FAIR VALUE MEASUREMENTS

6 Months Ended

Jun. 30, 2013

Fair Value Measurements

FAIR VALUE MEASUREMENTS

NOTE 15 – 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, 2013 and December 31, 2012, Level 3 securities include a common stock investment in Bankers’ Bank, Madison, Wisconsin that is not traded on an active market. Historical cost of the common stock is assumed to approximate fair value of this investment.

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

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

In the absence of a recent independent appraisal, collateral dependent impaired loans are valued based on a recent broker price opinion generally discounted by 10% plus estimated selling costs. In the absence of a broker price opinion, collateral dependent impaired loans are valued at the lower of last appraisal value or the current real estate tax value discounted by 30% 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. Estimated selling costs typically range from 5% to 15% of the property value. 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 less than two years old 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, 2013 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		46.02%
Weighted average prepayment speed: PSA		734.57%
Weighted average discount rate		8.03%
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.

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, 2013:
Securities available for sale:
U.S. Treasury and agency debentures	$	997	$	—	$	997	$	—
U.S. agency issued residential MBS and CMO		58,712		—		58,712		—
Privately issued residential MBS and CMO		127		—		127		—
Solomon Hess SBA loan fund (CDFI Fund)		950		—		950		—
Other equity securities		47		—		—		47
Total securities available for sale		60,833		—		60,786		47
Loans held for sale		132		—		132		—
Mortgage rate lock commitments		56		—		56		—
Interest rate swap agreements		378		—		378		—
Total assets	$	61,399	$	—	$	61,352	$	47
Liabilities – Interest rate swap agreements	$	847	$	—	$	847	$	—
Assets measured at fair value on a recurring basis at December 31, 2012:
Securities available for sale:
U.S. Treasury and agency debentures	$	10,027	$	—	$	10,027	$	—
U.S. agency issued residential MBS and CMO		59,640		—		59,640		—
Privately issued residential MBS and CMO		173		—		173		—
Nonrated commercial paper		5,500		—		5,500		—
Other equity securities		47		—		—		47
Total securities available for sale		75,387		—		75,340		47
Loans held for sale		884		—		884		—
Mortgage rate lock commitments		91		—		91		—
Interest rate swap agreements		673		—		673		—
Total assets	$	77,035	$	—	$	76,988	$	47
Liabilities – Interest rate swap agreements	$	1,372	$	—	$	1,372	$	—

Reconciliation of fair value measurements using significant unobservable inputs:

	Securities
	Available
(dollars in thousands)	For Sale
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 June 30, 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	$	—
Balance at January 1, 2013	$	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 June 30, 2013	$	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, 2013	$	—

			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, 2013:
Impaired loans	$	2,958	$	—	$	916	$	2,042
Foreclosed assets		1,336		—		628		708
Mortgage servicing rights		1,604		—		—		1,604
Total assets	$	5,898	$	—	$	1,544	$	4,354
Assets measured at fair value on a nonrecurring basis at December 31, 2012:
Impaired loans	$	2,973	$	—	$	328	$	2,645
Foreclosed assets		1,774		—		752		1,022
Mortgage servicing rights		1,233		—		—		1,233
Total assets	$	5,980	$	—	$	1,080	$	4,900

At June 30, 2013, loans with a carrying amount of $3,977 were considered impaired and were written down to their estimated fair value of $2,958 net of a valuation allowance of $1,019. At December 31, 2012, loans with a carrying amount of $3,955 were considered impaired and were written down to their estimated fair value of $2,973, net of a valuation allowance of $982. 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, 2013, foreclosed assets with a carrying amount of $2,063 had been written down to a fair value of $1,336, less costs to sell. During the six months ended June 30, 2013, foreclosed assets with a fair value of $409 were acquired through or in lieu of foreclosure, which is the fair value net of estimated costs to sell. An impairment charge of $149 was recorded as a reduction to earnings during the six months ended June 30, 2013.

At December 31, 2012, foreclosed assets with a carrying amount of $2,352 had been written down to a fair value of $1,774, less costs to sell. During the six months ended June 30, 2012, foreclosed assets with a fair value of $408 were acquired through or in lieu of foreclosure, which is the fair value net of estimated costs to sell. An impairment charge of $205 was recorded as a reduction to earnings during the six months ended June 30, 2012.

At June 30, 2013, mortgage servicing rights with a carrying amount of $1,640 were considered impaired and were written down to their estimated fair value of $1,604, resulting in an impairment allowance of $36. At December 31, 2012, mortgage servicing rights with a carrying amount of $1,513 were considered impaired and were written down to their estimated fair value of $1,233, resulting in an impairment allowance of $280. Changes in the impairment allowances are reflected through earnings as a component of mortgage banking income.

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

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

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

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

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

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

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

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

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

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

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

The carrying amounts and fair values of PSB’s financial instruments consisted of the following at June 30, 2013:

	June 30, 2013
	Carrying		Estimated		Fair Value Hierarchy Level
	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets ($000s):
Cash and cash equivalents	$	17,639	$	17,639	$	17,639	$	—	$	—
Securities		132,916		134,129		—		132,302		1,827
Other investments		2,729		2,785		—		—		2,785
Net loans receivable and loans held for sale		505,975		507,181		—		1,048		506,133
Accrued interest receivable		2,117		2,117		—		—		2,117
Mortgage servicing rights		1,604		1,604		—		—		1,604
Mortgage rate lock commitments		56		56		—		56		—
FHLB stock		3,594		3,594		—		—		3,594
Cash surrender value of life insurance		12,521		12,521		12,521		—		—
Interest rate swap agreements		378		378		—		378		—
Financial liabilities ($000s):
Deposits	$	531,732	$	533,077	$	—	$	—	$	533,077
FHLB advances		66,124		67,073		—		67,073		—
Other borrowings		21,584		22,553		—		14,570		7,983
Senior subordinated notes		4,000		3,429		—		—		3,429
Junior subordinated debentures		7,732		4,512		—		—		4,512
Interest rate swap agreements		847		847		—		847		—
Accrued interest payable		470		470		—		—		470

The carrying amounts and fair values of PSB’s financial instruments consisted of the following at December 31, 2012:

	December 31, 2012
	Carrying		Estimated		Fair Value Hierarchy Level
	Amount		Fair Value		Level 1		Level 2		Level 3
Financial assets ($000s):
Cash and cash equivalents	$	48,847	$	48,847	$	48,847	$	—	$	—
Securities		145,209		147,751		—		145,795		1,956
Other investments		4,465		4,538		—		—		4,538
Net loans receivable and loans held for sale		478,875		484,925		—		1,212		483,713
Accrued interest receivable		2,157		2,157		—		—		2,157
Mortgage servicing rights		1,233		1,233		—		—		1,233
Mortgage rate lock commitments		91		91		—		91		—
FHLB stock		2,506		2,506		—		—		2,506
Cash surrender value of life insurance		11,813		11,813		11,813		—		—
Interest rate swap agreements		673		673		—		673		—
Financial liabilities ($000s):
Deposits	$	565,442	$	568,014	$	—	$	—	$	568,014
FHLB advances		50,124		51,590		—		51,590		—
Other borrowings		20,728		22,118		—		14,890		7,228
Senior subordinated notes		7,000		7,000		—		—		7,000
Junior subordinated debentures		7,732		4,911		—		—		4,911
Interest rate swap agreements		1,372		1,372		—		1,372		—
Accrued interest payable		697		697		—		—		697