as “Accrual TDR” represent troubled debt restructured loans maintained on accrual status.

Table 7: Largest Nonperforming Assets at June 30, 2012 ($000s)

Collateral Description	Asset Type		Gross Principal			Specific Reserves
Northern Wisconsin hotel	Accrual TDR	$	1,764		$	—
Cranberry producing agricultural real estate	Accrual TDR		1,578			—
Vacation home/recreational properties (three)	Foreclosed		1,280			n/a
Owner occupied cabinetry contractor real estate and equipment	Accrual TDR		758			31
Johnson Financial Group (WI) Capital Trust III debentures	Nonaccrual		750			—
Owner occupied multi use, multi-tenant real estate	Accrual TDR		676			193
Owner occupied restaurant real estate and business assets	Nonaccrual		658			173
Total listed nonperforming assets		$	7,464		$	397
Total bank wide nonperforming assets		$	17,360		$	2,210
Listed assets as a percent of total nonperforming assets			43	%		18	%

No large nonperforming assets in excess of $500 were added to Table 7 during the June 2012 quarter. At March 31, 2012, we included a large nonperforming loan with $1,233 in outstanding principal and $295 in specific reserves secured by multi-family rental apartment units and vacant land in Table 7 above. However, during the June 2012 quarter, the majority of this troubled debt restructured loan maintained on accrual status was settled with the borrower in which we received a payment of $833 on the sale of the property and recorded a $34 charge-off. We continue to have a $359 loan receivable outstanding with the borrower on which $190 in specific reserves are maintained. Our settlement with the borrower decreased our required specific reserves on the relationship by $71, net of the charge-off incurred.

During March 2011, we were informed by Johnson Financial Capital Trust of its intent to defer payment of interest on its 7% trust preferred capital debentures. Johnson Financial Group is the holding company for Johnson Bank, headquartered in Racine, Wisconsin. Our investment in the $750 debentures was placed on nonaccrual status at March 31, 2011 and all accrued but uncollected interest was reversed against income. Our internal evaluation has determined this investment is not other than temporarily impaired and no charge against net income for impairment has been recorded. During the March 2012 quarter, Johnson Financial Group received a significant new capital injection from its shareholders and is expected to return to profitability within the next several years. We expect to be repaid all interest due on the debentures in future years. Total Johnson Financial Capital Trust interest not accrued totaled $79 at June 30, 2012. Similar bank holding company investments held in our portfolio (identified by name of the operating bank subsidiary) include $800 par value to McFarland State Bank (Madison, WI), and $500 par value to River Valley Bank (Wausau, WI). These other investments are supported by the continued profitable operations and reasonable credit quality metrics represented within their portfolios and are expected to continue to remit scheduled quarterly payments of interest.

In addition to nonperforming loans, we have classified some performing loans as impaired loans under accounting standards due to heightened risk of nonperformance within the next year or other factors. Impaired loans maintained on accrual status that have not been restructured are not reported as nonperforming loans. At June 30, 2012, all impaired but performing loans aggregating to $500 or more measured by gross principal outstanding per credit relationship are summarized in the following table.

Table 8: Largest Performing, but Impaired Loans at June 30, 2012 ($000s)

Collateral Description	Asset Type	Gross Principal			Specific Reserves
Owner occupied cabinetry contractor real estate and equipment	Impaired	$	706		$	—
Owner occupied manufacturer real estate & equipment	Impaired		582			—
Total listed performing, but impaired loans		$	1,288		$	—
Total performing, but impaired loans		$	2,558		$	360
Listed assets as a % of total performing, but impaired loans			50	%		0	%

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Provision for Loan Losses and Loss of Foreclosed Assets

We determine the adequacy of the provision for loan losses based on past loan loss experience, current economic conditions, and composition of the loan portfolio. Accordingly, the amount charged to expense is based on management’s evaluation of the loan portfolio. It is our policy that when available information confirms that specific loans, or portions thereof, including impaired loans, are uncollectible, these amounts are promptly charged off against the allowance.

Our provision for loan losses was $165 in the June 2012 quarter compared to $430 in the June 2011 quarter. The lower quarterly provision needed was due to a modest $2.1 million in June 2012 quarterly net loan growth (excluding loans recorded at net fair value associated with the Marathon State Bank acquisition) and favorable resolution of a large problem loan that reduced specific loan reserves discussed previously. In addition, quarterly loss on foreclosed assets declined to $4 in June 2012 compared to $278 in June 2011 (which included a valuation write-down of $233 during 2011). Combined credit costs totaled $169 during the June 2012 quarter and $708 during the June 2011 quarter. The decline in credit costs compared to 2011 was an important driver of June 2012 quarterly increased earnings.

Year to date for the six months ended June 30, provision for loan losses was $325 during 2012 and $790 during 2011. Loss on foreclosed assets was $237 during 2012 and $573 during 2011. Combined credit costs were $562 during the six months ended June 30, 2012 compared to $1,363 during 2011, down 59%. Valuation write-downs included as loss on foreclosed assets were $205 during 2012 and $457 during 2011. Refer to Note 5 in the Notes to Consolidated Financial Statements for more information on foreclosed asset activity during the three months and six months ended June 30, 2012 and 2011.

Nonperforming loans are reviewed to determine exposure for potential loss within each loan category. The adequacy of the allowance for loan losses is assessed based on credit quality and other pertinent loan portfolio information. The adequacy of the allowance and the provision for loan losses is consistent with the composition of the loan portfolio and recent internal credit quality assessments. We maintain our headquarters and one branch location in the City of Wausau, Wisconsin, and maintain the majority of our deposits (including six of our nine locations, including Marathon State Bank), and loan customers in Marathon County, Wisconsin. During the June 2012 quarter, the 7.1% unemployment rate in Marathon County (not seasonally adjusted) declined from 8.2% at March 2012 but remained above the 6.5% measured during December 2011 due to two separate large manufacturing employers who announced plant closures cutting approximately 1,000 Marathon County jobs during the March 2012 quarter. The unemployment rate for all of Wisconsin (not seasonally adjusted) was 6.8% during May 2012. Despite the increased local unemployment rate, the current 7.1% Marathon County rate compares favorably to national levels and is in line with Wisconsin’s overall level. Outside of these plant closures in the paper and window industries, manufacturing and other local economies are seeing slow but consistent improvement. Because of these and other factors, we expect credit costs during the remainder of 2012 to continue to be slightly less than that seen during 2011. However, future provisions will be impacted by the actual amount of impaired and other problem loans identified by internal procedures or regulatory agencies. In addition, fair value of existing foreclosed assets continue to be reviewed in light of local market data and may be subject to a partial write-down of value during the remainder of 2012.

Table 9: Allowance for Loan Losses

	Three months ended						Six months ended
	June 30,						June 30,
(dollars in thousands)	2012			2011			2012			2011
Allowance for loan losses at beginning	$	7,755		$	7,377		$	7,941		$	7,960
Provision for loan losses		165			430			325			790
Recoveries on loans previously charged-off		12			147			13			150
Loans charged off		(284	)		(137	)		(631	)		(1,083	)
Allowance for loan losses at end	$	7,648		$	7,817		$	7,648		$	7,817

Net charge-offs of loan principal were $272 and $618 during the quarter and six months ended June 30, 2012 respectively. Net loan recoveries were $10 during the June 2011 quarter and net loan charge-offs were $933 during the six months ended June 30, 2011. During the June 2012 quarter, four borrowers represented 68% of all charge-offs including $34 charged off in connection with a problem loan settlement discussed previously. Charge-offs during the six months ended June 30, 2011 were led by a $700 charge-off related to a customer line of credit secured by building supply inventory and accounts receivable. Annualized net loan charge offs were .24% during the June 2012 quarter and were a net recovery of principal of .01% during the June 2011 quarter. Annualized net loan charge-offs were 0.28% and 0.43% during the six months ended June 30, 2012 and 2011, respectively.

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Net Interest Income

Quarter ended June 30, 2012 compared to June 30, 2011

Net interest income is the most significant component of earnings. Tax adjusted net interest income totaled $5,086 during the June 2012 quarter compared to $5,051 during the June 2011 quarter, an increase of $35, or 0.7%. Although net interest income remained largely unchanged, net interest margin declined from 3.57% in June 2011 to 3.42% during June 2012 as loan and investment security yields declined faster than average deposit costs. The decline in margin was also impacted by the Marathon acquisition as approximately 47% of the assets acquired ($50,547) were agency and municipal securities yielding 1.81% on a tax adjusted basis. Increased earning asset volume during the June 2012 quarter compared to June 2011 offset the decline in net interest income from reduced net margin as average earning assets increased 5.6%. During the June 2012 quarter, long-term market rates declined significantly (for example, the 10 year U.S. Treasury rate declined from 2.15% to 1.66% during the June 2012 quarter) and the rate decline experienced in the national economy during the 2008-2009 recession continues and loans, securities, and funding continue to reprice lower to current rate levels.

Reinvestment yields for investment security cash flows remain very low and taxable securities yields are expected to continue to decline throughout 2012. In addition, loan yields may decline significantly due to competitive pressures as competitors seek to increase loan originations while quality credit demand remains weak in addition to domestic and global economic actions which have lowered long-term rates. With average cost of interest bearing deposits (representing 72% of total average liabilities) at 1.01% during the June 2012 quarter, further reduction of deposit costs to offset lower loan yields may be difficult. Asset yields are expected to continue to decline faster than funding costs during the remainder of 2012 and net interest income is likely to decline if earning assets do not grow from existing levels. Although a portion of the decline in earning asset rates will be offset by further declines in certificate of deposit funding costs and nonmaturity deposit costs, September 2012 quarterly net interest margin is anticipated to continue in a range of 3.35% to 3.40%.

Six months ended June 30, 2012 compared to June 30, 2011

Tax adjusted net interest income totaled $10,082 during the six months ended June 30, 2012 compared to $10,011 during the six months ended June 30, 2011, an increase of $71, or 0.7%. As during the June 2012 quarter, year to date net interest income increased slightly from increased earning asset volume which offset a decline in net margin from 3.51% during 2011 to 3.46% during 2012.

We have increased net interest margin since 2009 by inserting interest rate floors in commercial-related loans and retail residential home equity lines of credit to avoid the negative impacts to net interest margin from a sustained low interest rate environment and to appropriately price for credit risk in the current market. At June 30, 2012, approximately 80% of our $124 million in adjustable rate loans carried a contractual interest rate floor and, of those loans with floors, approximately 97% carried current loan yields in excess of the normal adjustable rate coupon due to the interest rate floor. Of those loans with current loan yields in excess of the normal adjustable coupon rate, approximately 76% of principal have “in the money” loan floors which increased the adjustable rate between 100 basis points and 200 basis points. If current interest rate levels were assumed to remain the same, the annualized increase to net interest income and net interest margin would be approximately $1,340 and .22%, respectively, based on those existing loan floors and average quarterly earning assets at June 30, 2012. During a period of rising short-term interest rates, we expect average funding costs (which are not currently subject to contractual caps on the interest rate) to rise while the yield on loans with interest rate floors would remain the same until those loans’ adjustable rate index caused coupon rates to exceed the loan rate floor. This mismatch compared to rising funding costs is likely to lower net interest margin and possibly period over period net interest income. The speed in which short-term interest rates increase is expected to have a significant impact on net interest income from loans with interest rate floors. Quickly rising short-term rates would allow adjustable rate loans with floors to reprice to rates higher than the existing floor more quickly, impacting net interest income less adversely than if short-term rates rose slowly or deliberately.

During the September 2011 quarter, the Dodd-Frank Wall Street Reform Act repealed the prohibition on paying interest on commercial checking accounts. We currently provide an earnings credit against account fees in lieu of an interest payment and do not expect costs to increase because of this change in the short term. Despite the law change, we do not sell or promote an interest bearing commercial checking account at this time. However, the change could have greater long-term implications as competitor banks begin to use premium interest rate levels on commercial deposits in attempts to raise deposits in coming years.

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The following Tables present a schedule of yields and costs for the quarter and six months ended June 30, 2012 compared to the prior year periods ended June 30, 2011 and the interest income and expense volume and rate analysis for the six months ended June 30, 2012 compared to the six months ended June 30, 2011.

Table 10: Net Interest Income Analysis (Quarter)

(dollars in thousands)	Quarter ended June 30, 2012								Quarter ended June 30, 2011
	Average					Yield/			Average					Yield/
	Balance			Interest		Rate			Balance			Interest		Rate
Assets
Interest-earning assets:
Loans(1)(2)	$	455,734		$	5,837		5.15	%	$	444,844		$	6,152		5.55	%
Taxable securities		93,727			575		2.47	%		81,355			705		3.48	%
Tax-exempt securities(2)		36,673			453		4.97	%		32,808			426		5.21	%
FHLB stock		2,819			3		0.43	%		3,250			—		0.00	%
Other		9,925			17		0.69	%		4,947			15		1.22	%
Total(2)		598,878			6,885		4.62	%		567,204			7,298		5.16	%
Non-interest-earning assets:
Cash and due from banks		15,611								8,068
Premises and equipment, net		9,914								10,287
Cash surrender value insurance		11,545								11,136
Other assets		11,304								12,813
Allowance for loan losses		(7,848	)							(7,530	)
Total	$	639,404							$	601,978
Liabilities & stockholders’ equity
Interest-bearing liabilities:
Savings and demand deposits	$	145,675		$	203		0.56	%	$	125,134		$	295		0.95	%
Money market deposits		108,956			148		0.55	%		98,766			203		0.82	%
Time deposits		169,755			719		1.70	%		173,587			898		2.07	%
FHLB borrowings		50,674			353		2.80	%		56,483			459		3.26	%
Other borrowings		19,705			149		3.04	%		26,154			165		2.53	%
Senior subordinated notes		7,000			142		8.16	%		7,000			141		8.08	%
Junior subordinated debentures		7,732			85		4.42	%		7,732			86		4.46	%
Total		509,497			1,799		1.42	%		494,856			2,247		1.82	%
Non-interest-bearing liabilities:
Demand deposits		68,963								53,727
Other liabilities		8,109								4,417
Stockholders’ equity		52,835								48,978
Total	$	639,404							$	601,978
Net interest income				$	5,086							$	5,051
Rate spread							3.20	%							3.34	%
Net yield on interest-earning assets							3.42	%							3.57	%

⁽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%.

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Table 11: Net Interest Income Analysis (Six Months)

	Quarter ended June 30, 2012								Quarter ended June 30, 2011
	Average					Yield/			Average					Yield/
(dollars in thousands)	Balance			Interest		Rate			Balance			Interest		Rate
Assets
Interest-earning assets:
Loans(1)(2)	$	450,347		$	11,722		5.23	%	$	442,012		$	12,239		5.58	%
Taxable securities		86,288			1,147		2.67	%		79,902			1,383		3.49	%
Tax-exempt securities(2)		33,556			852		5.11	%		33,411			876		5.29	%
FHLB stock		2,938			4		0.27	%		3,250			2		0.12	%
Other		13,684			35		0.51	%		16,470			37		0.45	%
Total(2)		586,813			13,760		4.72	%		575,045			14,537		5.10	%
Non-interest-earning assets:
Cash and due from banks		12,013								8,240
Premises and equipment, net		9,917								10,341
Cash surrender value insurance		11,495								11,059
Other assets		11,372								12,969
Allowance for loan losses		(7,951	)							(7,768	)
Total	$	623,659							$	609,886
Liabilities & stockholders’ equity
Interest-bearing liabilities:
Savings and demand deposits	$	140,699		$	425		0.61	%	$	128,448		$	585		0.92	%
Money market deposits		108,052			321		0.60	%		104,279			438		0.85	%
Time deposits		165,966			1,476		1.79	%		170,656			1,802		2.13	%
FHLB borrowings		50,970			705		2.78	%		56,656			916		3.26	%
Other borrowings		19,388			297		3.08	%		28,421			332		2.36	%
Senior subordinated notes		7,000			284		8.16	%		7,000			283		8.15	%
Junior subordinated debentures		7,732			170		4.42	%		7,732			170		4.43	%
Total		499,807			3,678		1.48	%		503,192			4,526		1.81	%
Non-interest-bearing liabilities:
Demand deposits		64,489								53,923
Other liabilities		7,415								4,556
Stockholders’ equity		51,948								48,215
Total	$	623,659							$	609,886
Net interest income				$	10,082							$	10,011
Rate spread							3.24	%							3.29	%
Net yield on interest-earning assets							3.46	%							3.51	%

⁽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%.

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Table 12: Interest Income and Expense Volume and Rate Analysis (Year to Date)

	2012 compared to 2011
	increase (decrease) due to (1)
(dollars in thousands)	Volume			Rate			Net
Interest earned on:
Loans(2)	$	217		$	(734	)	$	(517	)
Taxable securities		85			(321	)		(236	)
Tax-exempt securities(2)		4			(28	)		(24	)
FHLB stock		—			2			2
Other interest income		(7	)		5			(2	)
Total		299			(1,076	)		(777	)
Interest paid on:
Savings and demand deposits		37			(197	)		(160	)
Money market deposits		11			(128	)		(117	)
Time deposits		(42	)		(284	)		(326	)
FHLB borrowings		(79	)		(132	)		(211	)
Other borrowings		(138	)		103			(35	)
Senior subordinated notes		—			1			1
Total		(211	)		(637	)		(848	)
Net interest earnings	$	510		$	(439	)	$	71

⁽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.

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 Note 13 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. The following Table represents our earnings sensitivity to changes in interest rates at June 30, 2012. 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 other 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.

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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.

The gap analysis reflects an asset sensitive gap position during the next year, with a cumulative negative one-year gap ratio at June 30, 2012 of 90.6% compared to a positive gap of 107.9% at December 31, 2011. In general, a current negative gap would be favorable in a falling interest 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. The existence of our significant “in the money” floating rate loan floors could also lessen the impact of an asset sensitive gap position in a rising interest rate environment. These factors can result in change to net interest income from changing interest rates different than expected from review of the gap table.

Table 13: Interest Rate Sensitivity Gap Analysis

	June 30, 2012
(dollars in thousands)	0-90 Days			91-180 days			181-365 days			1-2 yrs.			2-5 yrs.			Beyond 5 yrs.			Total
Earning assets:
Loans	$	182,960		$	32,728		$	58,853		$	69,665		$	94,602		$	35,622		$	474,430
Securities		11,431			7,656			11,974			20,352			57,236			55,359			164,008
FHLB stock		—			—			—			—			—			2,761			2,761
CSV bank-owned life ins.		—			—			—			—			—			11,608			11,608
Other earning assets		6,503			—			—			748			1,736			—			8,987
Total	$	200,894		$	40,384		$	70,827		$	90,765		$	153,574		$	105,350		$	661,794
Cumulative rate sensitive assets	$	200,894		$	241,278		$	312,105		$	402,870		$	556,444		$	661,794
Interest-bearing liabilities
Interest-bearing deposits	$	91,157		$	32,246		$	196,344		$	31,899		$	44,494		$	78,358		$	474,498
FHLB advances		16,000			—			4,000			20,384			14,740			—			55,124
Other borrowings		4,586			—			—			—			8,000			5,500			18,086
Senior subordinated notes		—			—			—			—			—			7,000			7,000
Junior subordinated debentures		—			—			—			—			—			7,732			7,732
Total	$	111,743		$	32,246		$	200,344		$	52,283		$	67,234		$	98,590		$	562,440
Cumulative interest sensitive liabilities	$	111,743		$	143,989		$	344,333		$	396,616		$	463,850		$	562,440
Interest sensitivity gap for the individual period	$	89,151		$	8,138		$	(129,517	)	$	38,482		$	86,340		$	6,760
Ratio of rate sensitive assets to rate sensitive liabilities for the individual period		179.8	%		125.2	%		35.4	%		173.6	%		228.4	%		106.9	%
Cumulative interest sensitivity gap	$	89,151		$	97,289		$	(32,228	)	$	6,254		$	92,594		$	99,354
Cumulative ratio of rate sensitive assets to rate sensitive liabilities		179.8	%		167.6	%		90.6	%		101.6	%		120.0	%		117.7	%

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We use financial modeling techniques that measure interest rate risk. These policies are intended to limit exposure of earnings to risk. A formal liquidity contingency plan exists that directs management to the least expensive liquidity sources to fund sudden and unanticipated liquidity needs. We also use various policy measures to assess interest rate risk as described below.

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. The following table 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 14: Net Interest Margin Rate Simulation Impacts

Period Ended:	June 2012			December 2011			June 2011
Cumulative 1 year gap ratio
Base		91	%		108	%		95	%
Up 200		87	%		104	%		90	%
Down 100*		93	%		111	%		95	%
Change in Net Interest Income – Year 1
Up 200 during the year		-3.6	%		-2.1	%		-3.4	%
Down 100 during the year*		-0.8	%		-0.7	%		-0.5	%
Change in Net Interest Income – Year 2
No rate change (base case)		-3.5	%		-5.1	%		-2.9	%
Following up 200 in year 1		-6.0	%		-3.5	%		-2.3	%
Following down 100 in year 1*		-3.8	%		-9.8	%		-7.6	%

* Simulations reflect net interest income changes from a down 100 basis point scenario, rather than a down 200 basis point scenario as dictated by internal policy due to the currently low level of relative short-term rates.

To assess whether interest rate sensitivity beyond one year helps mitigate or exacerbate the short-term rate sensitive position, a quarterly measure of core funding utilization is made. Core funding is defined as liabilities with a maturity in excess of 60 months and stockholders’ equity capital. Core deposits including DDA, lower yielding NOW, and non-maturity savings accounts (not including 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 63.3% at June 30, 2012 compared to 61.9%% at December 31, 2011.

At June 30, 2012, internal interest rate simulations that project interest rate changes that maintain the current shape of the yield curve (often referred to as “parallel yield curve shifts”) and those which assume a flattening of the yield curve all point to decreased net interest income from a static balance sheet compared to the June 30, 2012 “base case.” If market rates decline, net interest income is negatively impacted by falling asset yields while funding costs currently near 0% have little room to decline. If market rates increase, net interest income is negatively impacted by existing interest rate floors on floating rate loans. As funding costs rise, these floating rate loans could remain at the same yield for several periods, reducing net interest margin and net interest income. During a period of rising interest rates, net interest income is also negatively impacted by a flattening yield curve. When the yield curve flattens, repriced short-term funding cost, such as for terms of 1 year or less increases, while maturing fixed rate balloon loans, such as with terms from 3 to 5 years, increase much less. During flattening periods, assets and liabilities may reprice at the same time but to a much different extent.

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The table below summarizes the percentage change to current “base case” net interest income as a result of certain interest simulations:

Table 15: Projected Changes to Net Interest Income Under Alternative Rate Simulations

	Down 100 bp		Up 400 bp 24M		Delayed (12M)  Flat up 500 bp
Year 1	-0.8	%	-2.3	%	1.3	%
Year 2	-3.8	%	-7.3	%	1.7	%
Year 3	-5.6	%	-13.5	%	-12.7	%
Year 4	-8.3	%	3.7	%	-19.8	%
Year 5	-10.0	%	21.2	%	-0.3	%

Current negative domestic and global economic trends, including potential sovereign debt defaults by industrialized nations, are expected to continue interest rate volatility and raise the potential for continued declines in market interest rates. Current indications by the Board of Governors of the Federal Reserve call for the existing very low rate environment to continue through the end of 2014. We regularly monitor our asset-liability position in light of this potential long-term risk to net interest income levels from such a protracted low interest rate environment.

Noninterest Income

Quarter ended June 30, 2012 compared to June 30, 2011

Total noninterest income for the quarter ended June 30, 2012 was $2,323, compared to $1,197 earned during the June 2011 quarter, an increase of $1,126 primarily from an $851 gain on bargain purchase of Marathon State Bank. Other factors increasing quarterly noninterest income were a $158 increase in mortgage banking (up 56%) due to customer home loan refinancing to lower long-term rates and a $96 increase in investment and insurance sales commissions (up 68%). PSB expects to see similar elevated mortgage banking income during the upcoming September 2012 quarter, although current quarterly levels of investment and insurance sales commissions are unlikely to remain at such a high level.

Despite 2011 regulation to limit bank debit card interchange and overdraft fees, these income types were not yet adversely affected and totaled $532 and $515 during the quarters ended June 30, 2012 and 2011, respectively.

Six months ended June 30, 2012 compared to June 30, 2011

During the six months ended June 30, noninterest income was $3,565 in 2012, up $971 from $2,594 in 2011. Excluding the Marathon bargain purchase gain, noninterest income would have increased $120, or 4.6%, from 2011 primarily from a $104 increase in investment and insurance sales commissions.

Noninterest Expense

Quarter ended June 30, 2012 compared to June 30, 2011

Noninterest expenses totaled $4,064 during the June 2012 quarter compared to $3,869 during the June 2011 quarter, an increase of $195, or 5.0%. Excluding the $4 loss on foreclosed assets and $75 of merger related costs during 2012 and $278 of loss on foreclosed assets during 2011, noninterest expense would have increased $394, or 11.0%. The majority of the operating expense increase was due to $90 in Marathon daily operating costs following the acquisition, self-insured employee health plan costs up $95 (up 50%), and higher data processing costs, up $115, or 36.7%, during June 2012 compared to June 2011. Data processing expense increased as special conversion contractual cost reductions associated with the June 2010 data system conversion were fully phased out during the September 2011 quarter. On a linked quarter basis, Peoples’ data processing costs (excluding Marathon costs) were $402 during the June 2012 quarter and $404 during the March 2012 quarter.

Six months ended June 30, 2012 compared to June 30, 2011

During the six months ended June 30, 2012, noninterest expense, excluding $192 of merger related costs and loss on foreclosed assets, was $7,754 compared to $7,249 during 2011, up $505, or 7.0%. Similar to the June 2012 quarter, the expense increase was led by an increase of $235 in wages and benefits (excluding Marathon, up 5.7%), data processing costs up $180 (excluding Marathon), and Marathon daily operating costs of $90.

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During the remainder of 2012, PSB expects to incur substantial additional merger costs up to $600 before income tax benefits related to the data conversion of Marathon customer information. Approximately $270 of the data conversion cost will be payments to Marathon’s prior third party data processing service to obtain Marathon customer information for the conversion which will be expensed when incurred. Approximately $130 of the data conversion cost includes payments to our data processor for licensing fees and software parameter design charges which will be capitalized as premises and equipment investment and amortized to expense over the remaining seven years of our data processing contract. The remaining estimated $200 of data conversion fees will be paid to our data processor for conversion services and expensed when incurred.

Future integration costs may also include a loss on disposal of the existing Peoples Marathon branch location later in 2012 if market and sale conditions for the real estate decline. The remaining premises and equipment investment in the Peoples’ Marathon branch is approximately $190. Integration of Peoples’ existing Marathon branch with Marathon State Bank is expected to generate annual run-rate expense savings of approximately $250 to be fully phased in by the end of 2013.

LIQUIDITY

Liquidity refers to the ability to generate adequate amounts of cash to meet our need for cash at a reasonable cost. We manage our liquidity to provide adequate funds to support borrowing needs and deposit flow of our customers. We also view liquidity as the ability to raise cash at a reasonable cost or with a minimum of loss and as a measure of balance sheet flexibility to react to marketplace, regulatory, and competitive changes. Retail and local deposits and repurchase agreements are the primary source of funding. Retail and local deposits and repurchase agreements were 69.5% of total assets at June 30, 2012 compared to 66.3% of total assets at December 31, 2011 and 63.0% of total assets at June 30, 2011.

Table 16: Period-end Deposit Composition

	June 30,										December 31,
(dollars in thousands)	2012					2011					2011
	$		%			$		%			$		%
Non-interest bearing demand	$	82,909		14.9	%	$	55,460		12.4	%	$	75,298		15.6	%
Interest-bearing demand and savings		169,450		30.4	%		121,584		27.0	%		136,950		28.4	%
Money market deposits		108,712		19.5	%		98,498		22.0	%		102,993		21.4	%
Retail and local time deposits less than $100		65,712		11.8	%		48,514		10.8	%		45,653		9.5	%
Total core deposits		426,783		76.7	%		324,056		72.2	%		360,894		74.9	%
Retail and local time deposits $100 and over		61,192		11.0	%		47,242		10.5	%		46,049		9.6	%
Broker & national time deposits less than $100		737		0.1	%		832		0.2	%		835		0.2	%
Broker & national time deposits $100 and over		68,695		12.3	%		76,537		17.1	%		73,731		15.3	%
Totals	$	557,407		100.0	%	$	448,667		100.0	%	$	481,509		100.0	%

The acquisition of Marathon State Bank increased demand deposits and savings balance as these deposit types represented approximately $57.2 million (57%) of the acquired portfolio while certificates of deposit represented approximately $38.0 million of the portfolio (38%) and money market deposits represented approximately $5.7 million of the portfolio (5%).

Separately from the new Marathon deposits, we continue to experience ongoing retail time deposit quarterly declines that began during the March 2009 quarter as wholesale funding rates for various funding types began to be lower than local retail certificates of deposit. Certificate balances have also been replaced by higher interest bearing demand account balances and money market accounts as customers have moved certificate funds into liquid, short-term deposit vehicles as certificate rates locally have moved to very low levels relative to certain nonmaturity deposit accounts.

We discontinued sale of our Rewards Checking account effective October 1, 2011. Balances in Rewards Checking totaled $48,850 at September 30, 2011 and continued at $46,627 at June 30, 2012. Peoples Rewards Checking paid a premium interest rate and reimbursement of ATM fees to depositors who meet account usage requirements including minimum debit card purchases, acceptance of electronic account statements, and direct deposit activity. The average interest cost of Reward Checking balances (excluding debit card interchange fee income, savings from delivery of electronic periodic statements, customer reimbursement of ATM fees, and vendor software costs of maintaining the program) was 1.59% during the year ended December 31, 2011 and was 1.01% during the June 2012 quarter and 1.27% during the March 2012 quarter. Existing Rewards Checking customers at October 1, 2011 were allowed to remain in this account which at June 30, 2012 paid a premium 1.50% yield up to $15,000 in balances. Balances above these levels earn a yield of .25%. Participation in the account requires customers to receive their periodic statement via email and complete monthly ACH or direct deposit activity within the account.

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We originate retail certificates of deposit with local depositors under the CDARS program, in which our customer deposits (with participation of other banks in the CDARS network) are able to obtain levels of FDIC deposit insurance coverage in amounts greater than traditional limits. For purposes of the Period-end Deposit Composition Table above, these certificates are included in retail time deposits $100 and over and totaled $10,272 at June 30, 2012 compared to $11,825 at December 31, 2011. Although classified as retail time deposits $100 and over in the table above, we are required to report these balances as broker deposits on our quarterly regulatory call reports. We also originate certificates of deposit obtained through a national rate listing service and held $4,180 and $3,840 of such deposits at June 30, 2012 and December 31, 2011, respectively. These national certificates are classified with broker deposits in the table above.

Wholesale funding often carries higher interest rates than local core deposit funding, so loan growth supported by wholesale funds can generate lower net interest spreads than loan growth supported by local funds. However, wholesale funds provide us the ability to quickly raise large funding blocks and to match loan terms to minimize interest rate risk and avoid the higher incremental cost to existing deposits from simply increasing retail rates to raise local deposits. Rates paid on local deposits are significantly impacted by competitor interest rates and the local economy’s ability to grow in a way that supports the deposit needs of all local financial institutions. Current brokered certificate of deposit rates available to us are less costly than equivalent local deposits due to very low rates of return available on the most conservative fixed income investments and as national wholesale funds place a premium on FDIC insurance available on their large deposit when placed with brokers in amounts less than current FDIC insurance limits. Due to large demand through brokers for these types of deposits, brokered deposit rates for well performing banks are historically low. In addition, declines in profitability and capital at some banks have reduced their access to wholesale funding or otherwise increased its cost. In many cases, these institutions with reduced wholesale funding access have increased their retail interest rates to gather funds through local depositors. Consequently, local certificate of deposit rates in many markets are priced higher than equivalent wholesale brokered deposits due to a limited supply of retail deposits. We expect this difference in pricing between wholesale and local certificates of deposit to be removed by the wholesale funding market as the banking industry becomes well capitalized and regains consistent profits. An improving national economy will likely increase wholesale rates relative to local core deposit rates which could increase the volatility of our interest expense due to a significant portion of our funding coming from wholesale sources.

Our internal policy is to limit broker and national time (not including CDARS) deposits to 20% of total assets. Broker and national deposits as a percentage of total assets were 9.8%, 12.0%, and 12.9% at June 30, 2012, December 31, 2011, and June 30, 2011, respectively. During the remainder of 2012, we do not expect to increase our usage of brokered certificates due to limited loan growth opportunities and liquidity added by our acquisition of Marathon State Bank. Beyond the use of brokered and national time deposits, secondary wholesale sources also include FHLB advances, Federal Reserve Discount Window advances, and pledging of investment securities against wholesale repurchase agreements.

Table 17: Summary of Balance by Significant Deposit Source

	June 30,				December 31,
(dollars in thousands)	2012		2011		2011
Total time deposits $100 and over	$	129,887	$	123,779	$	119,780
Total broker and national deposits		69,432		77,369		74,566
Total retail and local time deposits		126,904		95,756		91,702
Core deposits, including money market deposits		426,783		324,056		360,894

Table 18: June 30, 2012 Change in Deposit Balance since Period Ended:

	June 30, 2011						December 31, 2011
(dollars in thousands)	$			%			$			%
Total time deposits $100 and over	$	6,108			4.9	%	$	10,107			8.4	%
Total broker and national deposits		(7,937	)		-10.3	%		(5,134	)		-6.9	%
Total retail and local time deposits		31,148			32.5	%		35,202			38.4	%
Core deposits, including money market deposits		102,727			31.7	%		65,889			18.3	%

As a supplement to local deposits, we use short-term and long-term funding sources other than retail deposits including federal funds purchased from other correspondent banks, advances from the FHLB, use of wholesale and national time deposits, advances taken from the Federal Reserve’s Discount Window, and repurchase agreements from security pledging. The table below outlines the available and unused portion of these funding sources (based on collateral and/or company policy limitations) as of June 30, 2012 and December 31, 2011. Currently unused but available funding sources at June 30, 2012 are considered sufficient to fund anticipated 2012 asset growth and meet contingency funding needs.

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We maintain formal policies to address liquidity contingency needs and to manage a liquidity crisis. The following table provides a summary of how the wholesale funding sources normally available to us would be impacted by various operating conditions.

Table 19: Environmental Impacts on Availability of Wholesale Funding Sources:

	Normal	Moderately	Highly
	Operating	Stressed	Stressed
	Environment	Environment	Environment
Repurchase Agreements	Yes	Likely*	Not Likely
FHLB (primary 1-4 REM collateral)	Yes	Yes*	Less Likely*
FHLB (secondary loan collateral)	Yes	Likely*	Not Likely
Brokered CDs	Yes	Likely*	Not Likely
National CDs	Yes	Likely*	Not Likely
Federal Funds Lines	Yes	Less Likely*	Not Likely
FRB (Borrow-In-Custody)	Yes	Yes	Less Likely*
FRB (Discount Window securities)	Yes	Yes	Yes
Holding Company line of credit	Yes	Yes	Less Likely*

* May be available but subject to restrictions

Table 20 summarizes the availability of various wholesale funding sources at June 30, 2012 and December 31, 2011.

Table 20: Available but Unused Funding Sources other than Retail Deposits

	June 30, 2012						December 31, 2011
	Unused, but			Amount			Unused, but			Amount
(dollars in thousands)	Available			Used			Available			Used
Overnight federal funds purchased	$	35,000		$	—		$	28,000		$	—
Federal Reserve discount window advances		86,209			—			100,000			—
FHLB advances under blanket mortgage lien		21,326			55,124			22,559			50,124
Repurchase agreements and other FHLB advances		36,375			18,086			34,416			19,691
Wholesale and national deposits		72,372			69,432			50,007			74,566
Holding company secured line of credit		3,000			—			3,000			—
Totals	$	254,282		$	142,642		$	237,982		$	144,381
Funding as a percent of total assets		35.9	%		20.1	%		38.2	%		23.2	%

The following discussion examines each of the available but unused funding sources listed in the table above and the factors that may directly or indirectly influence the timing or the amount ultimately available to us.

June 30, 2012 compared to December 31, 2011

Overnight federal funds purchased

Our consolidated federal funds purchase availability of $35,000 is from $28,000 of agreements with Peoples State Bank from three correspondent banks and $7,000 of agreements with Marathon State Bank from two correspondent banks. Following conversion of Marathon State Bank into a branch of Peoples State Bank later this year, the two correspondent bank lines with Marathon will be eliminated resulting in consolidated federal funds purchase availability of $28,000 once again as at December 31, 2011. The most significant portion of the total is $15,000 from our primary correspondent bank, Bankers’ Bank located in Madison, Wisconsin. We make regular use of the Bankers’ Bank line as part of our normal daily cash settlement procedures, but rarely have used the lines offered by the other two correspondent banks. Federal funds must be repaid each day and borrowings may be renewed for up to 14 consecutive business days. To unilaterally draw on the existing federal funds line, we need to maintain a “composite ratio” as defined by Bankers’ Bank of 40% or less. Bankers’ Bank defines the composite ratio to be nonaccrual loans and foreclosed assets divided by tangible capital including the allowance for loan losses calculated at our subsidiary bank level. Due to existence of the composite ratio, an increase in nonaccrual loans or foreclosed assets could impact availability of the line or subject us to further review. In addition, a rising composite ratio could cause our other two correspondent banks to reconsider their federal funds line with us since they do not also serve as our primary correspondent bank. Our subsidiary bank’s composite ratio was approximately 16% at June 30, 2012 and December 31, 2011, and less than the 40% benchmark used by Bankers’ Bank.

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Federal Reserve discount window advances

We have a $100,000 line of credit with the Federal Reserve Discount Window supported by both commercial and commercial real estate collateral provided to the Federal Reserve under their Borrower in Custody (“BIC”) program. During 2011 and as of June 30, 2012, the annualized interest rate applicable to Discount Window advances was .75%. Under the BIC program, we provide a monthly listing of detailed loan information on the loans provided as collateral. We are subject to annual review and certification by the Federal Reserve to retain participation in the program. The Discount Window represents the primary source of liquidity on a daily basis following our federal funds purchased lines of credit discussed above. We were limited to a maximum advance of $86,209 and $100,000 at June 30, 2012 and December 31, 2011, respectively, based on the BIC loan collateral pledged. Discount Window advances must be repaid or renewed each day. No Discount Window advances were used during the six months ended June 30, 2012.

Only performing loans are permitted as collateral under the BIC and each individual loan is subject to a haircut to collateral value based on the Federal Reserve’s review of the listing each month. In general, approximately 75% of the loan principal offered as collateral is able to support Discount Window advances. Similar to the federal funds purchased lines of credit, an increase in nonperforming loans would decrease the amount of collateral available for Discount Window advances.

Federal Home Loan Bank (FHLB) advances under blanket mortgage lien and other FHLB advances

We maintain an available line of credit with the FHLB of Chicago based on a pledge of 1 to 4 family mortgage loan collateral, both first and secondary lien positions. We may borrow on the line to the lesser of the blanket mortgage lien collateral provided, or 20 times our existing FHLB capital stock investment. Based on our existing $2,761 capital stock investment, total FHLB advances in excess of $55,220 require us to purchase additional FHLB stock equal to 5% of the advance amount. At June 30, 2012, we could have drawn an FHLB advance up to $96 of the $21,326 available without the purchase of FHLB stock. At December 31, 2011, we could have drawn an FHLB advance up to $14,876 of the $22,559 available without the purchase of FHLB stock. Further advances of the remaining $21,230 available at June 30, 2012 would have required us to purchase additional FHLB stock totaling $1,062. FHLB stock currently pays an annualized dividend of .30% with expectations of continuing this dividend level. Therefore, additional FHLB advances carry additional cost relative to other wholesale borrowing alternatives due to the requirement to hold relatively low yielding FHLB stock.

Similar to the Discount Window, only performing residential mortgage loans may be pledged to the FHLB under the blanket lien. In addition, we are subject to a haircut of approximately 36% on first mortgage collateral and 60% on secondary lien collateral at June 30, 2012 and December 31, 2011. The FHLB also conducts periodic audits of collateral identification and submission procedures and adjusts the collateral haircuts higher in response to negative exam findings. The FHLB also assigns a credit risk grade to each member based on a quarterly review of the member’s regulatory CALL report. Our current credit risk is within the normal range for a healthy member bank. Negative financial performance trends such as reduced capital levels, increased nonperforming assets, net operating losses, and other factors can increase a member’s credit risk grade. Higher risk grades can require a member to provide detailed loan collateral listings (rather than a blanket lien), physical collateral, and other restrictions on the maximum line usage. FHLB advances are available on a daily basis and along with Discount Window advances represent a primary source of liquidity following our federal funds purchased lines of credit.

FHLB advances carry substantial penalties for early prepayment that are generally not recovered from the lower interest rates in refinancing. The amount of early prepayment penalty is a function of the difference between the current borrowing rate, and the rate currently available for refinancing. Under a new collateral and pledging agreement we maintain with the FHLB effective April 12, 2011, we are also permitted to pledge commercial related collateral for advances. However, we did not pledge any commercial loan collateral to the FHLB at June 30, 2012 or December 31, 2011.

In connection with the lifting of their regulatory consent order, the FHLB of Chicago announced a capital stock conversion plan and $106 of our FHLB stock was repurchased during the June 2012 quarter after $383 was repurchased during the March 2012 quarter. A member must continue to hold capital stock no less than 5% of outstanding FHLB advances. Our FHLB capital stock shares are considered “B-2” capital shares. Excess holdings of B-2 shares may be redeemed by the FHLB at the request of a member following a five year redemption period. We do not expect to offer more of our FHLB stock for repurchase during the remainder of 2012.

Repurchase agreements and FHLB advances collateralized by investment securities

Wholesale repurchase agreements may be available from a correspondent bank counterparty for both overnight and longer terms. Such arrangements typically call for the agreement to be collateralized by us at 110% of the repurchase principal. In the current market, repurchase counterparty providers are extremely limited and would likely require a minimum $10 million transaction. Repurchase agreements could require up to several business days to receive funding. Due to the lack of availability of counterparties offering the product, wholesale repurchase agreements are not a reliable source of liquidity. At June 30, 2012, $13,500 of our repurchase agreements are wholesale agreements with correspondent banks and $4,586 are overnight repurchase agreements with local customers using our treasury management services. At December 31, 2011, $13,500 of our repurchase agreements were wholesale agreements with correspondent banks and $6,191 were overnight repurchase agreements with local customers.

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In addition to availability of FHLB advances under the blanket mortgage lien, we also have the ability to pledge investment securities as collateral against FHLB advances. Advances secured by investments are also subject to the FHLB stock ownership requirement as described previously. Due to the need to purchase additional FHLB member stock, FHLB advances secured by investments are not considered a primary source of liquidity. At June 30, 2012, $36,375 of additional FHLB advances were available based on pledging of securities if an additional $1,819 of member capital stock were purchased. At December 31, 2011, $34,416 of additional FHLB advances were available based on pledging of securities if an additional $1,721 of member capital stock were purchased.

Wholesale market deposits

Due to the strength of our capital position, balance sheet, and ongoing earnings, we enjoy the lowest possible costs when purchasing wholesale certificates of deposit on the brokered market. We have an internal policy that limits use of brokered deposits to 20% of total assets, which gave availability of $72,372 at June 30, 2012 and $50,007 at December 31, 2011. Brokered and national certificates were 9.8% and 12.0% of assets at June 30, 2012 and December 31, 2011, respectively. Increased brokered deposit availability came with increased assets following the Marathon purchase. Due to a limited number of providers of repurchase agreement funding as well as our desire to retain unencumbered securities for liquidity purposes and adverse impacts from holding additional FHLB capital stock, loan growth in past years was often funded with brokered certificate of deposit funding. Following our purchase of Marathon State Bank, we expect our reliance on brokered deposits to decline during the remainder of 2012.

Participants in the brokered certificate market must be considered “well capitalized” under current regulatory capital standards to acquire brokered deposits without approval of their primary federal regulator. We regularly acquire brokered deposits from three market providers and maintain relationships with other providers to obtain required funds at the lowest possible cost. Ten business days are typically required between the request for brokered funding and settlement. Therefore, brokered deposits are a reliable, but not daily, source of liquidity. Brokered deposits represent our largest source of wholesale funding and we would see significant negative impacts if capital levels or earnings were to decline to levels not considered to be well capitalized. In addition to the requirement to be considered well-capitalized, banks under regulatory consent orders are not permitted to participate in the brokered deposit market without approval of their primary federal regulator even if they maintain a well-capitalized capital classification.

Holding company unsecured line of credit

We maintained a $3,000 line of credit with Bankers’ Bank in Madison, Wisconsin as a contingency liquidity source at June 30, 2012 and December 31, 2011. No amounts were drawn on the line at June 30, 2012 or December 31, 2011. Although our bank subsidiary has in the past provided the holding company’s liquidity needs through semi-annual upstream cash dividend of profits, losses or other negative performance trends could prevent the bank from providing these dividends as cash flow. Because our bank holding company has approximately $892 of financing payments per year as well as approximately $150 of other expenses (before tax benefits), the holding company line of credit is a critical source of potential liquidity.

We were subject to financial covenants associated with the line which require our bank subsidiary to:

• Maintain Tier 1 leverage, Tier 1 risk based capital, and Tier 2 risk based capital ratios above 8%, 10%, and 12%, respectively.

• Maintain nonperforming assets (excluding accruing troubled debt restructured loans) as a percentage of tangible equity plus the allowance for loan losses to less than 20%.

At June 30, 2012 and December 31, 2011, we were not in violation of any of the line of credit covenants. A violation of any covenant could prevent us from utilizing the unused balance of the line of credit. The line of credit expires during December 2012.

If liquidity needs persist after exhausting all available funds from the sources described above, we would consider more drastic methods to raise funds including, but not limited to, sale of investment securities at a loss, cessation of lending to new or existing customers, sale of branch real estate in a sale-leaseback transaction, surrender of bank owned life insurance to obtain the cash surrender value net of taxes due, packaging and sale of residential mortgage loan pools held in our portfolio, sale of foreclosed assets at a loss, and sale of mortgage servicing rights. Such actions could generate undesirable sale losses or income tax impacts.

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While sale of additional common stock or issuance of other types of capital could provide additional liquidity, the ability to find significant buyers of such capital issues during a liquidity crisis would be difficult making such a source of funding unlikely or unreliable if the liquidity crisis was caused by our deteriorating financial condition.

Liquidity Measurements and Contingency Plan

Our liquidity management and contingency plan calls for quarterly measurement of key funding, capital, problem loan, and liquidity contingency ratios at our banking subsidiary level. The measurements are compared to various risk levels that direct management to further responses to declining liquidity measurements as outlined below:

Risk Level 1 is defined as circumstances that create the potential for elevated liquidity risk, thus requiring an assessment of possible funding deficiencies. Normal business operations, plans and strategies are not anticipated to be immediately impacted.

Risk Level 2 is defined as circumstances that point to an increased potential for disruptions in the Bank’s funding plans, needs and/or resources. Assessment of the probability of a liquidity crisis is more urgent, and identification and prioritization of pre-emptive alternatives and actions may be both warranted and time sensitive.

Risk Level 3 is defined as circumstances that create a likely funding problem, or are symptomatic of circumstances that are highly correlated with impending funding problems; and, therefore, are expected to require some level of immediate action depending upon the situation.

These risk parameters and other qualitative and environmental factors are considered to determine whether a “Stress Level” response is required. Identification of a risk trigger does not automatically call for a stress level response. The following summarizes our response plans to various degrees of liquidity stress:

Stress Level A – Management provides a written summary evaluating the warning indicators and why it is deemed unlikely that there will be a resulting liquidity challenge.

Stress Level B – Management provides an assessment of the probability of a liquidity crisis and completes a sources and uses of funds report to estimate the impact on pro forma liquidity. Liquidity stress tests will be reviewed to ensure the scenarios being simulated are sufficiently robust and that there is adequate funding to satisfy potential demands for cash. Various pre-emptive actions will be considered and acted on as needed.

Stress Level C – Management has determined a funding crisis is likely and documents detailed assessments of the current liquidity situation and future liquidity needs. The Board approved action plan is carried out with vigor and may call for one or all of the following steps, among others, to mitigate the liquidity concern: sale of loans, intensify local deposit gathering programs, transferring unencumbered securities and loans to the Federal Reserve for Discount Window borrowings, curtail all lending except for specifically approved loans, reduce or suspend stock dividends, and investigate opportunities to raise new capital.

No Risk Level triggers were exceeded at June 30, 2012 or December 31, 2011 and no liquidity stress levels were considered to exist in either period.

As part of our formal quarterly asset-liability management projections, we also measure basic surplus as the amount of existing net liquid assets (after deducting short-term liabilities and coverage for anticipated deposit funding outflows during the next 30 days) divided by total assets. The basic surplus calculation does not consider unused but available correspondent bank federal funds purchased, as those funds are subject to availability based on the correspondent bank’s own liquidity needs and therefore are not guaranteed contractual funds. However, basic surplus does include unused but available FHLB advances under the open line of credit supported by a blanket lien on mortgage collateral. Basic surplus does not include available brokered certificate of deposit funding as those funds generally may not be obtained within one business day following the request for funding. Our policy is to maintain a basic surplus of at least 5%. Basic surplus was 16.4% and 7.9% at June 30, 2012 and December 31, 2011, respectively. Basic surplus increased significantly at June 30, 2012 due to the acquisition of Marathon and its $34.2 million of U.S. Agency securities (its largest class of assets).

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CAPITAL RESOURCES

During the six months ended June 30, 2012, stockholders’ equity increased $2,270 primarily from $2,483 in retained net income, net of $615 in cash dividends paid. Net book value per share at June 30, 2012 was $31.64 compared to $30.44 at December 31, 2011. The stockholders’ equity ratio declined during 2012 to 7.42% at June 30, 2012 compared to 8.09% at December 31, 2011 due to the purchase of Marathon State Bank without the issuance and new common stock. In addition, our regulatory leverage ratio declined at June 30, 2012, although the ratio is still significantly higher than the regulatory well-capitalized minimum of 5%.

We declared a 5% stock dividend to shareholders on June 19, 2012 to celebrate the 50^th anniversary of our subsidiary Peoples State Bank, which was paid in additional shares of our common stock on July 30, 2012 to shareholders of record on July 16, 2012. All references to per share information in this Quarterly Report on Form 10-Q have been updated to reflect the 5% stock dividend.

For regulatory purposes, the $7 million 8% senior subordinated notes maturing July 2019 and $7.7 million junior subordinated debentures maturing September 2035 reflected as debt on the Consolidated Balance Sheet are reclassified as Tier 2 and Tier 1 regulatory equity capital, respectively. The floating rate payments required by the junior subordinated debentures have been hedged with a fixed rate interest rate swap resulting in a total interest cost of 4.42% through September 2017. PSB was considered “well capitalized” under banking regulations at June 30, 2012. The senior subordinated notes will phase out of qualifying Tier 2 capital beginning July 1, 2014 equal to 20% of the original note principal per year. Beginning July 1, 2012, we have the right to prepay all or a portion of the 8% senior subordinated notes on a monthly basis. To the extent Tier 2 capital is not required for asset growth, changing regulatory requirements, or merger and acquisition activities in the near term, we may consider prepayment of the debt to reduce our level of interest expense, subject to regulatory approval. In addition, proposed new regulatory rules would phase the $7.7 million junior subordinated debentures out of Tier 1 capital and into Tier 2 capital over a 10 year period beginning in 2013.

Unrealized gains on securities available for sale, net of tax, reflected as accumulated other comprehensive income represented approximately $1.24, or 3.9% of total net book value per share at June 30, 2012 compared to $.70, or 2.3% of total net book value per share at December 31, 2011. The decline in market interest rates since September 30, 2008 has increased the fair value of the fixed rate debt securities held in our investment portfolio and classified as available for sale, which is recorded as an increase to equity. If market rates were to increase in the future, existing unrealized gains on our fixed rate investment portfolio would decline, negatively influencing net book value per share.

During the March 2012 quarter, we issued 8,897 shares of restricted stock having a grant date value of $200 to certain key employees as a retention tool and to align employee performance with shareholder interests. The shares vest over the service period using a straight-line method and unvested shares are forfeited if, prior to vesting, the employee is no longer employed with the Bank. Refer to Footnote 10 of the Notes to Consolidated Financial Statements for more information on the restricted shares.

We purchased 200 shares of our common stock on the open market at a price of $23.25 per share during the quarter ended March 31, 2012. No shares were repurchased during 2011 as we sought to conserve capital for growth, merger and acquisition activity, repayment of our 8% senior subordinated notes, and increased regulatory capital ratios. Industry wide, the cost of capital has increased significantly compared to prior years and many sources of previously low cost capital such as pooled trust preferred offerings have been closed. The banking industry continues to place a premium on capital and we expect to refrain from significant treasury stock repurchases during the remainder of 2012.

The adequacy of our capital is regularly reviewed to ensure sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. As of June 30, 2012 and December 31, 2011, the Bank’s Tier 1 risk-weighted capital ratio, total risk-weighted capital, and Tier 1 leverage ratio were in excess of regulatory minimums and were classified as “well-capitalized.” Failure to remain well-capitalized could prevent us from obtaining future whole sale brokered time deposits which are an important source of funding.

As discussed earlier in the Executive Summary section of this Quarterly Report on Form 10-Q, banking regulators recently issued two proposals that would substantially change how regulatory capital is calculated and the minimum capital to be retained. While we do not expect to be required to raise common stock capital solely to meet these new requirements, the new rules would increase the likelihood we would need capital through the issuance of new common stock if we continued merger and acquisition activity for growth, similar to our recent purchase of Marathon State Bank. Because the market price of our stock currently trades at less than our book value, issuance of new common stock shares, such as for an acquisition, would dilute the book value of existing shareholders.

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Table 21: Capital Ratios – PSB Holdings, Inc. – Consolidated

	June 30,						December 31,
(dollars in thousands)	2012			2011			2011
Stockholders’ equity	$	52,632		$	48,731		$	50,362
Junior subordinated debentures, net		7,500			7,500			7,500
Disallowed mortgage servicing right assets		(111	)		(123	)		(121	)
Accumulated other comprehensive income		(1,654	)		(2,575	)		(1,934	)
Tier 1 regulatory capital		58,367			53,533			55,807
Senior subordinated notes		7,000			7,000			7,000
Allowance for loan losses		6,173			5,697			5,745
Total regulatory capital	$	71,540		$	66,230		$	68,552
Total quarterly average assets (as defined by current regulations)	$	637,608		$	602,181		$	604,252
Disallowed mortgage servicing right assets		(111	)		(125	)		(121	)
Accumulated other comprehensive (income) loss		(1,654	)		(2,509	)		(2,060	)
Quarterly average tangible assets (as defined by current regulations)	$	635,843		$	599,547		$	602,071
Risk-weighted assets (as defined by current regulations)	$	492,380		$	453,619		$	457,443
Tier 1 capital to average tangible assets (leverage ratio)		9.18	%		8.93	%		9.27	%
Tier 1 capital to risk-weighted assets		11.85	%		11.80	%		12.20	%
Total capital to risk-weighted assets		14.53	%		14.60	%		14.99	%

Table 22: Capital Ratios – Peoples State Bank – Subsidiary

Tier 1 capital to average tangible assets (leverage ratio)	9.45	%	9.74	%	9.99	%
Tier 1 capital to risk-weighted assets	12.57	%	12.88	%	13.13	%
Total capital to risk-weighted assets	13.82	%	14.14	%	14.39	%

Table 23: Capital Ratios – Marathon State Bank – Subsidiary

Tier 1 capital to average tangible assets (leverage ratio)	5.71	%
Tier 1 capital to risk-weighted assets	15.12	%
Total capital to risk-weighted assets	15.14	%

As a measurement of the adequacy of a bank’s capital base related to its level of nonperforming assets, many investors use a “non-GAAP” measure commonly referred to as the “Texas Ratio.” We also track changes in our Texas Ratio against our internal capital and liquidity risk parameters to highlight negative capital trends that could impact our ability for future growth, payment of dividends to shareholders, or other factors. As noted previously, correspondent bank providers of our daily federal funds purchased line of credit and the holding company operating line of credit use similar measures that impact our ability to continued use of those lines of credit if our level of nonperforming assets to capital were to rise above prescribed levels. The following table presents the calculation of our Texas Ratio.

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Table: 24: Calculation of “Texas Ratio” (a non-GAAP measure)

	As of Quarter End
	June 30,			March 31,			December 31,			September 30,			June 30,
(dollars in thousands)	2012			2012			2011			2011			2011
Total nonperforming assets	$	17,360		$	18,850		$	17,883		$	18,583		$	19,378
Total stockholders’ equity	$	52,632		$	51,502		$	50,362		$	49,756		$	48,731
Less: Mortgage servicing rights, net (intangible assets)		(1,110	)		(1,151	)		(1,205	)		(1,154	)		(1,230	)
Less:  Preferred stock capital elements		—			—			—			—			—
Add: Allowance for loan losses		7,648			7,755			7,941			8,019			7,817
Total tangible common stockholders’ equity and reserves	$	59,170		$	58,106		$	57,098		$	56,621		$	55,318
Total nonperforming assets as a percentage of total tangible common stockholders’ equity and reserves		29.34	%		32.44	%		31.32	%		32.82	%		35.03	%

OFF BALANCE-SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS

Off Balance Sheet Arrangements

We service residential mortgage loans originated by our lenders and sold to the FHLB and FNMA. As a FHLB Mortgage Partnership Finance (“MPF”) loan servicer, we provide a credit enhancement guarantee to reimburse the FHLB for foreclosure losses in excess of 1% of the original loan principal sold to the FHLB prior to November 2008. These first mortgage loans are underwritten using standardized criteria we consider to be conservative on residential properties in our local communities. We believe loans serviced for the FHLB will realize minimal foreclosure losses in the future and that we will experience no loan losses related to charge-offs in excess of the FHLB 1% First Loss Account. The north central Wisconsin residential real estate market is experiencing similar home value declines as the state of Wisconsin as a whole, which are moderate when compared to other states in the country. The average residential first mortgage originated by us under the FHLB program which required a credit enhancement was approximately $154 in 2008 and $140 during 2007, the last two years of the program.

Under bank regulatory capital rules, this FHLB recourse obligation to the FHLB is risk-weighted for the purposes of the total capital to risk-weighted assets capital calculation. Total risk-based capital required to be held for the recourse obligations under the FHLB MPF programs for capital adequacy purposes was $1,859 at June 30, 2012 and December 31, 2011. During October 2008, we ceased origination and sale of loans to the FHLB that required a credit enhancement and no additional risk-based capital will be required to support such loans. More information on all loans serviced for other investors, including FHLB and FNMA, is outlined in Table 24.

During 2011, we began sale of a new product that allowed certain adjustable rate commercial loan customers to fix their interest rate with an interest rate swap. Refer to Note 8 of the Notes to Consolidated Financial Statements for details on the program. There were $15,298 and $14,324 in interest rate swaps outstanding under the program at June 30, 2012 and December 31, 2011, respectively.

Residential Mortgage Loan Servicing

We service $258,072 and $261,811 of residential real estate loans which have been sold to the FHLB and FNMA at June 30, 2012 and December 31, 2011, respectively. Loans sold to FHLB and FNMA are not reflected on our Consolidated Balance Sheets. An annualized servicing fee equal to .25% of outstanding principal is retained from payments collected from the customer as compensation for servicing the loan for the FHLB and FNMA. We recognize a mortgage servicing right asset due to the substantial volume of loans serviced for the FHLB and FNMA. Despite ongoing heightened customer mortgage refinance activity since December 31, 2011, total serviced loans have declined due to keeping approximately $10.1 million of 15 year fixed rate mortgage originations during 2012 in our on-balance sheet loan portfolio rather than selling those loans and retaining servicing.

For loans originated and sold to the FHLB prior to November 2008, we are also paid an annualized “credit enhancement” fee of .07% to .10% of outstanding serviced principal in addition to the .25% collected for servicing the loan for the FHLB impacting $41,952, or 16%, of serviced loans at June 30, 2012 compared to $51,518, or 20%, at December 31, 2011. Mortgage loan servicing and credit enhancement fees have been an important source of mortgage banking income. Because no further loans are sold to the FHLB with our credit enhancement and because foreclosure principal losses on these loans are credited against any available credit enhancement fees, we expect credit enhancement fees to be negligible during the year ended December 31, 2012.

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Losses incurred by the FHLB on loans in the MPF 100 program and the MPF 125 program are absorbed by the FHLB in their First Loss Account. If cumulative losses were to exceed the First Loss Account, we would reimburse the FHLB for any excess losses up to the extent of our Credit Enhancement Guarantee. Ten years after the original pool master commitment date, the First Loss Account and the Credit Enhancement Guarantee are reset to current levels based on loans remaining in the pool. These factors are further reset every subsequent five years until the pool is repaid. During 2010, the MPF 100 program reached its ten year anniversary and the First Loss Account and Credit Enhancement Guarantee associated with that program were reset to the new level shown in Table 21. The next First Loss Account reset date for any individual master commitment containing our Credit Enhancement Guarantee is scheduled for August 18, 2013.

Due to historical strength of mortgage borrowers in our markets and relative stability of collateral home values, and the original 1% of principal First Loss Account provided by the FHLB, we believe the possibility of losses under guarantees to the FHLB to be remote. Since inception of our pools containing guarantees to the FHLB in 2000, only $0.3 million of $425 million of loans originated with guarantees have incurred a principal loss, all of which has been borne by the FHLB within their First Loss Account. Accordingly, no provision for a recourse liability has been made for this recourse obligation on loans currently serviced by us. Loans originated and sold to the FHLB under their XTRA program do not require credit enhancement and PSB has no risk of principal loss on such loans properly underwritten and sold. Under the MPF 100 and MPF 125 credit enhancement programs, the FHLB is reimbursed for any incurred principal losses in its First Loss Account by withholding the monthly credit enhancement fee normally paid to us until their principal loss is recovered. We recognize credit enhancement income on a cash basis when received monthly from the FHLB.

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. During 2011, we were required to repurchase a foreclosed loan and incur a $37 loss related to underwriting violations related to private mortgage guarantee insurance. During the March 2012 quarter, we reviewed our existing portfolio and believe we do not have continued risk for significant loss on other loans that could have this underwriting issue. Other than this loan, we have originated loans to these secondary market providers since 2000 and have never been required to repurchase a loan for underwriting or servicing violations and do not expect to be required to repurchase loans in the near term.

The following tables summarize loan principal serviced for the FHLB under various MPF programs and for FNMA as of June 30, 2012 and December 31, 2011.

Table 25: Residential Mortgage Loans Serviced for Others as of June 30, 2012 ($000s)

	Principal		Loan		Weighted Average Coupon			Average Monthly Payment		PSB Credit Enhancement		Agency Funded First Loss		Mortgage Servicing Right, net
Agency Program	Serviced		Count		Rate			Seasoning		Guarantee		Account		$		%
FHLB MPF 100	$	14,784		283		5.38	%		110	$	94	$	353	$	28		0.19	%
FHLB MPF 125		27,168		303		5.75	%		70		1,851		1,585		79		0.29	%
FHLB XTRA		190,165		1,472		4.25	%		20		n/a		n/a		869		0.46	%
FNMA		25,955		197		3.88	%		15		n/a		n/a		134		0.52	%
Totals	$	258,072		2,255		4.44	%		30	$	1,945	$	1,938	$	1,110		0.43	%

Table 26: Residential Mortgage Loans Serviced for Others as of December 31, 2011 ($000s)

					Weighted			Average Monthly		PSB Credit		Agency Funded First		Mortgage Servicing Right, net
Agency Program	Principal Serviced		Loan Count		Average Coupon Rate			Payment Seasoning		Enhancement Guarantee		Loss Account		$		%
FHLB MPF 100	$	18,132		329		5.38	%		104	$	94	$	353	$	46		0.25	%
FHLB MPF 125		33,386		350		5.75	%		66		1,851		1,587		131		0.39	%
FHLB XTRA		191,421		1,451		4.50	%		18		n/a		n/a		931		0.49	%
FNMA		18,872		146		4.00	%		13		n/a		n/a		97		0.51	%
Totals	$	261,811		2,276		4.68	%		30	$	1,945	$	1,940	$	1,205		0.46	%

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

There has been no material change in the information provided in response to Item 7A of our Form 10-K for the year ended December 31, 2011.

Item 4. Controls and Procedures

As of the end of the period covered by this report, management, under the supervision, and with the participation, of our President and Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) pursuant to Exchange Act Rule 13a 15. Based upon, and as of the date of such evaluation, the President and Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective.

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PART II – OTHER INFORMATION

Item 1A. Risk Factors

In addition to the other information set forth in this report, this report should be considered in light of the risk factors referenced in Part I of PSB’s Annual Report on Form 10-K for the year ended December 31, 2011, under the caption “Forward-Looking Statements.” These and other risk factors could materially affect PSB’s business, financial condition, or future results of operations. The risks referenced in PSB’s Annual Report on Form 10-K are not the only risks facing PSB. Additional risks and uncertainties not currently known to PSB or that it currently deems to be immaterial also may materially adversely affect PSB’s business, financial condition, and/or operating results.

Item 6. Exhibits

Exhibits required by Item 601 of Regulation S-K.

Exhibit
Number	Description
31.1	Certification of CEO under Section 302 of Sarbanes-Oxley Act of 2002
31.2	Certification of CFO under Section 302 of Sarbanes-Oxley Act of 2002
32.1	Certifications under Section 906 of Sarbanes-Oxley Act of 2002
101.INS*	XBRL Instance Document
101.SCH*	XBRL Taxonomy Extension Schema Document
101.CAL*	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF*	XBRL Taxonomy Definition Linkbase Document
101.LAB*	XBRL Taxonomy Extension Label Linkbase Document
101.PRE*	XBRL Taxonomy Extension Presentation Linkbase Document
* XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	PSB HOLDINGS, INC.
August 14, 2012	SCOTT M. CATTANACH
	Scott M. Cattanach
	Treasurer
	(On behalf of the Registrant and as Principal Financial Officer)

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EXHIBIT INDEX

to

FORM 10-Q

of

PSB HOLDINGS, INC.

for the quarterly period ended June 30, 2012

Pursuant to Section 102(d) of Regulation S-T

(17 C.F.R. §232.102(d))

The following exhibits are filed as part this report:

31.1	Certification of CEO under Section 302 of Sarbanes-Oxley Act of 2002
31.2	Certification of CFO under Section 302 of Sarbanes-Oxley Act of 2002
32.1	Certifications under Section 906 of Sarbanes-Oxley Act of 2002
101.INS*	XBRL Instance Document
101.SCH*	XBRL Taxonomy Extension Schema Document
101.CAL*	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF*	XBRL Taxonomy Definition Linkbase Document
101.LAB*	XBRL Taxonomy Extension Label Linkbase Document
101.PRE*	XBRL Taxonomy Extension Presentation Linkbase Document
* XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.

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