DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

3 Months Ended

Mar. 31, 2013

Derivative Instruments And Hedging Activities

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

NOTE 9 – DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

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

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

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

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

	March 31, 2013	December 31, 2012
Notional amount	$7,500	$7,500
Pay fixed rate	2.72%	2.72%
Receive variable rate	0.28%	0.31%
Maturity	September 2017	September 2017
Unrealized gain (loss) fair value	$ (645)	$ (699)

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 quarter ended March 31, 2013 or 2012. Risk management results for the quarter ended March 31, 2013 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 March 31, 2013, approximately $183 of losses ($111 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 March 31, 2014. The interest rate swap agreement was secured by cash and cash equivalents of $850 at March 31, 2013, and December 31, 2012.

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:

	March 31, 2013	December 31, 2012
Notional amount	$14,816	$14,979
Receive fixed rate (average)	1.99%	1.99%
Pay variable rate (average)	0.20%	0.21%
Maturity	March 2015 – Oct. 2021	March 2015 – Oct. 2021
Weighted average remaining term	3.7 years	3.9 years
Unrealized gain (loss) fair value	$  589	$   673

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

	March 31, 2013	December 31, 2012
Notional amount	$14,816	$14,979
Pay fixed rate (average)	1.99%	1.99%
Receive variable rate (average)	0.20%	0.21%
Maturity	March 2015 – Oct. 2021	March 2015 – Oct. 2021
Weighted average remaining term	3.7 years	3.9 years
Unrealized gain (loss) fair value	$  (589)	$  (673)