UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

For Annual and Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
x     Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2003.
or
o     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 0-49731

SEVERN BANCORP, INC.
(Exact name of registrant as specified in its charter)

MARYLAND
52-1726127
(State or other jurisdiction
(I.R.S. Employer Identification Number)
of incorporation or organization)
 
 
 
1919 A West Street, Annapolis, Maryland
21401
(Address of principal executive offices)
(Zip Code)

Registrant's telephone number, including area code: (410) 268-4554
Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act
 
Common Stock, par value $.01 per share
(Title of Class)

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 reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x   No o .

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K. x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Yes o No x

  The aggregate market value of the voting stock held by non-affiliates of the registrant, based on the closing sale price of the registrant’s common stock on June 30, 2003 was $44,732,373 ($22.95 per share based on shares of common stock outstanding).
 
As of March 2, 2004, there were issued and outstanding 4,159,092 shares of the registrant’s common stock.

Documents Incorporated by Reference:
          Portions of the definitive Proxy Statement (Part III).



     

Table of Contents

Section
 
Page No.
PART I
 
1
 
 
 
Item 1.
Business
1
Item 2.
Properties
30
Item 3.
Legal Proceedings
30
Item 4.
Submission of Matters to a Vote of Security Holders
30
 
 
 
PART II
 
30
 
 
 
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters
30
Item 6.
Selected Financial Data
31
Item 7.
Management’s Discussion and Analysis of Financial Condition
 
 
and Results of Operations
35
Item 7.A.
Quantitative and Qualitative Disclosures About Market Risk
42
Item 8.
Financial Statements and Supplementary Data
43
Item 9.
Changes in and Disagreements with Accountants on
 
 
Accounting and Financial Disclosures
43
Item 9A.
Controls and Procedures
44
 
 
 
PART III
 
44
 
 
 
Item 10.
Directors and Executive Officers of the Registrant
44
Item 11.
Executive Compensation
45
Item 12.
Security Ownership of Certain Beneficial Owners and Management
45
Item 13.
Certain Relationships and Related Transactions
45
 
 
45
Item 14.
Principal Accountant Fees and Services
45
 
 
 
PART IV
 
45
 
 
 
Item 15.
Exhibits, Financial Statements, Schedules and Reports on Form 8-K
46
 
Signatures
46
 
 
 
 
i

 
 
     
 
 
Severn Bancorp
Financial Highlights
 
  At the period ended:  
December 31,
 
     
2003  
   
2002  
   
2001  
   
2000  
   
1999  
 
   

  (dollars in thousands, except per share information)

 
Balance Sheet Data:
   
 
   
 
   
 
   
 
   
 
 
Total assets
 
$
540,471
 
$
458,415
 
$
366,890
 
$
293,230
 
$
233,724
 
Total loans, net
   
506,026
   
418,825
   
342,641
   
274,652
   
214,066
 
Total nonperforming assets
   
469
   
1,982
   
2,413
   
1,490
   
1,597
 
Deposits
   
419,726
   
377,925
   
286,918
   
229,312
   
186,204
 
Short-term borrowings
   
6,000
   
-
   
17,000
   
18,000
   
2,000
 
Notes payable
   
59,000
   
34,000
   
25,000
   
16,000
   
22,000
 
Total liabilities
   
487,501
   
415,233
   
332,059
   
268,009
   
211,743
 
Minority Interest – Preferred Securities of Subsidiary
   
4,000
   
4,000
   
4,000
   
3,892
   
3,892
 
Stockholders' equity
   
48,970
   
39,181
   
30,831
   
21,329
   
18,089
 
Book value per share
   
11.77
   
9.46
   
7.60
   
6.58
   
5.59
 
 
 
For the period ended:
 

  December 31,

 
     
2003  
   
2002  
   
2001  
   
2000  
   
1999   
 
Operations Data:
   
 
   
 
   
 
   
 
   
 
 
Net interest income
 
$
24,746
 
$
19,603
 
$
13,395
 
$
10,884
 
$
9,524
 
Net interest income after provision for loan losses
   
23,846
   
18,933
   
12,687
   
10,293
   
9,020
 
Noninterest income
   
4,674
   
4,133
   
2,570
   
1,439
   
1,586
 
Noninterest expense
   
9,616
   
8,447
   
6,588
   
5,348
   
5,477
 
Net income
   
11,329
   
8,948
   
5,256
   
3,945
   
3,127
 
Basic earnings per share *
   
2.68
   
2.13
   
1.38
   
1.15
   
0.90
 
Diluted earnings per share *
   
2.67
   
2.13
   
1.37
   
1.12
   
0.84
 
Common Stock Cash dividends declared per share*
   
0.34
   
0.24
   
0.19
   
0.17
   
0.15
 
Common Stock dividends declared per share to
   
 
   
 
   
 
   
 
   
 
 
diluted earnings per share *
   
12.73
%
 
11.27
%
 
13.87
%
 
15.18
%
 
17.86
%
Weighted number of shares outstanding basic *
   
4,146,566
   
4,092,188
   
3,647,451
   
3,237,888
   
3,230,940
 
Weighted number of shares outstanding diluted *
   
4,157,302
   
4,103,223
   
3,683,346
   
3,330,915
   
3,450,831
 
 
   
 
   
 
   
 
   
 
   
 
 
 
   
 
   
 
   
 
   
 
   
 
 
Performance Ratios:
   
 
   
 
   
 
   
 
   
 
 
Return on average assets
   
2.23
%
 
2.14
%
 
1.55
%
 
1.47
%
 
1.38
%
Return on average equity
   
25.22
%
 
25.58
%
 
20.22
%
 
20.04
%
 
18.31
%
Interest rate spread
   
4.77
%
 
4.59
%
 
3.65
%
 
3.75
%
 
3.94
%
Net interest margin
   
4.99
%
 
4.86
%
 
4.05
%
 
4.17
%
 
4.34
%
Noninterest expense to average assets
   
1.76
%
 
2.02
%
 
1.95
%
 
2.00
%
 
2.43
%
Efficiency ratio
   
30.33
%
 
35.59
%
 
41.27
%
 
43.40
%
 
49.30
%
 
   
 
   
 
   
 
   
 
   
 
 
* Retroactively adjusted to reflect three-for-one stock split declared February 19, 2002 and effective for shares outstanding
as of March 1, 2002.
   
 
   
 
   
 
   
 
   
 
 
 
ii

 
 
     
 
 


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Severn Bancorp, Inc. ( “Bancorp”) may from time to time make written or oral “forward-looking statements”, including statements contained in Bancorp’s filings with the Securities and Exchange Commission (including this annual report on Form 10-K and the exhibits thereto), in its reports to stockholders and in other communications by Bancorp, which are made in good faith by Bancorp pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

In addition to the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. Bancorp operations and actual results could differ significantly from those discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences include, but are not limited to, changes in the economy and interest rates in the nation and Bancorp’s general market area. The forward-looking statements contained herein include, but are not limited to, those with respect to management’s determination of the amount of loan loss allowance; the effect of changes in interest rates; and changes in deposit insurance premiums.
 
 
 
 
 
 
 
 
 
 

 
 
 
 
 
iii

 

     
 
PART I

Item 1. Business
General

Severn Bancorp, Inc. is a savings and loan holding company that was incorporated in Maryland in August 1990. It conducts business through three subsidiaries: Severn Savings Bank, FSB (the “Bank”), its principal subsidiary; Louis Hyatt, Inc., (“Hyatt Real Estate”), a real estate brokerage and property management company, which it acquired in June 2001; and SBI Mortgage Company (“SBI”), which engages in the origination of mortgages not suitable to the Bank, such as mortgages to borrowers with credit backgrounds that the Bank does not find suitable, and continues to hold some of those mortgages. SBI owns investment real estate through subsidiary limited liability companies, and plans to continue the acquisition and holding of investment real estate.

The Bank’s primary lending market is Anne Arundel County, Maryland, where it also offers savings products through its two branches. To a lesser extent, it also lends to borrowers located in other parts of Maryland and in Delaware and Northern Virginia.

As of December 31, 2003, Bancorp had total assets of $540,471,233 total deposits of $419,726,185, and stockholders’ equity of $48,970,153, for the year ended December 31, 2003 net income was $11,329,138, of which $11,306,608 was net income of the Bank.

Bancorp’s internet address is www.severnbank.com. We make available free of charge on www.severnbank.com our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

In addition, we will provide, at no cost, paper or electronic copies of our reports and other filings made with the SEC. Requests should be directed to:

S. Scott Kirkley
Senior Vice President
Severn Bancorp, Inc.
1919A West Street
Annapolis, Maryland 21401

The information on the website listed above, is not and should not be considered part of this annual report on Form 10-K and is not incorporated by reference in this document. This website is and is only intended to be an inactive textual reference.

Business of the Bank

Severn Savings Bank, FSB (the “Bank”) was organized in 1946 in Baltimore, Maryland as Pompei Permanent Building and Loan Association. It relocated to Annapolis, Maryland in 1980 and its name was changed to Severn Savings Association. Subsequently, the Bank obtained a federal charter and changed its name to Severn Savings Bank, FSB. The Bank operates two full-service branch offices, one administrative office and one accounting and servicing office. The Bank operates as a federally charted savings bank whose principal business is attracting deposits from the general public and investing those funds in mortgage loans. The Bank also uses advances, or loans from the Federal Home Loan Bank of Atlanta, to fund its mortgage activities. The Bank’s revenues are derived principally from interest earned on mortgage loans, fees charged in connection with the loans and banking services, and gains realized from the sale of mortgage loans. The Bank’s primary sources of funds are deposits, advances from the Federal Home Loan Bank of Atlanta, principal amortization and prepayment of its loans. The principal executive offices of the Bank are maintained at 1919 A West Street, Annapolis Maryland, 21401. Its telephone number is 410-268-4554 and its e-mail address is mailman@severnbank.com.
 
 
 
  1  
 
 
In addition to its deposit and lending activities, the Bank offers title insurance and real estate settlement services through its wholly owned subsidiary, Homeowner’s Title and Escrow Corporation (“Homeowner’s”).

The Bank also owns all of the common stock of Severn Preferred Capital Corporation (“Severn Capital”), which was formed in 1997. Severn Capital is a real estate investment trust that issued and has outstanding 200,002 shares of Series A Preferred Stock. This preferred stock has an aggregate outstanding balance of $4,000,040, which qualifies as regulatory capital of the Bank. The Series A Preferred Stock pays a 9% annual non-cumulative dividend and is callable at par, by the Bank, at any time.

The Thrift Industry

Thrift institutions are financial intermediaries which historically have accepted savings deposits from the general public and, to a lesser extent, borrowed funds from outside sources and invested those deposits and funds primarily in loans secured by first mortgage liens on residential and other types of real estate. Such institutions may also invest their funds in various types of short- and long-term securities. The deposits of thrift institutions are insured by the SAIF as administered by the FDIC, and these institutions are subject to extensive regulations. These regula­tions govern, among other things, the lending and other investment powers of thrift institutions, including the terms of mortgage instruments these institutions are permitted to utilize, the types of deposits they are permitted to accept, and reserve require­ments.

The operations of thrift institutions, including those of the Bank, are significantly affected by general economic conditions and by related monetary and fiscal policies of the federal government and regulations and policies of financial institution regulatory authorities, including the Board of Governors of the Federal Reserve System and the OTS. Lending activities are influenced by a number of factors including the demand for housing, conditions in the construction industry, and availability of funds. Sources of funds for lending activities include savings deposits, loan principal payments, proceeds from sales of loans, and borrowings from the Federal Home Loan Bank and other sources. Savings flows at thrift institutions such as the Bank are influenced by a number of factors including interest rates on competing investments and levels of personal income.

Earnings

The Bank’s earnings depend primarily on the difference between income from interest-earning assets such as loans and investments, and interest paid on interest-bearing liabilities such as deposits and borrowings. The Bank typically engages in long-term mortgage lending at fixed rates of interest, generally for periods of up to 30 years, while accepting deposits for consider­ably shorter periods. However, many of the Bank’s long term fixed rate loans are sold in the secondary market, resulting in gains on the sale of such loans by the Bank.

Generally, rapidly rising interest rates cause the cost of interest-bearing liabilities to increase more rapidly than yields on interest-earning assets, thereby adversely affecting the earnings of many thrift institutions. While the industry has received expanded lending and borrowing powers in recent years permitting different types of investments and mortgage loans, including those with floating or adjustable rates and those with shorter terms, earnings and operations are still highly influenced by levels of interest rates and financial market conditions and by substantial investments in long-term mortgage loans.

Competition

The Annapolis area has a high density of financial institutions, many of which are significantly larger and have greater financial resources than the Bank, and all of which are competitors of the Bank to varying degrees. The Bank’s competition for loans comes primarily from savings and loan associations, savings banks, mortgage banking companies, insurance companies, and commercial banks. Its most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks, and credit unions. The Bank faces additional competition for deposits from short-term money market funds and other corporate and government securities funds. The Bank also faces increased competition from other financial institutions such as brokerage firms and insurance companies for deposits. The Bank is a community-oriented financial institution serving its market area with a wide selection of mortgage loans. Management considers the Bank’s reputation for financial strength and customer service as its major competitive advantage in attracting and retaining customers in its market area. The Bank also believes it benefits from its community orientation.

 
  2  
 
 
Net Interest Income

Net interest income increases during periods when the spread is widened between the Bank’s weighted average rate at which new loans are originated and the weighted average cost of interest-bearing liabilities. The Bank’s ability to originate loans is affected by market factors such as interest rates, competition, consumer preferences, the supply of and demand for housing, and the availability of funds.

The Bank has supplemented its interest income through purchases of investments when appropriate. This activity generates positive interest rate spreads on large principal balances with minimal administrative expense.

Interest Rate and Volume of Interest-Related Assets and Liabilities

Both changes in rate and changes in the composition of the Bank’s interest-earning assets and interest-bearing liabilities can have a significant effect on net interest income.

For information regarding the total dollar amount of interest income from interest-earning assets, the average yields, the amount of interest expense from interest-bearing liabilities and the average rate, net interest income, interest rate spread, and the net yield on interest-earning assets, refer to page 35 of Management's Discussion and Analysis of Financial Condition and Results of Operations contained herein.

For information regarding the combined weighted average effective interest rate earned by the Bank on its loan portfolios and investments, the combined weighted average effective cost of the Bank’s deposits and borrowings, the interest rate spread of the Bank, and the net yield on combined monthly weighted average interest-earning assets of the Bank on its loan portfolios and investments for the fiscal years ending December 31, 2003, 2002, and 2001, refer to page 34 Average Balance Sheet Table contained herein.
For information concerning the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected the Bank’s interest income and expense during the fiscal years ending December 31, 2003, 2002, and 2001, refer to page 35 Rate Volume Table contained herein.

Market Area

The Bank’s market area for deposit gathering is primarily Anne Arundel County, Maryland and nearby areas, since it has two branch locations, both of which are located in Anne Arundel County. Anne Arundel County has a population of approxi­mately 500,000. The principal business of the Bank is attracting deposits from the general public and investing those deposits, together with other funds, in mortgage and consumer loans, mortgage-backed securities and investment securities. The Bank’s revenues are derived principally from interest earned on mortgage, consumer and other loans, fees charged in connection with loans and banking services, interest and dividends earned on other investments. The Bank’s primary sources of funds are deposits and loan interest, principal amortization and prepayments.

The primary focus of the Bank’s lending activities has been on first mortgage loans secured by real estate for the purpose of purchasing, refinancing, developing and constructing one-to-four family residences and commercial properties in and near Anne Arundel County, Maryland. The Bank does originate mortgage loans throughout the state of Maryland, Northern Virginia and Delaware. The Bank is an active participant in the secondary market and sells substantially all fixed rate long-term mortgages that it originates.



  3  


Loan Portfolio Composition

The following table sets forth the composition of the Bank’s loan portfolios by type of loan at the dates indicated. The table includes a reconciliation of  total net loans receivable, including loans available for sale, after consideration of undisbursed portion of loans, deferred loan fees and discounts, and allowances for losses on loans.
 
 
2003
 
2002
 
2001
 
2000
 
1999
 
Amount
Percent
 
Amount
Percent
 
Amount
Percent
 
Amount
Percent
 
Amount
Percent
Real Estate Loans
(dollars in thousands)
 
Residential, one to four family units
$220,165
36.20%
 
$180,397
36.58%
 
$151,250
36.90%
 
$137,498
41.95%
 
$ 101,640
39.89%
Residential, multifamily
866
0.14%
 
1,318
0.27%
 
1,065
0.26%
 
1,026
0.31%
 
991
0.39%
Commercial and industrial real estate
112,382
18.48%
 
95,298
19.33%
 
71,557
17.46%
 
54,024
16.48%
 
49,231
19.32%
Construction and land acquisition and
 
 
 
 
 
 
 
 
 
 
 
 
 
 
development loans
240,757
39.58%
 
191,197
38.77%
 
163,849
39.98%
 
117,325
35.80%
 
90,324
35.45%
Land
25,820
4.25%
 
20,109
4.08%
 
16,895
4.12%
 
11,390
3.48%
 
7,018
2.76%

 

 

 

 

 

Total real estate loans
599,990
98.65%
 
488,319
99.03%
 
404,616
98.72%
 
321,263
98.02%
 
249,204
97.81%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Business, commercial
7,088
1.16%
 
3,894
0.79%
 
3.970
0.97%
 
5,592
1.71%
 
170
0.07%
Consumer
1,144
0.19%
 
870
0.18%
 
1,257
0.31%
 
885
0.27%
 
5,406
2.12%

 

 

 

 

 

Total other loans
8,232
1.35%
 
4,764
0.97%
 
5,227
1.28%
 
6,477
1.98%
 
5,576
2.19%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 

 

 

 

 

Total gross loans
608,222
100.00%
 
493,083
100.00%
 
409,843
100.00%
 
327,740
100.00%
 
254,780
100.00%

 

 

 

 

 

 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unearned fees, premiums & discounts, net
(3,343)
 
 
(2,674)
 
 
(2,164)
 
 
(2,149)
 
 
(1,852)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans in process
(94,020)
 
 
(67,593)
 
 
(61,685)
 
 
(48,211)
 
 
(36,715)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan loss
(4,833)
 
 
(3,991)
 
 
(3,353)
 
 
(2,728)
 
 
(2,147)
 
 
 
 
 
 
 
 
 
 
 
Total Loans net
$506,026
 
 
$418,825
 
 
$342,641
 
 
$274,652
 
 
$214,066
 

 

 

 

 

 

 

 

 

 

 





  4  

Lending Activities - Residential Mortgage Loans

General
The Bank originates mortgage loans of all types, including residential, residential-construction, commercial-construction, commercial and land and residential lot loans. To a lesser extent, the Bank also originates non-mortgage loans, which include consumer, business and commercial loans. These loans constitute a small part of the Bank’s portfolio.

For the years ending December 31, 2003 and 2002, the Bank originated $320,902,000 and $343,590,000 of mortgage loans, respectively.

Loan Origination Procedures

The following table contains information on the activity of Bancorp’s loans available for sale and its loans held for investment in its portfolio:
 
 
For the year ended December 31,
 
2003
2002
2001
 
(dollars in thousands)
Available for Sale:
 
 
   
 
   
 
 
Beginning balance
$
17,481
 
$
7,499
 
$
4,169
 
Originations
 
119,660
   
110,565
   
63,565
 
Repurchases
 
-
   
-
   
41
 
Repayments
 
(95
)
 
(48
)
 
-
 
Deferred fees
 
-
   
-
   
26
 
Net sales
 
(133,871
)
 
(100,535
)
 
(60,302
)
Transfers (to) from available for sale
 
-
   
-
   
-
 
 
 
  		 
  		 
Ending Balance
$
3,175
 
$
17,481
 
$
7,499
 
 
 
 
 
 
 
 
   
 
   
 
 
 
 
 
   
 
   
 
 
Held for investment
 
 
   
 
   
 
 
Beginning balance
$
475,602
 
$
402,345
 
$
323,571
 
Originations and purchases
 
201,242
   
233,222
   
293,195
 
Repurchases
 
-
   
-
   
-
 
Repayments/payoffs
 
(71,797
)
 
(159,965
)
 
(214,295
)
Sales
 
-
   
-
   
-
 
Transfers (to) from repossessed assets
 
-
   
-
   
(127
)
 
  		 
  		 
  		 
Ending balance
$
605,047
 
$
475,602
 
$
402,344
 
 
 
 
 

The Bank originates residential mortgage loans that are intended for sale in the secondary market as well as loans that are to be held in the Bank’s investment portfolio. Loans sold in the secondary market are either sold directly to the Federal Home Loan Mortgage Corporation (“FHLMC”) or are sold to other investors with which the Bank maintains a correspondent relationship. These loans are made in conformity with standard underwriting criteria to assure maximum eligibility for possible resale in the secondary market, and are approved either by the Bank’s underwriter or the correspondent’s underwriter. Loans considered for the Bank’s portfolio are approved by the Bank’s loan committee, which is comprised of the Executive Vice President and the Senior Vice President. Meetings of the loan committee are open to attendance by any member of the Bank’s Board of Directors who wishes to attend. The loan committee reports to and consults with the Board of Directors in interpreting and applying the Bank’s lending policy.
 
 
  5  
 
Loans that are sold are typically long-term (15 or more years) loans with fixed interest rates eligible for resale in the secondary market. Loans retained for the Bank’s portfolio include construction loans, commercial loans and loans that periodically reprice or mature prior to the end of an amortized term. Loans are generally sold with servicing released. However, as of December 31, 2003 the Bank was servicing $2,531,476 in loans for FHLMC and $21,484,664 in loans for other investors.

The following table contains information, as of December 31, 2003, on the percentage of fixed rate single-family loans serviced for others by the Bank, by interest rate category.

Coupon range
 
Percentage of Portfolio
Less than 6.00%
   
30.97
%
6.01 - 7.00%
   
41.81
%
7.01 - 8.00%
   
17.34
%
8.01 - 9.00%
   
4.80
%
9.01 - 10.00%
   
3.73
%
Over 10.01%
   
1.35
%
      
   		 
 
   
100.00
%
   
 

The Bank’s mortgage loan approval process is intended to assess the borrower’s ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan. The authority of the loan committee to approve loans is established by the Board of Directors and currently is commensurate with the Bank’s limitation on loans to one borrower. The Bank’s maximum amount of loans to one borrower currently is equal to 15% of the Bank’s unimpaired capital or $7,435,000 as of December 31, 2003. Loans greater than this amount require participation by one or more additional lenders. Letters of credit are subject to the same limitations as direct loans. The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate. The Bank requires borrowers to maintain fire and casualty insurance on its secured properties.

The procedure for approval of construction loans is the same for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs. The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer. In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long-term loan to replace the construction loan upon completion of construction.

Commercial Real Estate Loans

At December 31, 2003, the Bank’s commercial real estate loan portfolio totaled $112,382,000, or 18.48% of the Bank’s total loan portfolio. All of the Bank’s commercial loans are secured by improved property such as office buildings, retail strip shopping centers, industrial condominium units and other small businesses most of which are located in the Bank’s primary lending area. The largest commercial real estate loan at December 31, 2003 was a $5,200,000 loan secured by two office buildings in Reston, Virginia. The loan is subject to the partial personal guarantees of a principal of the borrower, and has consistently performed in accordance with the terms of the debt instrument.

Loans secured by commercial real estate properties generally involve a greater degree of risk than residential mortgage loans. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to a greater extent to adverse conditions in the real estate market or the economy.
 
 
  6  
 
 
Construction Loans

The Bank originates loans to finance the construction of one-to-four family dwellings, and to a lesser extent, commercial real estate. It also originates loans for the acquisition and development of unimproved property to be used for residential and/or commercial purposes in cases where the Bank is to provide the construction funds to improve the properties. As of December 31, 2003, the Bank had 589 construction loans outstanding in the aggregate amount of $240,757,000, representing 39.58% of its loan portfolio.

Construction loan amounts are based on the appraised value of the property and, for builder loans, a feasibility study as to the potential marketability and profitability of the project. Construction loans generally have terms of up to one year, with reasonable extensions as needed, and typically have interest rates that float monthly at margins typically ranging ½ percent to 2 percent above the prime rate. In addition to builders’ projects, the Bank finances the construction of single family, owner-occupied houses where qualified contractors are involved and on the basis of strict written underwriting and construction loan guidelines. Construction loans are structured either to be converted to permanent loans with the Bank upon the expiration of the construction phase or to be paid off by financing from another financial institution.

Construction loans afford the Bank the opportunity to increase the interest rate sensitivity of its loan portfolio and to receive yields higher than those obtainable on loans secured by existing residential properties. These higher yields correspond to the higher risks associated with construction lending. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the project under construction that is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to value accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the ultimate success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank is forced to foreclose on a project prior to or at completion, due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of the loan as well as related foreclosure and holding costs. In addition, the Bank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time. The Bank has attempted to address these risks through its underwriting procedures and its limited amount of construction lending on multi-family and commercial real estate properties.

It is the policy of the Bank to conduct physical inspections of each property secured by a construction or rehabilitation loan for the purpose of reporting upon the progress of the construction of improvements. These inspections, referred to as “construction draw inspections,” are to be performed at the time of a request for an advance of construction funds. If no construction advance has been requested, an inspection is made by a fee inspector or senior officer of the institution on the subject property at least quarterly.

Multi-Family Lending

The Bank occasionally originates multi-family loans with terms up to 30 years, but with rate adjustments or balloon payments generally at three to five years. These loans are generally made in amounts up to 75% of the appraised value of the secured property. In making these loans, the Bank bases its underwriting decision primarily on the net operating income generated by the real estate to support the debt service, the financial resources and income level of the borrower, the borrower’s experience in owning or managing similar property, the marketability of the property and the Bank’s lending experience with the borrower. The Bank also typically receives a personal guarantee from the borrower. As of December 31, 2003, $866,000, or 0.14% of the Bank’s total loan portfolio, consisted of multi-family residential loans.

Land and Residential Building Lots

Land loans include loans to developers for the development of residential subdivisions and loans on unimproved lots primarily to individuals. At December 31, 2003 the Bank had land and residential building lot loans totaling $25,820,000, or 4.25% of the Bank’s total loan portfolio. The largest of these loans is for $4,400,000, and is secured by residentially zoned land in Ocean Pines, Maryland, and has performed in accordance with the terms of the debt instrument. Land development loans typically are short-term loans; the duration of these loans is typically not greater than three years. The interest rate on land loans is generally at least 1% or 2% over the prime rate. The loan-to-value ratio generally does not exceed 75%. Loans typically are made to customers of the Bank and developers and contractors with whom the Bank has had previous lending experience. In addition to the customary requirements for this type loan, the Bank may also require a clean Phase I environmental study and feasibility study to determine the profit potential of the development.

 
  7  
 
 
Consumer and Other Loans

The Bank also offers other loans, primarily business and commercial loans. These are loans to businesses not secured by real estate although they may be secured by equipment, securities, or other collateral. They constitute a relatively small part of the Bank’s business, and are typically offered to customers with long-standing relationships with the Bank. At December 31, 2003, $7,088,000, or 1.16%, of the loan portfolio consisted of business and commercial loans. Approximately .19% of the loan portfolio is in consumer loans.

Loan Portfolio Cash Flows

The following table sets forth the estimated maturity of the Bank’s loan portfolios by type of loan at December 31, 2003. The estimated maturity reflects contractual terms at December 31, 2003. Contractual principal repayments of loans do not necessarily reflect the actual term of the Bank’s loan portfolios. The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and because of enforcement of "due on sale" clauses. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans.

 
 
Due
Due after
 
 
 
 
within
1 through
Due after
 
 
 
one year
5 years
5 years
Total
 
 
(dollars in thousands)  
One to four family residential
 
$
13,578
 
$
71,027
 
$
135,560
 
$
220,165
 
Multifamily
   
-
   
283
   
583
   
866
 
Commercial and industrial real estate
   
16,350
   
35,344
   
60,688
   
112,382
 
Construction and land acquisition
   
 
   
 
   
 
   
 
 
and development loans
   
201,490
   
39,267
   
-
   
240,757
 
Land
   
7,117
   
18,374
   
329
   
25,820
 
Commercial, non-real estate
   
3,124
   
1,303
   
2,661
   
7,088
 
Consumer
   
282
   
364
   
498
   
1,144
 
Total
 
$
241,941
 
$
165,962
 
$
200,319
 
$
608,222
 
   
 
 
 
 


The following table contains certain information as of December 31, 2003 relating to the loan portfolio of the Bank with the dollar amounts of loans due after one year that have fixed and floating rates. All loans are shown maturing based upon contractual maturities and include scheduled payments but not possible prepayments.
 
 
  8  
 

 
 
Fixed
Floating
Total
 
 
(dollars in thousands)
                     
One to four family residential
 
$
155,288
 
$
51,299
 
$
206,587
 
Multifamily
   
475
   
391
   
866
 
Commercial and industrial real estate
   
63,445
   
32,587
   
96,032
 
Construction and land acquisition
   
 
   
 
   
 
 
and development loans
   
21,961
   
17,306
   
39,267
 
Land
   
18,703
   
-
   
18,703
 
Commercial, non-real estate
   
1,658
   
2,306
   
3,964
 
Consumer
   
862
   
-
   
862
 
Total
 
$
262,392
 
$
103,889
 
$
366,281
 
   
 
 
 

Loans to One Borrower

The aggregate amount of loans that the Bank may make to one borrower is 15% of the Bank’s unimpaired capital and unimpaired surplus. The Bank’s largest loan is in the amount of $5,200,000 and is secured by two office buildings in Reston Virginia. The second largest loan is in the amount of $4,400,000 and is secured by land for condominiums in Ocean Pines, Maryland . The third largest loan is in the amount of $3,850,000 and is secured by residential property in Arnold, Maryland. All of these loans have fully performed since their inception.
 
Origination and Purchase and Sale of Loans

The Bank originates residential loans in conformity with standard underwriting criteria to assure maximum eligibility for possible resale in the secondary market. Although the Bank has authority to lend anywhere in the United States, they have confined their loan origination activities to the states of Maryland, Virginia and Delaware.

Loan originations are developed from a number of sources, primarily from referrals from real estate brokers, builders, and existing and walk-in customers. Severn Savings also utilizes the services of loan brokers in its market area. Loan brokers are paid on a commission basis (generally 1% of the loan amount) for loans brokered to the Bank.

The Bank’s mortgage loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan. The loan committee of the Bank can approve residential and commercial loans ranging up to $7,435,000 (the maximum amount of a loan to one borrower as of December 31, 2003). The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate. The Bank requires borrowers to maintain fire and casualty insurance on its secured properties.

The procedure for approval of construction loans is the same as for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs. The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer. In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long-term loan to replace the construction loan upon completion of construction.

Consumer loans are underwritten on the basis of the borrower's credit history and an analysis of the borrower's income and expenses, ability to repay the loan, and the value of the collateral, if any.

Currently, it is the Bank’s policy to originate both fixed-rate and adjustable-rate loans. The Bank is currently active in the secondary market and sells the majority of its fixed rate loan products.
 
 
  9  
 
 
Interest Rates, Points and Fees

The Bank realizes interest, point, and fee income from their lending activities. The Bank also realizes income from commitment fees for making commitments to originate loans, from prepayment and late charges, loan fees, application fees, and fees for other miscellaneous services.

The Bank accounts for loan origination fees in accordance with the Statement of Financial Accounting Standards on Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans ("SFAS No. 91") issued by the Financial Accounting Standards Board (the "FASB"). SFAS No. 91 prohibits the immediate recognition of loan origination fees as revenues and requires that such income (net of certain direct loan origination costs) for each loan be amortized, generally by the interest method, over the estimated life of the loan as an adjustment of yield. The Bank also realizes income from gains on sales of loans, and servicing released fees for loans sold with servicing released.

Delinquency and Classified Assets
Delinquencies

The Board of Directors reviews delinquencies on all loans monthly. The Bank’s collection procedures include sending a past due notice to the borrower on the 17th day of nonpayment, making telephone contact with the borrower between 20 and 30 days after nonpayment, and sending a letter after the 30th day of nonpayment. A notice of intent to foreclose is sent between 60 and 90 days after delinquency. When the borrower is contacted, the Bank attempts to obtain full payment of the amount past due. However, the Bank generally will seek to reach agreement with the borrower on a payment plan to avoid foreclosure.

The Bank categorizes its classified assets within four categories: A) Special Mention, B) Substandard, C) Doubtful and D) Loss. Special Mention loans are 60 days or more in arrears and include all borrowers who are in bankruptcy that have not missed any post-petition payments. The Bank reserves 5% on all Special Mention loans. Substandard loans are loans that are 90 days or more delinquent and are loans that have borrowers in bankruptcy that have missed a post-petition payment. The Bank reserves 15% of substandard loans. The Doubtful category consists of loans where the Bank expects a loss, but not a total loss. Various subjective factors are considered with the most important consideration being the estimated underlying value of the collateral. The Bank reserves 50% of the amount of Doubtful loans. Loans that are classified as “Loss” are fully reserved.

All loans are individually evaluated if they are deemed classified. The Bank also evaluates all delinquent loans, individually. The rest of the portfolio is evaluated as a group and a determination is made, periodically, concerning the inherent risks associated with particular types of loans and an allowance is assigned to those particular groups.

The Bank allocates reserves to its allowance for loan losses in two ways. Where the Bank has classified an asset it generally allocates the percentage of that asset under its classification system to a specific reserve if the asset is classified as Doubtful or Loss. In cases where loans are classified as Special Mention or Substandard the Bank usually does not allocate its allowance for loan loss reserves to a specific reserve. The Bank does not allocate its allowance for loan losses based upon the unclassified portion of its loan portfolio to specific loan reserves.

It is the policy of the Bank to discontinue the accrual of interest on any loan that is 90 days or more past due. The Bank historically has not incurred any significant losses on delinquent mortgage loans.

The following table sets forth information as to non-accrual loans. The Bank discontinues the accrual of interest on loans 90 days or more past due, at which time all previously accrued but uncollected interest is deducted from income. As of the most recent reported period, $27,878 would have been recorded for the year ended December 31, 2003 if the loans had been current in accordance with their original terms and had been outstanding throughout the year ended December 31, 2003 or since their origination (if held for only part of the fiscal year). For the year ended December 31, 2003, $16,787 in interest income on such loans was actually included in net income.
 
 
  10  
 


 
   

  At December 31,

 
     
2003  
   
2002  
   
2001  
   
2000  
   
1999  
 
   

  (dollars in thousands)

 
Loans accounted for on a non-accrual basis:
   
 
   
 
   
 
   
 
   
 
 
Mortgage loans:
   
 
   
 
   
 
   
 
   
 
 
One-to-four family real estate
 
$
378
 
$
1,366
 
$
1,801
 
$
872
 
$
909
 
Home equity lines of credit
   
50
   
-
   
-
   
-
   
16
 
Commercial
   
-
   
253
   
300
   
292
   
 
 
Land
   
24
   
139
   
-
   
-
   
-
 
Non-mortgage loans:
   
 
   
 
   
 
   
 
   
 
 
Consumer
   
17
   
-
   
-
   
14
   
-
 
Commercial loans
   
-
   
-
   
-
   
-
   
-
 
   
 
 
 
 
 
Total non-accrual loans
   
469
   
1,758
   
2,101
   
1,178
   
925
 
                                 
Accruing loans which are contractually past due 90 days or more:
   
 
   
 
   
 
   
 
   
 
 
Mortgage loans:
   
 
   
 
   
 
   
 
   
 
 
Permanent loans secured by one-to-four family real estate
   
-
   
-
   
-
   
-
   
-
 
Commercial
   
-
   
-
   
-
   
-
   
-
 
Non-mortgage loans
   
 
   
 
   
 
   
 
   
 
 
Consumer
   
-
   
-
   
-
   
-
   
-
 
Total accruing loans greater than 90 days past due
   
-
   
-
   
-
   
-
   
-
 
   
 
 
 
 
 
Total non-performing loans
 
$
469
 
$
1,758
 
$
2,101
 
$
1,178
 
$
925
 
   
 
 
 
 
 
Foreclosed real-estate
  $
-
  $
224
  $
312
  $
312
  $  
672
 
   
 
 
 
 
 
Total nonperforming assets
 
$
469
 
$
1,982
 
$
2,413
 
$
1,490
 
$
1,597
 
   
 
 
 
 
 
Total non-accrual and accrual loans to net loans
   
0.09
%
 
0.42
%
 
0.61
%
 
0.43
%
 
0.43
%
                                 
Allowance for loan losses to total non-performing loans,
   
 
   
 
   
 
   
 
   
 
 
including loans contractually past due 90 days or more
   
1030.49
%
 
227.02
%
 
159.59
%
 
231.58
%
 
232.11
%
   
 
 
 
 
 
Total non-accrual and accruing loans greater than
   
 
   
 
   
 
   
 
   
 
 
90 days past due to total assets
   
0.09
%
 
0.38
%
 
0.57
%
 
0.40
%
 
0.40
%
   
 
 
 
 
 
Total non-performing assets to total assets
   
0.09
%
 
0.43
%
 
0.66
%
 
0.51
%
 
0.68
%
   
 
 
 
 
 

Classified Assets        

Federal regulations provide for the classification of loans and other assets, such as debt and equity securities, considered by the Office of Thrift Supervision (OTS) to be of lesser quality as “substandard,” “doubtful” or “loss assets.” An asset is considered substandard if it is inadequately protected by the paying capacity and net worth of the obligor or the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions, and values. Assets classified as loss assets are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to a sufficient degree of risk to warrant classification in one of these categories but possess credit deficiencies or potential weakness are required to be designated special mention by management.
 
 
  11  
 
 
When an insured institution classifies problem assets as either substandard or doubtful, it is required to establish general allowance for losses in an amount deemed prudent by management. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as loss assets, it is required either to establish a specific allowances for losses equal to the full amount of the asset so classified or to charge-off such amount. An institution’s determination as to the classification of its assets is subject to scrutiny by the OTS, which can require the establishment of additional general or specific loss allowances. The Bank reviews monthly the assets in its portfolio to determine whether any assets require classification in accordance with applicable regulations.

Total classified loans as of December 31, 2003 were $1,824,282. Allowance for loan losses as of December 31, 2003 was $4,833,000 which is 0.96% of net loans receivable and 1,030% of total non-performing loans.
[see table on following page]
 
 
 
 
 
 
 
 
 
 

 


  12  

The following table summarizes the allocation of the allowance for loan losses by loan type and the percent of loans in each category compared to total loans at the dates indicted:

 
 

  2003  

  2002

  2001

  2000

  1999

 
  		 
 
 
 
 

  Allowance Amount

Percentage of Loans in each Category to Total Loans  

  Allowance Amount

Percentage of Loans in each Category to Total Loans  

  Allowance Amount

Percentage of Loans in each Category to Total Loans  

  Allowance Amount

Percentage of Loans in each Category to Total Loans  

  Allowance Amount

Percentage of Loans in each Category to Total Loans  

 
  (dollars in thousands)
                                                   
Residential, one to four family
$
1,938
 
36.20
%
$
1,542
 
36.58
%
$
1,081
 
36.90
%
$
995
 
41.95
%
$
776
 
39.89
%
Multifamily
 
21
 
0.14
%
 
21
 
0.27
%
 
24
 
0.26
%
 
18
 
0.31
%
 
10
 
0.39
%
Commercial and industrial real estate
 
1,154
 
18.48
%
 
881
 
19.33
%
 
850
 
17.46
%
 
658
 
16.48
%
 
567
 
19.32
%
Construction and land acquisition and
 
 
 
 
   
 
 
 
   
 
 
 
   
 
 
 
   
 
 
 
 
development loans
 
1,173
 
39.58
%
 
1,202
 
38.77
%
 
917
 
39.98
%
 
662
 
35.80
%
 
428
 
35.45
%
Land
 
476
 
4.25
%
 
300
 
4.08
%
 
413
 
4.12
%
 
308
 
3.48
%
 
292
 
2.76
%
Business, commercial
 
59
 
1.16
%
 
33
 
0.79
%
 
52
 
.97
%
 
75
 
1.71
%
 
4
 
0.07
%
Other
 
12
 
0.19
%
 
12
 
0.18
%
 
16
 
.31
%
 
12
 
0.27
%
 
70
 
2.12
%
 
 
 
 
 
 
 
 
 
 
 
Total
$
4,833
 
100.00
%
$
3,991
 
100.00
%
$
3,353
 
100.00
%
$
2,728
 
100.00
%
$
2,147
 
100.00
%
 
 
 
 
 
 
 
 
 
 
 




  13  



The following table contains information with respect to Severn Bancorp’s allowance for loan losses for the periods indicated:



 
   

  At or for the Year Ended

   

  December 31,

 
     
2003  
   
2002  
   
2001  
   
2000  
   
1999  
 
   

  (dollars in thousands)

 
Average loans outstanding, net
 
$
466,512
 
$
384,537
 
$
313,798
 
$
246,631
 
$
203,237
 
   
 
 
 
 
 
Total gross loans outstanding at end of period
 
$
608,222
 
$
493,083
 
$
409,844
 
$
327,740
 
$
254,780
 
   
 
 
 
 
 
Allowance balance at beginning of period
 
$
3,991
 
$
3,353
 
$
2,728
 
$
2,147
 
$
1,984
 
 
   
 
   
 
   
 
   
 
   
 
 
Provision for loan losses
   
900
   
670
   
709
   
591
   
504
 
 
   
 
   
 
   
 
   
 
   
 
 
Actual charge-offs
   
 
   
 
   
 
   
 
   
 
 
1-4 family residential real estate
   
25
   
-
   
74
   
30
   
89
 
Other
   
33
   
32
   
10
   
-
   
263
 
   
 
  		 
  		 
  		 
  		 
Total charge-offs
   
58
   
32
   
84
   
30
   
352
 
   
 
 
 
 
 
Recoveries
   
 
   
 
   
 
   
 
   
 
 
Total recoveries
   
-
   
-
   
-
   
20
   
11
 
   
  		 
  		 
  		 
  		 
  		 
Net chargeoffs
   
58
   
32
   
84
   
10
   
341
 
   
 
 
 
 
 
Allowance balance at end of period
 
$
4,833
 
$
3,991
 
$
3,353
 
$
2,728
 
$
2,147
 
   
 
 
 
 
 
Net chargeoffs as a percent of average loans
   
0.01
%
 
0.01
%
 
0.03
%
 
0.00
%
 
0.17
%
Allowance for loan losses to total gross loans at end of period
   
0.79
%
 
0.81
%
 
0.82
%
 
0.83
%
 
0.84
%
   
 
 
 
 
 


  14  

Investment Activities

Federal thrift institutions, such as the Bank, have authority to invest in various types of liquid assets, including United States Treasury obliga­tions and securities of various federal agencies, certificates of deposit at insured banks, bankers' acceptances and federal funds. As a member of the FHLB System, the Bank must maintain minimum levels of liquid assets specified by the Office of Thrift Supervision (“OTS”), which vary from time to time. Subject to various regulatory restrictions, federal thrift institutions may also invest a portion of their assets in certain commercial paper, corporate debt securities and mutual funds whose assets conform to the investments that a federal thrift institution is authorized to make directly.

The carrying values of the Bank’s investment securities, including its liquid assets, as of the dates indicated are presented in the following table:
 
 
at December 31,
 
2003
2002
2001
 
(dollars in thousands)
Investment Securities Held to Maturity
 
 
   
 
   
 
 
U.S. Treasury Notes
$
-
 
$
-
 
$
2,001
 
FHLB Notes
 
6,000
   
4,000
   
5,000
 
 
  		 
  		 
  		 
Total Investment Securities Held to Maturity
 
6,000
   
4,000
   
7,001
 
 
 
 
 
Interest-bearing deposits in other banks
$
458
 
$
4,191
 
$
1,059
 
Federal funds sold
 
3,914
   
10,713
   
3,949
 
Mortgage-backed securities held to maturity
 
6,721
   
5,661
   
212
 
FHLB stock
 
3,250
   
1,900
   
2,500
 
 
  		 
  		 
  		 
 
 
14,343
   
22,465
   
7,720
 
 
 
 
 
 
$
20,343
 
$
26,465
 
$
14,721
 
 
 
 
 




  15  


Investment Scheduled Maturity Table
As of December 31, 2003

 
 
 
 
 
More than One to
 
More than Five to
 
 
 
 
 
 
 
 
One Year or Less
 
Five Years
 
Ten Years
 
More than Ten Years
 
Total Investment Securities
 
Carrying
Average
 
Carrying
Average
 
Carrying
Average
 
Carrying
Average
 
Carrying
Average
Market
 
Value
Yield
 
Value
Yield
 
Value
Yield
 
Value
Yield
 
Value
Yield
Value
 
(dollars in thousands)
Investment Securities Held to Maturity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
FHLB Notes
-
 
$ 4,000
2.58%
 
$ 2,000
5.05%
 
-
 
 
$  6,000
3.40%
$5,922
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits in other banks
$    458
0.85%
 
-
 
 
-
 
 
-
 
 
458
0.85%
458
Federal funds sold
3,914
0.88%
 
-
 
 
-
 
 
-
 
 
3,914
0.88%
3,914
Mortgage-backed securities held to maturity
-
 
2,918
4.37%
 
-
 
 
$ 3,803
5.53%
 
6,721
5.02%
6,694
FHLB stock
-
 
-
 
 
-
 
 
3,250
3.50%
 
3,250
3.50%
3,250
 
  
   		 
  
   		 
  
   		 
  
   		 
  
  
  
Total
$ 4,372
0.87 %
 
$ 6,918
2.58%
 
$ 2,000
5.05%
 
$ 7,053
4.59%
 
$ 20,343
3.41%
$20,238



  16  

Real Estate Owned

As of December 31, 2003, Bancorp owned no real estate through foreclosure.

Deposits
 
Deposits are attracted principally from within the Bank’s primary market areas through the offering of a variety of deposit instruments, including passbook and statement accounts and certificates of deposit ranging in terms from three months to five years. Deposit account terms vary, principally on the basis of the minimum balance required, the time periods the funds must remain on deposit and the interest rate. The Bank also offers individual retirement accounts (“IRA’s”).
 
The Bank’s policies are designed primarily to attract deposits from local residents rather than to solicit deposits from areas outside their primary markets. Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations.
 
Deposits in the Bank as of December 31, 2003 and 2002 consisted of savings programs described below:

 
 
2003
2002
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Category
   
 
   
 
   
 
   
 
 
NOW accounts
 
$
21,219,969
   
5.06
%
$
15,980,589
   
4.23
%
Money market accounts
   
152,412,884
   
36.31
   
132,767,052
   
35.13
 
Passbooks
   
19,190,968
   
4.57
   
18,189,610
   
4.81
 
Certificates
   
226,832,739
   
54.04
   
210,913,461
   
55.81
 

 

 
 
 
 
 
 
   
419,656,560
   
99.98
   
377,850,712
   
99.98
 
Accrued interest
   
69,625
   
.02
   
74,329
   
.02
 

 

 
 
 
 
 
 
   
 
   
 
   
 
   
 
 
Total savings
 
$
419,726,185
   
100.00
%
$
377,925,041
   
100.00
%
   
 
 
 
 

The Bank held certificates of deposit totaling $226,832,739 and $210,913,461 at December 31, 2003 and 2002 respectively, maturing as follows:

 
 
2003
 
 
Amount
Percent
One year or less
 
$
125,650,800
   
55.39
%
More than 1 year to 2 years
   
30,261,890
   
13.34
 
More than 2 years to 3 years
   
39,724,600
   
17.51
 
More than 3 years to 4 years
   
19,889,201
   
8.77
 
More than 4 years to 5 years
   
11,306,248
   
4.99
 
More than 5 years
   
-
   
.00
 
   
 
 
 
 
$
226,832,739
   
100.00
%
   
 
 
 
 
  17  
 
 
The following table contains information pertaining to the certificates of deposit held by the Bank in excess of $100,000 (“Jumbo CD’s”) as of December 31, 2003.

 
   
Jumbo Certificate
 
 
   
of Deposits
 
Time Remaining Until Maturity
   
(dollars in thousands
)
Less than three months
 
$
10,046
 
3 months to 6 months
   
7,852
 
6 months to 12 months
   
8,739
 
Greater than 12 months
   
31,242
 
   
 
Total
 
$
57,879
 
   
 

Liquidity and Asset/Liability Management

Two major objectives of asset and liability management are to maintain adequate liquidity and to control the interest sensitivity of the balance sheet.

Liquidity is the measure of a company’s ability to maintain sufficient cash flow to fund operations and to meet financial obligations to depositors and borrowers. Liquidity is provided by the ability to attract and retain deposits and by principal and interest payments on loans and maturing securities in the investment portfolio. A strong core deposit base, supplemented by other deposits of varying maturities and rates, contributes to the Bank’s liquidity.

Funds available through short-term borrowings and asset maturities are considered adequate to meet all current needs, and Management is continually monitoring the Bank’s liquidity position to meet projected needs.

Interest rate sensitivity is maintaining the ability to reprice interest earning assets and interest bearing liabilities in relationship to changes in the general level of interest rates. Management attributes interest rate sensitivity to a steady net interest margin through all phases of interest rate cycles. Management attempts to make the necessary adjustments to constrain adverse savings in net interest income resulting from interest rate movements through GAP analysis and income simulation modeling techniques.

Short Term Borrowings

The Bank has an available line of credit, secured by its residential mortgage portfolio, in the amount of Twenty-Five Percent (25%) of its total assets, with the Federal Home Loan Bank of Atlanta. As of year-end the available line of credit with the Federal Home Loan Bank of Atlanta was $135,118,000. The Bank, from time to time, utilizes the line of credit when interest rates are more favorable then obtaining deposits from the public. The following table sets forth short-term borrowings with the Federal Home Loan Bank of Atlanta, with original maturities of one year or less.
 
 
 
Year ended December 31,
 
 
2003
2002
2001
 
 
(dollars in thousands)
Short term borrowings and notes payable
   
 
   
 
   
 
 
Average balance outstanding during the period
 
$
1,500
 
$
4,917
 
$
21,917
 
Maximum amount outstanding at any month-end during
   
 
   
 
   
 
 
the period
   
8,000
   
14,000
   
27,000
 
Weighted Average interest rate during the period
   
0.62
%
 
3.16
%
 
5.38
%
Total short term borrowings at period end
   
6,000
   
-
   
17,000
 
Weighted average interest rate at period end
   
1.15
%
 
0.00
%
 
4.40
%
 
 

 

  18  
 
 
Employees

As of December 31, 2003, the Bank employed 76 persons on a full-time basis and 7 persons on a part-time basis. The Bank’s employees are not represented by any collective bargaining group, and management considers its relations with its employees to be excellent. The holding company has no employees.

Severn Capital

The Bank formed Severn Capital in 1997. Severn Capital was created for the purpose of acquiring, holding and managing mortgage loans. Severn Capital has elected to be subject to tax as a real estate investment trust under the Internal Revenue Code and regulations promulgated thereunder. The Bank owns all of the Common Stock of Severn Capital and administers the day-to-day operations of Severn Capital for a fee. There are 200,002 shares of preferred stock of Severn Capital outstanding. Dividends on the preferred stock are payable quarterly, in an amount equal to $1.80 per annum per preferred share. The preferred stock is redeemable, at $20 per share any time after June 30, 2001, at the option of the Bank.

Hyatt Real Estate

Bancorp acquired Hyatt Real Estate, a real estate brokerage and property management company, in June 2001. Hyatt Real Estate is a real estate brokerage company specializing in commercial real estate sales, leasing and property management. It owns the facility within which it is located, at 1919 West Street, and is also the owner of the property known as 1919A West Street, which is leased to the Bank for its administrative offices. As of December 31, 2003 Hyatt Real Estate had 16 licensed real estate agents and 7 employees.

SBI Mortgage Company

SBI is a subsidiary of Bancorp that has engaged in the origination of mortgages not suitable for the Bank. It owns subsidiary companies that have or are negotiating to purchase real estate for investment purposes. As of December 31, 2003, SBI had $298,143 in outstanding mortgage loans and it had $520,180 invested in subsidiaries, which funds were held in cash, pending potential acquisition of investment real estate.

HS West, LLC

HS West, LLC (“HS”) is a subsidiary of the Bank. It owns certain land, being approximately one acre in size, which is located in the City of Annapolis, Maryland fronting on Westgate Circle. HS has obtained a special exception approval from the City of Annapolis to construct an 82,000± square foot office building with parking garage on the site. A grading permit has been issued by the City of Annapolis and a building permit has been applied for. Estimates have been received for construction and revisions are currently being made in an attempt to reach a figure for construction deemed reasonable by the Bank. It is expected that construction of the office building will commence in the spring of 2004.

Regulation
 
Competition
The banking and financial services is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers. We compete for loans, deposits, and customers with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other nonbank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader range of financial services than us. Recent legislation permitting affiliations among commercial banks, insurance companies, securities firms, and other financial service providers has resulted in even larger financial institutions.
 
 
 
  19  
 
 
 
Economic Conditions, Government Policies, Legislation, and Regulation
 
Our profitability, like that of most financial institutions, is primarily dependent on interest rate differentials. In general, the difference between the interest rates paid by us on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans extended to its clients and securities held in its investment portfolio, will initially comprise the major portion of our earnings. These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic and foreign economic conditions might have on us cannot be predicted.

Our business is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (the “FRB”). The FRB implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact on us of any future changes in monetary and fiscal policies cannot be predicted.

From time to time, legislation, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies. This legislation may change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.

In addition, a number of state attorneys general and state bank commissioners have joined in a lawsuit seeking to limit the ability of federal regulators to preempt state law on behalf of federally chartered banks and thrifts such as the Bank. In the event the suit is successful, the Bank could be subject to additional regulation and compliance costs.

General

Savings and loan holding companies and savings associations are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors and the Savings Association Insurance Fund (“SAIF”) and not for the benefit of stockholders of Bancorp. The following information describes certain aspects of that regulation applicable to Bancorp and the Bank, and does not purport to be complete. The discussion is qualified in its entirety by reference to all particular statutory or regulatory provisions.

Regulation of Bancorp
 
General . Bancorp is a unitary savings and loan holding company subject to regulatory oversight by the Office of Thrift Supervision (“OTS”). As such, Bancorp is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over Bancorp and its subsidiaries, which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings association.

Activities Restriction Test. As a unitary savings and loan holding company, Bancorp generally is not subject to activity restrictions, provided the Bank satisfies the Qualified Thrift Lender (“QTL”) test or meets the definition of domestic building and loan association pursuant to the Internal Revenue Code of 1986, as amended (the “Code”). Bancorp presently intends to continue to operate as a unitary savings and loan holding company. Recent legislation terminated the “unitary thrift holding company exemption” for all companies that apply to acquire savings associations after May 4, 1999. Since Bancorp is grandfathered, its unitary holding company powers and authorities were not affected. See “Financial Modernization Legislation.” However, if Bancorp acquires control of another savings association as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of Bancorp and any of its subsidiaries (other than the Bank or any other SAIF-insured savings association) would become subject to restrictions applicable to bank holding companies unless such other associations each also qualify as a QTL or domestic building and loan association and were acquired in a supervisory acquisition. Furthermore, if Bancorp were in the future to sell control of the Bank to any other company, such company would not succeed to Bancorp grandfathered status under and would be subject to the same business activity restrictions. See “- Regulation of the Bank - Qualified Thrift Lender Test.”
 

 
 
  20  
 
 
Restrictions on Acquisitions . Bancorp must obtain approval from the OTS before acquiring control of any other SAIF-insured association. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings association.

Federal law generally provides that no “person,” acting directly or indirectly or through or in concert with one or more other persons, may acquire “control,” as that term is defined in OTS regulations, of a federally insured savings association without giving at least 60 days written notice to the OTS and providing the OTS an opportunity to disapprove the proposed acquisition. In addition, no company may acquire control of such an institution without prior OTS approval. These provisions also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of a savings and loan holding company, from acquiring control of any savings association not a subsidiary of the savings and loan holding company, unless the acquisition is approved by the OTS. For additional restrictions on the acquisition of a unitary thrift holding company, see “Financial Services Modernization Legislation.” Certain individuals, including Alan J. Hyatt, Louis Hyatt, and Melvin Hyatt, and their respective spouses (“Applicants”), filed an Application for Notice of Change In Control (“Notice”) in April 2001 pursuant to 12CFR Section 574.3(b). The Notice called for the Applicants to acquire up to 32.32% of the Company’s issued and outstanding shares of stock by April 16, 2002. The OTS approved requests by the Applicants to extend the time to consummate such acquisition of shares to February 9, 2005. The Applicants currently own approximately 28.65% of the total outstanding shares of the Company as of December 31, 2003.

The Sarbanes-Oxley Act of 2002
 
On July 30, 2002, President Bush signed into law The Sarbanes-Oxley Act of 2002. This new legislation addresses accounting oversight and corporate governance matters, including:
  • the creation of a five-member oversight board appointed by the SEC that will set standards for accountants and have investigative and disciplinary powers;
  • the prohibition of accounting firms from providing various types of consulting services to public clients and requiring accounting firms to rotate partners among public client assignments every five years;
  • increased penalties for financial crimes;
  • expanded disclosure of corporate operations and internal controls and required executive certification of financial presentations;
  • increased requirements for board audit committees and their members;
  • enhanced controls on, and reporting of, insider trading; and
  • statutory separations between investment bankers and analysts.
The new legislation and its implementing regulations will result in increased costs of compliance, including certain outside professional costs .
 
 
  21  
 
 
USA Patriot Act of 2001
 
On October 26, 2001, President Bush signed the USA Patriot Act of 2001. The Patriot Act is intended is to strengthen U.S. law enforcement's and the intelligence communities' abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including:

  • due diligence requirements for financial institutions that administer, maintain, or manage private banks accounts or correspondent accounts for non-US persons
  • standards for verifying customer identification at account opening
  • rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering
  • reports by nonfinancial trades and businesses filed with the Treasury Department's Financial Crimes Enforcement Network for transactions exceeding $10,000, and
  • filing of suspicious activities reports securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.
Financial Services Modernization Legislation
 
General . On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act of 1999 (the “GLB”). The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system to engage in a full range of financial activities through a new entity known as a “Financial Holding Company.” “Financial activities” is broadly defined to include not only banking, insurance, and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
 
The GLB provides that no company may acquire control of an insured savings association unless that company engages, and continues to engage, only in the financial activities permissible for a Financial Holding Company, unless grandfathered as a unitary savings and loan holding company. The GLB grandfathers any company that was a unitary savings and loan holding company on May 4, 1999 or became a unitary savings and loan holding company pursuant to an application pending on that date. Such a company may continue to operate under present law as long as the company continues to meet the two tests: it can control only one savings institution, excluding supervisory acquisitions, and each such institution must meet the QTL test. Such a grandfathered unitary savings and loan holding company also must continue to control at least one savings association, or a successor institution, that it controlled on May 4, 1999.

The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a Financial Holding Company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation.

While the GLB has not had a material adverse effect on the operations of Bancorp and the Bank in the near-term, to the extent that the act permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The GLB is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis and which unitary savings and loan holding companies already possess. Nevertheless, this act may have the result of increasing the amount of competition that Bancorp and the Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than Bancorp and the Bank. In addition, because Bancorp may only be acquired by other unitary savings and loan holding companies or Financial Holding Companies, the legislation may have an anti-takeover effect by limiting the number of potential acquirors or by increasing the costs of an acquisition transaction by a bank holding company that has not made the election to be a Financial Holding Company under the new legislation.
 
 
  22  
 
 
Regulation of the Bank
 
General . As a federally chartered, SAIF-insured savings association, the Bank is subject to extensive regulation by the OTS and the Federal Deposit Insurance Corporation (“FDIC”). Lending activities and other investments of the Bank must comply with various statutory and regulatory requirements. The Bank is also subject to certain reserve requirements promulgated by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”).

The OTS, in conjunction with the FDIC, regularly examines the Bank and prepares reports for the consideration of the Bank’s Board of Directors on any deficiencies found in the operations of the Bank. The relationship between the Bank and depositors and borrowers is also regulated by federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents utilized by the Bank.

The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the SAIF and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulations, whether by the OTS, the FDIC, or the Congress could have a material adverse impact on Bancorp, the Bank, and their operations.

Privacy . Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide:

  • initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates;
  • annual notices of their privacy policies to current customers; and
  • a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.
These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. Since FSMA’s enactment, a number of states have implemented their own versions of privacy laws. The Bank has implemented its privacy policies in accordance with the law.
 
Interagency Guidance on Response Programs to Protect Against Identity Theft
 
On August 12, 2003, the Federal bank and thrift regulatory agencies requested public comment on proposed guidance that would require financial institutions to develop programs to respond to incidents of unauthorized access to customer information, including procedures for notifying customers under certain circumstances. The proposed guidance
  • interprets previously issued interagency customer information security guidelines that require financial institutions to implement information security programs designed to protect their customers’ information; and
  • describes the components of a response program and sets a standard for providing notice to customers affected by unauthorized access to or use of customer information that could result in substantial harm or inconvenience to those customers, thereby reducing the risk of losses due to fraud or identity theft.

 

 
  23  
 
 
We are not able at this time to determine the impact of any such proposed guidance on our financial condition or results of operation.
 
Premiums for Deposit Insurance
 
Through the Bank Insurance Fund (BIF), the FDIC insures our customer deposits up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category. An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.

FDIC-insured depository institutions pay an assessment rate equal to the rate assessed on deposits insured by the Savings Association Insurance Fund (“SAIF”).

The assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. Due to continued growth in deposits and some recent bank failures, the BIF is nearing its minimum ratio of 1.25% of insured deposits as mandated by law. If the ratio drops below 1.25%, it is likely the FDIC will be required to assess premiums on all banks. Any increase in assessments or the assessment rate could have a material adverse effect on the company’s earnings, depending on the amount of the increase. Furthermore, the FDIC is authorized to raise insurance premiums under certain circumstances.

The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for one or more of the company’s subsidiary depository institutions could have a material adverse effect on the company’s earnings, depending on the collective size of the particular institutions involved.

All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The FDIC established the FICO assessment rates effective for the first half of 2004 at approximately 1.54 cents for each $100 of assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.

Regulatory Capital Requirements . The federal banking agencies have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk federal banking agencies, to 100% for assets with relatively high credit risk.

The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risk. Under the capital guidelines, a banking organization’s total capital is divided into tiers. “Tier I capital” consists of (1) common equity, (2) qualifying noncumulative perpetual preferred stock, (3) a limited amount of qualifying cumulative perpetual preferred stock and (4) minority interests in the equity accounts of consolidated subsidiaries (including trust-preferred securities), less goodwill and certain other intangible assets. Not more than 25% of qualifying Tier I capital may consist of trust-preferred securities. “Tier II capital” consists of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, preferred stock that does not qualify as Tier I capital, a limited amount of the allowance for loan and lease losses and a limited amount of unrealized holding gains on equity securities. “Tier III capital” consists of qualifying unsecured subordinated debt. The sum of Tier II and Tier III capital may not exceed the amount of Tier I capital.

 
  24  
 
 
The guidelines require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.

The Bank is not subject to any such individual minimum regulatory capital requirement.

As shown below, the Bank’s regulatory capital exceeded all minimum regulatory capital requirements applicable to it as of December 31, 2003.

 
 
 
 
Actual
 
For Capital
Adequacy Purpose s
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
   
Amount
 
 

%  

   
Amount
 

 

%  

 

 

Amount
 

 

%  
 
December 31, 2003
   
 
   
 
   
 
   
 
   
 
   
 
 
Tangible (1)
 
$
49,568,918
   
9.2
%
$
8,095,323
   
1.50
%
 
N/A
   
N/A
 
Tier I capital (2)
   
49,568,918
   
12.0
%
 
N/A
   
N/A
 
$
24,692,400
   
6.00
%
Core (1)
   
49,568,918
   
9.2
%
 
21,587,529
   
4.00
%
 
26,984,411
   
5.00
%
Risk-weighted (2)
   
54,313,918
   
13.2
%
 
32,923,200
   
8.00
%
 
41,154,000
   
10.00
%
 
   
 
   
 
   
 
   
 
   
 
   
 
 
December 31, 2002
   
 
   
 
   
 
   
 
   
 
   
 
 
Tangible (1)
 
$
39,898,384
   
8.8
%
$
6,837,788
   
1.50
%
 
N/A
   
N/A
 
Tier I capital (2)
   
39,898,384
   
12.1
%
 
N/A
   
N/A
 
$
19,768,800
   
6.00
%
Core (1)
   
39,898,384
   
8.8
%
 
18,234,100
   
4.00
%
 
22,792,625
   
5.00
%
Risk-weighted (2)
   
43,781,865
   
13.3
%
 
26,358,400
   
8.00
%
 
32,948,000
   
10.00
%
____________
(1) To adjusted total assets.
(2) To risk-weighted assets.

The Home Owners’ Loan Act (“HOLA”) permits savings associations not in compliance with the OTS capital standards to seek an exemption from certain penalties or sanctions for noncompliance. Such an exemption will be granted only if certain strict requirements are met, and must be denied under certain circumstances. If an exemption is granted by the OTS, the savings association still may be subject to enforcement actions for other violations of law or unsafe or unsound practices or conditions.

Predatory Lending . The term "predatory lending," much like the terms "safety and soundness" and "unfair and deceptive practices," is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:
  • making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation ("asset-based lending")
  • inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced ("loan flipping")
  • engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.
On October 1, 2002, FRB regulations aimed at curbing such lending became effective. The rule significantly widens the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. The following triggers coverage under the act:
  • interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities,
  • subordinate-lien loans of 10 percentage points above Treasury securities. and
  • fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.
 
  25  
 
 
In addition, the regulation bars loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law -- which says loans shouldn't be made to people unable to repay them -- unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.
 
The Bank is unable at this time to determine the impact of these rule changes and potential state action in this area on its financial condition or results of operation.

Prompt Corrective Action . The prompt corrective action regulation of the OTS, requires certain mandatory actions and authorizes certain other discretionary actions to be taken by the OTS against a savings association that falls within certain undercapitalized capital categories specified in the regulation.

The regulation establishes five categories of capital classification:
  • “well capitalized;”
  • “adequately capitalized;”
  • “undercapitalized;”
  • “significantly undercapitalized;” and
  • “critically undercapitalized.”
Under the regulation, the risk-based capital, leverage capital, and tangible capital ratios are used to determine an institution’s capital classification. At December 31, 2003, the Bank met the capital requirements of a “well capitalized” institution under applicable OTS regulations.
 
In general, the prompt corrective action regulation prohibits an insured depository institution from declaring any dividends, making any other capital distribution, or paying a management fee to a controlling person if, following the distribution or payment, the institution would be within any of the three undercapitalized categories. In addition, adequately capitalized institutions may accept Brokered Deposits only with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll-over Brokered Deposits.

If the OTS determines that an institution is in an unsafe or unsound condition, or if the institution is deemed to be engaging in an unsafe and unsound practice, the OTS may, if the institution is well capitalized, reclassify it as adequately capitalized; if the institution is adequately capitalized but not well capitalized, require it to comply with restrictions applicable to undercapitalized institutions; and, if the institution is undercapitalized, require it to comply with certain restrictions applicable to significantly undercapitalized institutions. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalized – without the express permission of the institution’s primary regulator.

Loans-to-One Borrower Limitations . Savings associations generally are subject to the lending limits applicable to national banks. With certain limited exceptions, the maximum amount that a savings association or a national bank may lend to any borrower (including certain related entities of the borrower) at one time may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. Savings associations are additionally authorized to make loans to one borrower, for any purpose, in an amount not to exceed $500,000 or, by order of the Director of OTS, in an amount not to exceed the lesser of $30,000,000 or 30% of unimpaired capital and surplus to develop residential housing, provided:
 
 
  26  
 
 
  • the purchase price of each single-family dwelling in the development does not exceed $500,000;
  • the savings association is in compliance with its fully phased-in capital requirements;
  • the loans comply with applicable loan-to-value requirements; and
  • the aggregate amount of loans made under this authority does not exceed 150% of unimpaired capital and surplus.
At December 31, 2003, the Bank’s loans-to-one-borrower limit was $7,435,000 based upon the 15% of unimpaired capital and surplus measurement. At December 31, 2003, the Bank’s largest single lending relationship had an outstanding balance of $5,200,000, and consisted of a loan secured by two office buildings in Reston, Virginia, and was performing in accordance with its terms.
 
Qualified Thrift Lender Test . Savings associations must meet a QTL test, which test may be met either by maintaining a specified level of assets in qualified thrift investments as specified in HOLA or by meeting the definition of a “domestic building and loan association” the Code. Qualified thrift investments are primarily residential mortgages and related investments, including certain mortgage-related securities. The required percentage of investments under HOLA is 65% of assets while the Code requires investments of 60% of assets. An association must be in compliance with the QTL test or the definition of domestic building and loan association on a monthly basis in nine out of every 12 months. Associations that fail to meet the QTL test will generally be prohibited from engaging in any activity not permitted for both a national bank and a savings association. As of December 31, 2003, the Bank was in compliance with its QTL requirement and met the definition of a domestic building and loan association.

Affiliate Transactions . Transactions between a savings association and its "affiliates" are quantitatively and qualitatively restricted under the Federal Reserve Act and regulations adopted by the Federal Reserve. Affiliates of a savings association include, among other entities, the savings association's holding company and companies that are under common control with the savings association. In general, a savings association or its subsidiaries are limited in their ability to engage in "covered transactions" with affiliates:
  • to an amount equal to 10% of the association's capital and surplus, in the case of covered transactions with any one affiliate; and
  • to an amount equal to 20% of the association's capital and surplus, in the case of covered transactions with all affiliates.
In addition, a savings association and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the savings association or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A "covered transaction" includes:
  • a loan or extension of credit to an affiliate;
  • a purchase of investment securities issued by an affiliate;
  • a purchase of assets from an affiliate, with some exceptions;
  • the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; or
  • the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, under the OTS regulations:
  • a savings association may not make a loan or extension of credit to an affiliate unless the affiliate is engaged only in activities permissible for bank holding companies;
  • a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary;
  • a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate;
  • covered transactions and other specified transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and
  • with some exceptions, each loan or extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.
 
  27  
 
 
Regulations generally exclude all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except for:
  • a financial subsidiary,
  • a subsidiary controlled by one or more affiliates,
  • an ESOP, or
  • a subsidiary determined by the OTS or the Federal Reserve to be an affiliate.
The regulations also require savings associations to make and retain records that reflect affiliate transactions in reasonable detail and provides that specified classes of savings associations may be required to give the OTS prior notice of affiliate transactions.

Some of the entities included in the definition of an affiliate are parent companies, sister banks, sponsored and advised companies, investment companies whereby the bank its affiliate serves as investment advisor, and financial subsidiaries of the bank. Additional restrictions on transactions with affiliates may be imposed on us under the prompt corrective action provisions of federal law. See “- Prompt Corrective Action and Other Enforcement Mechanisms.”

Capital Distribution Limitations . OTS regulations impose limitations upon all capital distributions by savings associations, like cash dividends, payments to repurchase or otherwise acquire its shares, payments to shareholders of another institution in a cash-out merger and other distributions charged against capital.
 
The OTS regulations require a savings association to file an application if:
  • it is not eligible for expedited treatment of its other applications under OTS regulations;
  • the total amount of all of capital distributions, including the proposed capital distribution, for the applicable calendar year exceeds its net income for that year to date plus retained net income for the preceding two years;
  • it would not be at least adequately capitalized, under the prompt corrective action regulations of the OTS following the distribution; or
  • the association's proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the savings association and the OTS, or the FDIC, or violate a condition imposed on the savings association in an OTS-approved application or notice.
In addition, a savings association must give the OTS notice of a capital distribution if the savings association is not required to file an application, but:
  • would not be well capitalized under the prompt corrective action regulations of the OTS following the distribution;
  • the proposed capital distribution would reduce the amount of or retire any part of the savings association's common or preferred stock or retire any part of debt instruments like notes or debentures included in capital, other than regular payments required under a debt instrument approved by the OTS; or
  • the savings association is a subsidiary of a savings and loan holding company.
If neither the savings association nor the proposed capital distribution meets any of the above listed criteria, the OTS does not require the savings association to submit an application or give notice when making the proposed capital distribution. The OTS may prohibit a proposed capital distribution that would otherwise be permitted if the OTS determines that the distribution would constitute an unsafe or unsound practice.

Interstate Banking and Branching. A federal savings association has the ability to establish branches outside its home state. Commercial banks can also branch across state lines, subject to any state law limitations or prohibitions. Competition may increase further as banks branch across state lines and enter new markets.
 
 
  28  
 
 
Community Reinvestment Act and the Fair Lending Laws . Savings associations have a responsibility under the Community Reinvestment Act and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities and the denial of applications. In addition, an institution's failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in the OTS, other federal regulatory agencies as well as the Department of Justice taking enforcement actions. Based on an examination conducted July 7,2003, the Bank received a satisfactory rating.

Effective January 1, 2002, the OTS raised the dollar amount limit in the definition of small business loans from $500,000 to $2.0 million, if used for commercial, corporate, business or agricultural purposes. Furthermore, the rule raises the aggregate level that a thrift can invest directly in community development funds, community centers and economic development initiatives in its communities from the greater of a quarter of one percent of total capital or $100,000 to one percent of total capital or $250,000.

Federal Home Loan Bank System . The Bank is a member of the FHLB system. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. As an FHLB member, the Bank is required to own capital stock in an FHLB in an amount equal to the greater of:
  • 1% of its aggregate outstanding principal amount of its residential mortgage loans, home purchase contracts and similar obligations at the beginning of each calendar year; or
  • 5% of its FHLB advances or borrowings.
At December 31, 2003, the Bank was in compliance with this requirement.

The GLB Act made significant reforms to the FHLB system, including:

  • Expanded Membership – (i) expands the uses for, and types of, collateral for advances; (ii) eliminates bias toward QTL lenders; and (iii) removes capital limits on advances using real estate related collateral (e.g., commercial real estate and home equity loans).
  • New Capital Structure – each FHLB is allowed to establish two classes of stock: Class A is redeemable within six months of notice; and Class B is redeemable within five years notice. Class B is valued at 1.5 times the value of Class A stock. Each FHLB will be required to maintain minimum capital equal to 5% of equity. As of July 17, 2002, each FHLB, including our FHLB of Atlanta, received Federal Housing Finance Board approval of its capital plan. These plans must be implemented by July 1, 2004.
  • Voluntary Membership – federally chartered savings associations, such as the Bank, are no longer required to be members of the system.
  • REFCorp Payments – changes the amount paid by the system on debt incurred in connection with the thrift crisis in the late 1980s from a fixed amount to 20% of net earnings after deducting certain expenses.
Federal Reserve System . The Federal Reserve Board requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits. At December 31, 2003, the Bank was in compliance with these requirements.

Activities of Subsidiaries . A savings association seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through a subsidiary must provide 30 days prior notice to the FDIC and the OTS and conduct any activities of the subsidiary in compliance with regulations and orders of the OTS. The OTS has the power to require a savings association to divest any subsidiary or terminate any activity conducted by a subsidiary that the OTS determines to pose a serious threat to the financial safety, soundness or stability of the savings association or to be otherwise inconsistent with sound banking practices.

 
  29  
 
 
Item 2. Properties

Bancorp owns its retail branch locations at 1917 West Street, Annapolis, Maryland 21401 and 413 Crain Highway, South-East, Glen Burnie, Maryland 21061. The Bank’s executive office at 1919A West Street, Annapolis, Maryland 21401 (which also serves as a loan production office) is leased from HRE, a wholly owned subsidiary of Bancorp. HRE owns its office building at 1919 West Street, Annapolis, Maryland 21401.

The Bank leases space for its accounting and loan servicing offices from a third party at 1927 West Street, Annapolis, Maryland 21401. Homeowner’s Title, a subsidiary of the Bank, leases space at 1925 West Street, Annapolis, Maryland 21401 from a limited liability company of which Alan J. Hyatt, Bancorp’s Chairman and Chief Executive Officer, is a principal, on a term of 3 years, subject to the right of Homeowner’s Title to exercise early termination, at its option. Current monthly rental paid by Homeowner’s Title is $3,664.50.

HS West, LLC, a subsidiary of Bancorp, intends to construct a building in the Annapolis, Maryland area to serve as the administrative headquarters. A branch office will be included. To date, HS West , LLC has incurred approximately $1,701,854 of cost including the value of the land. The total cost is expected to be approximately $17,000,000, with completion in November 2005.

Item 3. Legal Proceedings

There are no material pending legal proceedings to which Bancorp, the Bank or any subsidiary is a party or to which any of their property is subject.

Item 4. Submission of Matters to a Vote of Security Holders

None.
 
PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

Quarterly Stock Information*
2003
2002
 
Stock Price Range
 
 
Stock Price Range
 
Quarter
Low
High
Per Share Dividend
Quarter
Low
High
Per Share Dividend
1 st
$ 15.82
$ 22.00
$.08
1 st
$ 8.67
$ 11
$.06
2 nd
20.08
25.10
.08
2 nd
9.75
17
.06
3 rd
21.60
32.00
.09
3 rd
14.64
16.97
.06
4 th
29.85
34.20
.09
4 th
14.75
16.15
.06

*Adjusted to give retroactive effect to a 3 for 1 stock split declared February 19, 2002.

Common shares of Bancorp are traded on the National Association of Security Dealers Small Cap Market under the symbol “SVBI”.

Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016-3572, serves as the Transfer Agent and Registrar for Bancorp.

Equity Compensation Plan Table . See Part III, Item 11.
 
 
  30  
 

Item 6. Selected Financial Data

The following financial information is presented from the audited financial statements of Bancorp. The information is a summary and should be read in conjunction with management’s Discussions and Analysis of Financial Condition and Results of Operations.

Summary Financial and Other Data
 
 
 
 
 
 
at December 31,
 
2003
2002
2001
2000
1999
 
(dollars in thousands, except per share information)
Balance Sheet Data
 
 
 
 
 
Total assets
$
540,471
 
$
458,415
 
$
366,890
 
$
293,230
 
$
233,724
 
Cash and cash equivalents
 
8,426
   
18,660
   
6,038
   
1,007
   
2,430
 
Total loans, net
 
506,026
   
418,825
   
342,641
   
274,652
   
214,066
 
Securities available for sale
 
-
   
-
   
-
   
858
   
812
 
Mortgage backed securities and securities
 
 
   
 
   
 
   
 
   
 
 
held to maturity
 
12,721
   
9,661
   
7,213
   
9,779
   
10,326
 
 
 
 
   
 
   
 
   
 
   
 
 
Nonperforming loans
 
469
   
1,758
   
2,101
   
1,178
   
925
 
Real estate acquired through foreclosure
 
-
   
224
   
312
   
312
   
672
 
Total nonperforming assets
 
469
   
1,982
   
2,413
   
1,490
   
1,597
 
 
 
 
   
 
   
 
   
 
   
 
 
Deposits
 
419,726
   
377,925
   
286,918
   
229,312
   
186,204
 
Short-term borrowings
 
6,000
   
-
   
17,000
   
18,000
   
2,000
 
Notes payable
 
59,000
   
34,000
   
25,000
   
16,000
   
22,000
 
Total liabilities
 
487,501
   
415,233
   
332,059
   
268,009
   
211,743
 
 
 
 
   
 
   
 
   
 
   
 
 
Minority Interest – Preferred Securities of
Subsidiary
 
4,000
   
4,000
   
4,000
   
3,892
   
3,892
 
 
 
 
   
 
   
 
   
 
   
 
 
Stockholders’ equity
 
48,970
   
39,181
   
30,831
   
21,329
   
18,089
 
Common shares outstanding *
 
4,159,092
   
4,142,592
   
4,057,092
   
3,239,316
   
3,234,492
 
Book value per common shares *
 
11.77
   
9.46
   
7.60
   
6.58
   
5.59
 
 
 
 
   
 
   
 
   
 
   
 
 
Other Data:
 
 
   
 
   
 
   
 
   
 
 
Number of:
 
 
   
 
   
 
   
 
   
 
 
Full service retail banking facilities
 
2
   
2
   
2
   
2
   
2
 
Full-time equivalent employees
 
81
   
69
   
67
   
66
   
63
 
 
 
 
   
 
   
 
   
 
   
 
 
* Retroactively adjusted to reflect three-for-one stock split declared February 19, 2002.
 
 
   
 
 

 
  31  
 


Summary of Operations
 
 
 
 
 
 
For the Year Ended December 31,
 
2003
2002
2001
2000
1999
 
(dollars in thousands, except per share data)
Interest and dividend income
$
37,087
 
$
33,402
 
$
29,489
 
$
24,271
 
$
20,047
 
Interest expense
 
12,341
   
13,799
   
16,094
   
13,387
   
10,523
 
 
 
 
 
 
 
Net interest income
 
24,746
   
19,603
   
13,395
   
10,884
   
9,524
 
Provision for loan losses
 
900
   
670
   
708
   
591
   
504
 
 
 
 
 
 
 
Net interest income after provision for loan losses
 
23,846
   
18,933
   
12,687
   
10,293
   
9,020
 
Noninterest income
 
4,674
   
4,133
   
2,570
   
1,439
   
1,586
 
Noninterest expense
 
9,616
   
8,447
   
6,588
   
5,348
   
5,477
 
 
 
 
 
 
 
Earnings before income tax provision
 
18,904
   
14,619
   
8,669
   
6,384
   
5,129
 
Provision for income taxes
 
7,575
   
5,671
   
3,413
   
2,439
   
2,002
 
 
  		 
  		 
  		 
  		 
  		 
Net income
$
11,329
 
$
8,948
 
$
5,256
 
$
3,945
 
$
3,127
 
 
 
 
 
 
 
Per Share Data:
 
 
   
 
   
 
   
 
   
 
 
Basic earnings per share *
$
2.68
 
$
2.13
 
$
1.38
 
$
1.15
 
$
0.90
 
Diluted earnings per share *
$
2.67
 
$
2.13
 
$
1.37
 
$
1.12
 
$
0.84
 
Weighted number of shares outstanding basic *
 
4,146,566
   
4,092,188
   
3,647,451
   
3,237,888
   
3,230,940
 
Weighted number of shares outstanding diluted *
 
4,157,302
   
4,103,223
   
3,683,346
   
3,330,915
   
3,450,831
 
 
 
 
   
 
   
 
   
 
   
 
 
* Retroactively adjusted to reflect three-for-one stock split declared February 19, 2002.
 
 
   
 
 
 

 
 
  32  
 
 

 
Key Operating Ratios
 
 
 
 
 
 
 
 
 
 
 
 
For the Year Ended December 31,
 
2003
2002
2001
2000
1999
 
(dollars in thousands)
Performance Ratios:
 
 
   
 
   
 
   
 
   
 
 
Return on average assets
 
2.23
%
 
2.14
%
 
1.55
%
 
1.47
%
 
1.38
%
Return on average equity
 
25.22
%
 
25.58
%
 
20.22
%
 
20.04
%
 
18.31
%
Net interest margin
 
4.99
%
 
4.86
%
 
4.05
%
 
4.17
%
 
4.34
%
Interest rate spread
 
4.77
%
 
4.59
%
 
3.65
%
 
3.75
%
 
3.94
%
Noninterest expense to average assets
 
1.76
%
 
2.02
%
 
1.95
%
 
2.00
%
 
2.43
%
Efficiency ratio
 
30.33
%
 
35.59
%
 
41.27
%
 
43.40
%
 
49.30
%
 
 
 
   
 
   
 
   
 
   
 
 
Asset Quality Ratios:
 
 
   
 
   
 
   
 
   
 
 
Equity to Assets
 
9.06
%
 
8.55
%
 
8.40
%
 
7.27
%
 
7.74
%
Nonperforming assets to total assets
 
 
   
 
   
 
   
 
   
 
 
at end of period
 
0.09
%
 
0.43
%
 
0.66
%
 
0.51
%
 
0.68
%
Nonperforming loans to total gross
 
 
   
 
   
 
   
 
   
 
 
loans at end of period
 
0.08
%
 
0.36
%
 
0.51
%
 
0.36
%
 
0.36
%
Allowance for loan losses to total
 
 
   
 
   
 
   
 
   
 
 
gross loans at end of period
 
0.79
%
 
0.81
%
 
0.82
%
 
0.83
%
 
0.84
%
Allowance for loan losses to
 
 
   
 
   
 
   
 
   
 
 
nonperforming loans at end of period
 
1030.49
%
 
227.02
%
 
159.59
%
 
231.58
%
 
232.11
%
 
 
 
   
 
   
 
   
 
   
 
 
Mortgage Origination and Servicing Data:
 
 
   
 
   
 
   
 
   
 
 
Mortgage loans originated or purchased
$
320,902
 
$
343,787
 
$
342,915
 
$
213,614
 
$
180,782
 
Mortgage loans sold
 
133,871
   
100,535
   
60,302
   
36,869
   
37,706
 
Mortgage loans serviced for others
 
24,016
   
23,935
   
17,376
   
21,648
   
23,186
 
Capitalized value of mortgage
 
 
   
 
   
 
   
 
   
 
 
servicing rights
 
13
   
19
   
26
   
33
   
39
 



  33  

Average Balance Sheet
Average Balance Sheet. The following table contains for the periods indicated information regarding the total dollar amounts of interest income from interest-earning assets and the resulting average yields, the total dollar amount of interest expense on interest-bearing liabilities and the resulting average costs, net interest income, and the net yield on interest-earning assets.
 
 
Years Ended December 31,
 
2003
 
2002
 
2001
 
Average
 
 
 
Average
 
 
 
Average
 
 
 
Volume
Interest
Yield/Cost
 
Volume
Interest
Yield/Cost
 
Volume
Interest
Yield/Cost
 
(dollars in thousands)
ASSETS
 
 
 
 
 
 
 
 
 
 
 
Loans (1)
$ 466,512
$ 36,403
7.80%
 
$ 384,537
$ 32,723
8.51%
 
$ 313,798
$ 28,617
9.12%
Investments (2)
6,167
243
3.94%
 
7,339
362
4.93%
 
7,671
450
5.86%
Mortgage-backed securities
6,586
210
3.18%
 
1,346
54
4.00%
 
255
18
7.09%
Other interest-earning assets (3)
16,749
231
1.38%
 
10,123
263
2.60%
 
8,773
404
4.60%
Total interest-earning assets
496,014
37,087
7.48%
 
403,345
33,402
8.28%
 
330,497
29,489
8.92%
Non-interest earning assets
11,894
 
 
 
13,979
 
 
 
7,800
 
 
 
  		   
  		     
  		   
Total Assets
$ 507,908
 
 
 
$ 417,324
 
 
 
$ 338,297
 
 
 
 
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
 
 
 
 
Savings and checking deposits
$ 187,979
$  2,997
1.59%
 
$ 138,961
$  3,485
2.51%
 
$   69,846
$  2,422
3.47%
Certificates of deposits
222,819
7.964
3.57%
 
198,613
8,815
4.44%
 
190,391
11,170
5.87%
Borrowings
43,833
1,380
3.15%
 
36,500
1,499
4.11%
 
45,250
2,502
5.53%
Total interest-bearing liabilities
454,631
12,341
2.71%
 
374,074
13,799
3.69%
 
305,487
16,094
5.27%
Non-interest bearing liabilities
4,360
 
 
 
4,271
 
 
 
2,866
 
 
Minority Interest – Preferred Securities of Subsidiary
4,000
 
 
 
4,000
 
 
 
3.946
 
 
Stockholders' equity
44,917
 
 
 
34,979
 
 
 
25,998
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total liabilities and stockholders' equity
$ 507,908
 
 
 
$ 417,324
 
 
 
$ 338,297
 
 
Net interest income and Interest rate spread
 
$ 24,746
4.77%
 
 
$ 19,603
4.59%
 
 
$ 13,395
3.65%
Net interest margin
 
 
4.99%
 
 
 
4.86%
 
 
 
4.05%
Average interest-earning assets to
 
 
 
 
 
 
 
 
 
 
 
average interest-bearing liabilities
 
 
109.10%
 
 
 
107.82%
 
 
 
108.19%
             
(1) Non-accrual loans are included in the average balances and in the computation of yields.
 
 
 
 
 
 
(2) The Company does not have any tax exempt securities.
 
 
 
 
 
 
 
 
 
 
(3) Other interest earning assets includes interest bearing deposits in other banks, federal funds, and FHLB stock investments.
 
 



  34  

Rate Volume Table
 
   
Year ended December 31, 2003 vs. Year ended December 31, 2002  
   
Year ended December 31, 2002 vs. Year ended December 31, 2001  
 
   
Total   
 

  Changes Due to

   
Total   
   
Changes Due to  
 
   
Change  
   
Volume (1)
   
Rate (1)  
   
Change  
   
Volume (1)
   
Rate (1)  
 
 

  (dollars in thousands)

Interest-earning assets
 
 
   
 
   
 
   
 
   
 
   
 
 
Loans
$
3,680
 
$
6,631
 
$
(2,951
)
$
4,106
 
$
6,128
 
$
(2,022
)
Investments
 
(119
)
 
(53
)
 
(66
)
 
(88
)
 
(18
)
 
(70
)
Mortgage-backed securities
 
156
   
170
   
(14
)
 
36
   
46
   
(10
)
Other interest-earning assets
 
(32
)
 
121
   
(153
)
 
(141
)
 
55
   
(196
)
 
 
 
 
 
 
 
Total interest income
$
3,685
 
$
6,869
 
$
(3,184
)
$
3,913
 
$
6,211
 
$
(2,298
)
 
 
 
   
 
   
 
   
 
   
 
   
 
 
Interest-bearing liabilities
 
 
   
 
   
 
   
 
   
 
   
 
 
Savings and checking deposits
$
(488
)
$
1,010
 
$
(1,498
)
$
1,063
 
$
1,867
 
$
(804
)
Certificates of deposits
 
(851
)
 
1,000
   
(1,851
)
 
(2,355
)
 
463
   
(2,818
)
Borrowings
 
(119
)
 
340
   
(459
)
 
(1,003
)
 
(434
)
 
(569
)
 
 
 
 
 
 
 
Total interest expense
$
(1,458
)
$
2,350
 
$
(3,808
)
$
(2,295
)
$
1,896
 
$
(4,191
)
 
  		 
  		 
  		 
  		 
  		 
  		 
Net change in interest income
$
5,143
 
$
4,519
 
$
624
 
$
6,208
 
$
4,315
 
$
1,893
 
 
 
 
 
 
 
 
 
 
 
   
 
   
 
   
 
   
 
   
 
 
(1) Changes in interest income/expense not arising from volume or rate variances are allocated proportionately to rate and volume.

 
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies

The Company’s significant accounting policies are set forth in note 1 of the consolidated financial statements for the year ended December 31, 2003 which are set forth on pages F-2A through F-37. Of these significant accounting policies, the Company considers the policy regarding the allowance for loan losses to be its most critical accounting policy, given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio and the material effect that such judgments can have on the results of operations. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. The Company has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers that is not known to management at the time of the issuance of the consolidated financial statements.
 
 
  35  
 

Overview

The primary business of Bancorp is mortgage lending. The markets in which Bancorp operates, Anne Arundel County, Maryland, as well as surrounding areas in Maryland, northern Virginia and Delaware, have enjoyed strong real estate demand. This has fueled Bancorp’s growth, along with the demand to refinance existing mortgages as a result of historically low interest rates. Refinancing activity began to slow down toward the end of the third quarter of 2003, and slowed considerably in the fourth quarter of 2003. However, with interest rates remaining low, construction lending and purchase money mortgage lending have continued to be extremely active.

Bancorp has been able to take advantage of the low interest rate environment and reduce its cost of liabilities. Interest rates paid on deposits have decreased significantly, as have interest rates paid for borrowing funds from the Federal Home Loan Bank of Atlanta. The difference between Bancorp’s costs of funds and what it earns on mortgage loans is the interest rate “spread”. This spread has increased as Bancorp’s growing portfolio of mortgage loans coupled with the fees earned on loans sold in the secondary market, has driven up overall revenues. While variable expenses, such as compensation, have increased, Bancorp’s overall expenses have remained modest which has resulted in increasing profitability.

Bancorp’s asset quality has remained excellent, as there have been minimal losses due to defaulting loans.

Going forward, Bancorp’s challenge will be to continue to grow assets in the form of mortgage loans, while earning a profitable spread, and continuing to maintain good asset quality.

Interest rates are outside the control of Bancorp, so it must attempt to balance its pricing and duration of its loan portfolio against the risks of rising costs of its deposits and borrowings.

The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to Bancorp’s ability to originate and grow its mortgage loans, as will Bancorp’s continued focus on maintaining a low overhead.

Financial Condition
 
At December 31, 2003 total assets were $540,471,000 compared to $458,415,000 at December 31, 2002, which represents an increase of $82,056,000 or 17.9%. The following discusses the material changes between the December 31, 2003 and 2002 balance sheets.

Loans
 
Loans Held For Sale. At December 31, 2003 loans held for sale was $3,175,0000 compared to $17,481,000 at December 31, 2002. This decrease of $14,306,000 or 81.8% was due to a reduction in the loan portfolio intended to be sold to investors in the secondary market. Most of the loans sold in the secondary market have been loans that refinanced existing mortgages. Beginning in late third quarter, and continuing into the fourth quarter of 2003, loans that refinanced existing mortgages were significantly reduced and, as a result, there were less loans available for sale in the secondary market as of December 31, 2003.
 
Loans Receivable. Total net portfolio loans receivable were $502,851,000 at December 31, 2003, an increase of $101,508,000 or 25.3% from $401,343,000 at December 31, 2002. The increase in the loan portfolio resulted from the continuing increases in loan demand, resulting from the continued historically low interest rates. The increase in the loan portfolio included increases in residential mortgage loans, residential construction loans and commercial mortgage loans.
 
Federal Home Loan Bank of Atlanta Stock. Total Federal Home Loan Bank of Atlanta stock owned by Bancorp at December 31, 2003 was $3,250,000, compared to $1,900,000 of Federal Home Loan Bank of Atlanta Stock owned as of December 31, 2002. This increase of $1,350,000, or 71.1%, resulted from an increase in the advances taken by Bancorp from the Federal Home Loan Bank of Atlanta outstanding as of December 31, 2003 compared to December 31, 2002, as the Bank is obligated to purchase Federal Home Loan Bank stock based upon the amount outstanding in advances at any given time.

 
  36  
 
 
Premises and Equipment. Premises and equipment totaled $5,327,000 at December 31, 2003 compared to $4,738,000 at December 31, 2002. This increase of $589,000 or 12.4%, primarily represents the continued investment in the property owned by HS West, LLC, a subsidiary of the Bank, as it prepares to construct an office building for use by Bancorp and its subsidiaries for its corporate headquarters at West Gate Circle in Annapolis, Maryland.
 
The following table contains for the periods indicated information regarding the financial obligations owing by the Company for leases of certain properties.

Contractual Obligations
Payments due by period
(dollars in thousands)
 
Total
Less than 1 year
1-3
years
3-5
years
More than 5 years
 
 
 
 
 
 
Long term debt
$
59,000
 
$
5,000
 
$
12,000
 
$
15,000
 
$
27,000
 
 
 
 
   
 
   
 
   
 
   
 
 
Operating lease obligations
 
30
   
28
   
2
   
-
   
-
 
 
 
 
   
 
   
 
   
 
   
 
 
Certificates of Deposit
 
226,833
   
125,651
   
69,987
   
31,195
   
-
 
Other long term liabilities reflected
 
 
   
 
   
 
   
 
   
 
 
on the Company’s balance sheet
 
 
   
 
   
 
   
 
   
 
 
under GAAP
 
-
   
-
   
-
   
-
   
-
 
 
 
 
 
 
 
Total
$
285,863
 
$
130,679
 
$
81,989
 
$
46,195
 
$
27,000
 
 
 
 
 
 
 

Liabilities
 
Deposits.   Total deposits were $419,726,000 at December 31, 2003 compared to $377,925,000 at December 31, 2002. This represents an increase of $41,801,000 or 11.1%. The increase in deposits was used to fund loan growth, however, the Bank found it increasingly more difficult to generate deposits at reasonable rates throughout the year and implemented a plan to utilize wholesale funds, in the form of Federal Home Loan Bank advances, which had more attractive pricing than rates that would have had to be paid for retail deposits.
 
FHLB Advances. FHLB advances were $65,000,000 at December 31, 2003 compared to $34,000,000 at December 31, 2002, which is an increase of $31,000,000 or 91.2%. This increase was due to the fact that rates paid on Federal Home Loan Bank advances were less expensive than what the Bank was able to generate through retail deposits and the Bank implemented a strategy to lock in interest rates for a longer term in the form of advances from the Federal Home Loan Bank for terms of three years and longer.
 
Stockholders’ Equity. Total stockholders’ equity was $48,970,000 as of December 31, 2003, which compared to $39,181,000 as of December 31, 2002. This increase of $9,789,000, or 25.09%, resulted primarily from net income, offset by dividend declarations.
 
Off-Balance Sheet Arrangements . The Company has certain outstanding commitments and obligations that could impact the Company’s financial condition, liquidity, revenues or expenses. These commitments and obligations include standby letters of credit, home equity loans, loan commitments, lines of credit, and loans sold and serviced with limited repurchase provisions.
 
Standby letters of credit, which are obligations of the Company to guarantee performance of borrowers to governmental entities, were $7,982,000 as of December 31, 2003 compared to $6,694,000 as of December 31, 2002. This increase of $1,288,000 or 19.2% was a result of increased demand by the Company’s borrowers for letter of credit requirements.

 
  37  
 
 
Home equity loans increased $4,128,000, or 51.5%, from $8,014,000 as of December 31, 2002 to $12,142,000 as of December 31, 2003. Home equity loans are loans that allow the borrowers to draw funds up to a specified loan amount, from time to time. The Company’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans. This increase was a result of the general increase in loan demand and low interest rates offered on home equity loans.
 
Loan commitments as of December 31, 2003 were $24,520,000, compared to $24,772,000 as of December 31, 2002. This was a decrease of $252,000, or 1%. Loan commitments are obligations of the Company to provide loans, and such commitments are made in the usual course of business.
 
Lines of credit, which are obligations of the Company to fund loans made to certain borrowers, were $20,436,000 as of December 31, 2003, compared to $22,368,000 as of December 31, 2002. This decrease of $1,932,000, or 8.6%, was a result of less demand for this type of loan product. The Company’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans.
 
Loans sold and serviced with limited repurchase provisions increased $22,714,000, or 223.5%, from $10,163,000 as of December 31, 2002, to $32,877,000 as of December 31, 2003. This increase was a result of the increase in loans sold on the secondary market.
 
The Company uses the same credit policies in making commitments and conditional obligations as it does for its on-balance sheet instruments.

Comparison of Results of Operation for the Years Ended December 31, 2003 and 2002.
 
General. Bancorp’s net income for the year ended December 31, 2003 was $11,329,000 or $2.67 per share, diluted, compared to $8,948,000 or $2.13 per share, diluted, for the year ended December 31, 2002. This increase of $2,381,000 or 26.6% was primarily the result of increases in loan origination volume and the increase in interest income coupled with a reduction in the cost of deposits and other borrowings, as well as the maintenance of relatively low non-interest expenses. It is uncertain whether Bancorp will be able to generate the volume of loan originations that it has done over the past two years as the trend, beginning in the third quarter of 2003, was that refinances of mortgages were significantly slowing down. However, loan originations, overall, remain strong, and provided the real estate market in the Bank’s primary lending areas remain positive, the Bank may continue with strong loan originations.
 
Net Interest Income. Net interest income (interest earned net of interest charges) totaled $24,746,000 for the year ended December 31, 2003, as compared to $19,603,000 for the year ended December 31, 2002, or an increase of $5,143,000 or 26.2%. This increase was due to the growth in the loan portfolio and the reduction on the interest on deposits and Federal Home Loan Bank advances. The net interest margin increased to 4.99% at December 31, 2003 from 4.86% at December 31, 2002. The Bank’s net interest margin increased over the past year because interest rates paid on the Bank’s deposits have fallen faster than the interest rates earned on the Bank’s assets. However, the increase in the net interest margin slowed from the increase between December 31, 2001 and December 31, 2002 and the Bank does not expect that interest on its deposits and Federal Home Loan Bank advances will continue to drop as it has over the last two years. The Bank is uncertain whether it will be able to continue to attract low cost liabilities, as it has done in the last two years due to the general expectation of rising interest rates in the future and the recent flow of depositor funds into the stock market.
 
Provision for Loan Losses. Bancorp’s loan portfolio is subject to varying degrees of credit risk and an allowance for loan losses is maintained to absorb losses inherent in its loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what Bancorp determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio at least as often as quarterly and its loan delinquencies at least as often as monthly. All loans that are delinquent and all loans within the various categories of the Bank’s portfolio as a group are evalulated. The Bank’s Board, with the advice and recommendation of the Bank’s delinquency committee, estimates an allowance to be set aside for loan losses. Included in determining the calculation are such factors as the inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectibility. An increase in the loan loss provision from the beginning of the period to the end of a period would have come about after an analysis of the aforementioned factors and applying that rationale to the total portfolio.

 
  38  
 
 
The greater the construction, commercial and higher loan-to-value loans that are contained in the portfolio, the greater will be the allowance for loan losses. Changes in estimation methods may take place based upon the status of the economy and the estimate of the value of collateral and, as a result, the allowance may increase or decrease. The Bank believes that some portions of its loan portfolio have greater actual risk and, in other areas, there is greater inherent risk. The loan loss allowance has increased when the Board believes trends are negative and contributions to the allowance have decreased when trends are more positive. Management believes that the allowance for loan losses is adequate.
 
As of December 31, 2003, the total allowance for loan losses was $4,833,000 as compared to $3,991,000 as of December 31, 2002, which is an increase of $842,000 or 21.1%. The increase was a result of the current year’s addition to the allowance and minimal charge offs being incurred. During the year ended December 31, 2003, the provision for loan losses was $900,000 compared to $670,000 for the year ended December 31, 2002. This increase of $230,000 or 34.3%, was a result of Management’s determination that adding to the provision for loan losses was, more or less, appropriate for the level of inherent risk in its portfolio as compared to the year ended December 31, 2002.
 
Other Income and Non Interest Expense. Gain on sale of loans was $1,563,000 for the year ended December 31, 2003 compared to $1,264,000 for the year ended December 31, 2002. This increase of $299,000, or 23.7%, was a result of an increasing volume of loan originations due to the continued low interest rate environment that resulted in the continuing refinance of residential mortgages. However, beginning in the late third quarter of 2003 the refinance of residential mortgages began to decline significantly and the Bank anticipates, but is not certain, that loan originations in the form of residential refinances are likely to decrease in the future. If this happens, there is likely to be a reduction in the amount of gain on sale of loans which will also cause a reduction in mortgage processing fees. Compensation paid to loan officers for the originations of loans would also commensurately be reduced.
 
Real estate commissions and real estate management fees for the year ended December 31, 2003 were $1,160,000 and $369,000, respectively, as compared to December 31, 2002 when real estate commissions and real estate management fees were $1,237,000 and $383,000, respectively. In the aggregate, this was a decrease of $91,000 or 5.6%. Real estate management fees are a steadier recurring source of revenue and provided Hyatt Real Estate maintains property management accounts, there is a likelihood that management fees will continue in the future. It is Bancorp’s intention to acquire real estate through subsidiaries of SBI Mortgage Company, where such subsidiaries will serve as managing members or general partners of entities that expect to own real estate for investment purposes. Equity will be raised through private placements of securities and, if successful, Hyatt Real Estate should be able to earn commissions and/or acquisition fees on the properties acquired as well as receive leasing commission revenue and real estate management fees for services rendered.
 
Mortgage processing and servicing fees for the year ended December 31, 2003 were $928,000 compared to $724,000 for the year ended December 31, 2002. This increase of $204,000, or 28.2%, was a result of the continued growth in the Bank’s originations and loan portfolio.
 
Compensation and related expenses totaled $6,976,000 for the year ended December 31, 2003 compared to $6,065,000 for the year ended December 31, 2002, which was an increase of $911,000 or 15.02%. This increase during 2003 was attributable to the fact that the Bank increased its personnel to 81 full time equivalent employees as of December 31, 2003 compared to 69 full time equivalent employees as of December 31, 2002.

 
  39  
 
 
Other non-interest expense totaled $2,106,000 for the year ended December 31, 2003 compared to $1,883,000 for the year ended December 31, 2002 which was an increase of $223,000 or 11.8%. Other non-interest expense consists primarily of office and computer supplies, mail expenses, telephone and other expenses. In 2003 Bancorp underwent a conversion of its data service bureau.
 
Income taxes for the year ended December 31, 2003 were $7,575,000 compared to $5,671,000 for the year ended December 31, 2002. This increase of $1,904,000 or 33.6% was a result of an increase in income before income tax provision to $18,904,000 for the year ended December 31, 2003 compared to $14,619,000 for the year ended December 31, 2002, being an increase of $4,285,000 or 29.3%. The effective tax rate for the years ended December 31, 2003 and 2002 were 40.07% and 38.79% respectively.
 
Liquidity and Capital Resources. Bancorp’s liquidity is determined by its ability to raise funds through loan payments, maturing investments, deposits, borrowed funds, capital, or the sale of loans. Based on the internal and external sources available, Bancorp’s liquidity position exceeded anticipated short-term and long-term needs at December 31, 2003. Core deposits, considered to be stable funding sources and defined to include all deposits except time deposits of $100,000 or more, equaled 86% of total deposits at December 31, 2003. The Bank’s experience is that a substantial portion of certificates of deposit will renew at time of maturity and will remain on deposit with the Bank. Additionally, loan payments, maturities, deposit growth and earnings contribute a flow of funds available to meet liquidity requirements.
 
In addition to its ability to generate deposits, Bancorp has external sources of funds which may be drawn upon, when desired. The primary source of external liquidity is an available line of credit equal to 25% of the Bank’s assets with the Federal Home Loan Bank of Atlanta. The available line of credit with the Federal Home Loan Bank of Atlanta was $135,000,000 at December 31, 2003, of which $65,000,000 was outstanding at that time.
 
In assessing its liquidity the management of Bancorp considers operating requirements, anticipated deposit flows, expected funding of loans, deposit maturities and borrowing availability, so that sufficient funds may be available on short notice to meet obligations as they arise so that Bancorp may take advantage of business opportunities. A further consideration relating to liquidity concerns the need for funds to construct the administrative headquarters building at Westgate Circle, the construction of which should begin in 2004. As of December 31, 2003 Bancorp had $24,520,151 outstanding in loan commitments, which Bancorp expects to fund from the sources of liquidity described above. This amount does not include undisbursed lines of credit, home equity loans and standby letters of credit, in the aggregate amount of $40,559,919, which Bancorp anticipates it will be able to fund, if required, from these liquidity sources in the regular course of business.
 
In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on liquidity.
 
Comparison of Operating Results for the Years Ended December 31, 2002 and 2001
 
General. Bancorp’s net income for the year ended December 31, 2002 was $8,948,000 or $2.13 per share, diluted, compared to $5,256,000 or $1.37 per share, diluted, for the year ended December 31, 2001. The increase of $3,692,000 or 70.2% was primarily the result of increases in loan origination volume and in the loan portfolio, as well as the increase in interest income, coupled with a reduction in the cost of deposits and other liabilities.
 
Net Interest Income. Net interest income (interest earned net of interest charges) totaled $19,603,000 for the year ended December 31, 2002, as compared to $13,395,000 for the year ended December 31, 2001, or an increase of $6,208,000 or 46.3%. The change was primarily due to growth in the loan portfolio and reduction of interest on deposits. The net interest margin increased to 4.86% at December 31, 2002 compared to 4.05% at December 31, 2001. The Bank’s net interest margin increased because interest rates earned on the Bank’s assets have increased faster than its cost of funds. This was due to the historically low interest rate environment that the Bank is operated in.
 
Provision for Loan Losses. Bancorp’s loan portfolio is subject to varying degrees of credit risk and an allowance for loan losses is maintained to absorb losses inherent in its loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what Bancorp determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio at least as often as quarterly and its loan delinquencies at least as often as monthly. All loans that are delinquent and all loans within the various categories of the Bank’s portfolio as a group are tabulated. The Bank’s Board, with the advice and recommendation of the Bank’s delinquency committee, estimates an allowance to be set aside for loan losses. Included in determining the calculation are such factors as the inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectibility. An increase in the loan loss provision from the beginning of the period to the end of a period would have come about after an analysis of the aforementioned factors and applying that rationale to the total portfolio.

 
  40  
 
 
The greater the construction, commercial and higher loan-to-value loans that are contained in the portfolio, the greater will be the allowance for loan losses. Changes in estimation methods may take place based upon the status of the economy and the estimate of the value of collateral and, as a result, the allowance may increase or decrease. The Bank believes that some portions of its loan portfolio have greater actual risk and, in other areas, there is greater inherent risk. The loan loss allowance has increased when the Board believes trends are negative and contributions to the allowance have decreased when trends are more positive. Management believes that the allowance for loan losses is adequate.
 
During the year ended December 31, 2002, the provision for loan losses was $670,000 compared to $709,000 for the year ended December 31, 2001. This decrease of $39,000 or 5.5%, was a result of the Bank’s management having determined that the provision for loan losses contributed was commensurate to the inherent risk in the portfolio. As of December 31, 2002 the allowance for loan losses was $3,991,000 compared to $3,353,000 as of December 31, 2001 which is an increase of $638,000 or 19%. This increase was a result of contributions made to the provision for loan losses without any material charge offs to reduce the overall allowance for loan losses.
 
Other Income and Non Interest Expense. Gain on sale of loans was $1,264,000 for the year ended December 31, 2002 compared to $983,000 for the year ended December 31, 2001. This increase of $281,000 or 28.6% was a result of increased loan originations primarily from a lower interest rate environment which resulted in significant residential mortgage loan refinancings. Should loan originations decrease in the future, gain on sale of loans will also likely decrease. Loan originations may decrease as a result of greater competition, increases in general interest rates or a loss of personnel experienced in loan origination. A reduction in loan originations will also cause a reduction in mortgage processing fees.
 
Real estate commissions and real estate management fees for the year ended December 31, 2002 were $1,237,000 and $383,000, respectively, compared to $499,000 and $213,000, respectively for the year ended December 31, 2001. The increase in 2002, being an aggregate of $908,000 or 127.5% was due in part to the fact that Hyatt Real Estate was acquired by Bancorp in 2001 and the total year’s revenues were not included in 2001 and that real estate commission revenue is volatile and may be substantially different, from year to year.
 
Mortgage processing and servicing fees for the year ended December 31, 2002 were $724,000 compared to $607,000 for the year ended December 31, 2001. This increase of $117,000 or 19.3% was primarily attributable to the increase in operations and staffing and compensation levels of the Bank caused by the volume of loan production.
 
Compensation and related expenses totaled $6,065,000 for the year ended December 31, 2002 compared to $4,572,000 for the year ended December 31, 2001, or an increase of $1,493,000 or 32.7%. The increase during 2002 was primarily attributable to the increase in operations and staffing and compensation levels of the Bank caused by the increase in loan production and increases in commissions at Hyatt Real Estate.
 
Other non-interest expense totaled $1,883,000 for the year ended December 31, 2002 compared to $1,520,000 for the year ended December 31, 2001 which is an increase of $363,000 or 23.9%. Other non-interest expense consists primarily of office and computer supplies, mail expenses, telephone and other expenses. The increase during 2002 was primarily attributable to the increase in operations caused by an increase in loan production and expenses related to the registration of Bancorp’s shares with the Securities and Exchange Commission.

 
  41  
 
 
Income taxes for the year ended December 31, 2002 were $5,671,000 compared to $3,413,000 for the year ended December 31, 2001. This increase of $2,258,000 or 66.2% was a result of an increase in income before income tax provision to $14,619,000 for the year ended December 31, 2002 compared to $8,669,000 for the year ended December 31, 2001, being an increase of $5,950,000 or 68.6%. The effective tax rate for the years ended December 31, 2002 and 2001 were 38.79% and 39.37%, respectively.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk
 
Qualitative Information About Market Risk. The principal objective of Bancorp’s interest rate risk management is to evaluate the interest rate risk included in balance sheet accounts, determine the level of risks appropriate given Bancorp’s business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with Bancorp’s interest rate risk management policy. Through this management, Bancorp seeks to reduce the vulnerability of its operations to changes in interest rates. The Board of Directors of Bancorp is responsible for reviewing assets/liability policies and interest rate risk position. The Board of Directors reviews the interest rate risk position on a quarterly basis. In connection with this review, the Board of Directors evaluates Bancorp’s business activities and strategies, the effect of those strategies on Bancorp’s net interest margin and the effect that changes in interest rates will have on Bancorp’s loan portfolio. Continuous movement of interest rates is certain, however, the extent and timing of these movements is not always predictable. Any movement in interest rates has an effect on Bancorp’s profitability. Bancorp faces the risk that rising interest rates could cause the cost of interest bearing liabilities, such as deposits and borrowings, to rise faster than the yield on interest earning assets, such as loans and investments. Bancorp’s interest rate spread and interest rate margin may be negatively impacted in a declining interest rate environment even though Bancorp generally borrows at short-term interest rates and lends at longer-term interest rates. This is because loans and other interest earning assets may be prepaid and replaced with lower yielding assets before the supporting interest bearing liabilities reprice downward. Bancorp’s interest rate margin may also be negatively impacted in a flat or inverse-yield curve environment. Mortgage origination activity tends to increase when interest rates trend lower and decrease when interest rates rise.
 
Bancorp’s primary strategy to control interest rate risk is to sell substantially all long term fixed rate loans in the secondary market. To further control interest rate risk related to its loan servicing portfolio, Bancorp originates a substantial amount of construction loans that typically have terms of one year or less. The turnover in construction loan portfolio assists Bancorp in maintaining a reasonable level of interest rate risk.
 
Quantitative Information About Market Risk. The primary market risk facing Bancorp is interest rate risk. From an enterprise prospective, Bancorp manages this risk by striving to balance its loan origination activities with the interest rate market. Bancorp attempts to maintain a substantial portion of its loan portfolio in short-term loans such as construction loans. This has proven to be an effective hedge against rapid increases in interest rates as the construction loan portfolio reprices rapidly.
 
The matching of maturity or repricing of interest earning assets and interest bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring the Bank’s interest rate sensitivity gap. An interest earning asset or interest bearing liability is interest rate sensitive within a specific time period if it will mature or reprice within that time period. The difference between rate sensitive assets and rate sensitive liabilities represents the Bank’s interest sensitivity gap.
 
Exposure to interest rate risk is actively monitored by Bancorp’s management. Its objective is to maintain a consistent level of profitability within acceptable risk tolerances across a board range of potential interest rate environments. Bancorp uses the OTS Net Portfolio Value (NPV) model to monitor its exposure to interest rate risk, which calculates changes in NPV. The following table represents Bancorp’s NPV at December 31, 2003. The NPV was calculated by the OTS, based upon information provided to the OTS.
 
  42  
 

INTEREST RATE SENSITIVITY OF NET PORTFOLIO VALUE (NPV)
 
 
Net Portfolio Value
NPV as % of PV of Assets
Change In Rates
$ Amount
$ Change
% Change
NPV Ratio
Change
(dollars are in thousands)
+300 bp
63,590
-13,527
-18%
11.64%
-188 bp
+200 bp
69,494
- 7,623
-10%
12.51%
-100 bp
+100 bp
74,216
- 2,901
- 4%
13.17%
-35 bp
0 bp
77,116
 
 
13.52%
 
-100 bp
79,959
2,842
+ 4%
13.85%
+34 bp
-200 bp
---
0
0%
0.00%
0 bp
-300 bp
---
0
0%
0.00%
0 bp

 
12/31/2003
09/30/2003
12/31/2002
RISK MEASURES: FOR GIVE RATE SHOCK
 
 
 
 
 
 
 
Pre-Shock NPV Ratio: NPV as % of PV of Assets
13.52%
12.73%
12.68%
Post-Shock NPV Ratio
12.51%
11.38%
12.33%
Sensitivity Measure: Decline in NPV Ratio
100 bp
134 bp
36 bp
TB 13a Level of Risk
Minimal
Minimal
Minimal

Note: Calculations of 3/1/2004 using CMR data edited 02/12/2004. CMR Report filing required. For this quarter, the Sensitivity Measure is defined as the decline in the pre-shock NPV ratio caused by a 100 basis point decrease of a 200 basis point increase in interest rates, whichever produced the larger decline.

Due to the abnormally low prevailing interest rate environment, this report no longer provides NPV estimates for changes in interest rates of –400 or +400 basis points (beginning with the March 1999 cycle), -300 basis points (beginning with the September 2001 Cycle), and –200 basis points (beginning with the December 2001 cycle).

Item 8. Financial Statements and Supplementary Data

Financial statements and supplementary data are included herein at pages F1 through F37.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

Reference is made to the section captioned “Relationship With Independent Auditors” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
On January 2, 2004, Anderson Associates LLP (“Anderson”) announced that it was joining Beard Miller Company LLP (“Beard Miller”) to become the Baltimore office of Beard Miller. As a result, on January 2, 2004, Anderson resigned as independent auditors of the Company. On January 2, 2004, the Company engaged Beard Miller as its successor independent audit firm. The Company's engagement of Beard Miller was approved by the Company’s Audit Committee on January 5, 2004.
 
Anderson served as the Registrant's independent accountants to audit the Registrant's consolidated financial statements as of and for the fiscal years ended December 31, 2002 and 2001. Anderson’s reports on the Registrant's consolidated financial statements as of and for the years ended December 31, 2002 and 2001 did not contain an adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles.
 
During the Registrant's fiscal years ended December 31, 2002 and 2001 and the subsequent interim period from January 1, 2003 through January 2, 2004, there were no disagreements with Anderson on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Anderson, would have caused Anderson to make reference to the subject matter of the disagreements in their report on the financial statements for such years.

 
  43  
 
 
Item 9A. Controls and Procedures
 
Evaluation of Bancorp’s Disclosure Controls and Internal Controls . As of December 31, 2003, Bancorp evaluated the effectiveness of the design and operation of its “disclosure controls and procedures” (“Disclosure Controls”). This evaluation (“Controls Evaluation”) was done under the supervision and with the participation of management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).
 
Limitations on the Effectiveness of Controls . Bancorp’s management, including the CEO and CFO, does not expect that its Disclosure Controls or its “internal controls and procedures for financial reporting” (“Internal Controls”) will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Bancorp have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
 
Conclusions . Based upon the Controls Evaluation, the CEO and CFO have concluded that, subject to the limitations noted above, the Disclosure Controls are effective to timely alert management to material information relating to Bancorp during the period when its periodic reports are being prepared.
 
In accordance with SEC requirements, the CEO and CFO note that during the fourth quarter of 2003 there have been no significant changes in Internal Controls or in other factors that could significantly affect Internal Controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
PART III

Item 10. Directors and Executive Officers of the Registrant
 
Reference is made to the section captioned “Proposal 1: Election of Directors” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
Reference is made to the section captioned “Stock Ownership” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
Reference is made to the section captioned “Director Independence” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
Reference is made to the section captioned “Report of the Audit Committee” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
On March 16, 2004, the Company adopted a written Code of Ethics, attached hereto as an Exhibit, that applies to the Company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The Company intends to disclose waivers and amendments to the Code of Ethics on its website in the event that any such waiver or amendment is granted.

 
  44  
 
 
Item 11. Executive Compensation
 
Reference is made to the section captioned “Director and Executive Officer Compensation” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management
 
Reference is made to the sections captioned “Stock Ownership” and “Director and Executive Officer Compensation” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.

Item 13. Certain Relationships and Related Transactions
 
Reference is made to the section captioned “Certain Relationships and Transactions Where Certain Persons Have Material Interests” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.
 
Item 14. Principal Accounting Fees and Services
 
Reference is made to the section captioned “Relationship with Independent Auditors” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference. 
 
Reference is made to the section captioned “Report of the Audit Committee” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.


PART IV

Item 15. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K

(a)     The following financial statements of Bancorp and its wholly owned sub­sidiaries are filed as part of this report:

    1.     Financial Statements
·     CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND DECEMBER 31, 2002
·     CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
·     CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
·     CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001.
·     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PAGES F1 - F37
·     REPORT OF BEARD MILLER COMPANY, LLP, INDEPENDENT AUDITORS PAGE F1.
 
2. Financial Statement Schedules

    All financial statement schedules have been omitted, as required information is either inapplicable or included in the consolidated financial statements or related notes.
 
 
  45  
 
 
    3.     Exhibits

  The following exhibits are filed as part of this report:

Exhibit No. Description of Exhibit

3.1     Articles of Incorporation of Severn Bancorp, Inc. (1)

3.2      Bylaws of Severn Bancorp, Inc. (1)

10.5      Employee Stock Ownership Plan (1)

14         Code of Ethics
 
31.1     Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002
 
31.2    Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002

32.      Certification of CEO and CFO pursuant to Section 906 of Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to Exhibit bearing the same number in Bancorp's Registration Statement of Form 10 filed with the Securities and Exchange Commission on June 7, 2002
 
     (b)       Reports on Form 8-K filed for the period January 1, 2003 through December 31, 2003 as follows:
     Form 8-K dated May 12, 2003. Reporting the resignation of Dimitri Sfakiyanudis as Director.
     Form 8-K dated December 16, 2003. Reporting the appointment of Albert W. Shields as Director.
       
The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission including Bancorp. That address is http://www.sec.gov.
 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.
 
                                SEVERN BANCORP, INC.
                       
March 25, 2004                                      /s/        
                                        Alan J. Hyatt
                                         Chairman of the Board a nd Director
 

  46

     
 
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

March 25, 2004                         /s/        
                                       Alan J. Hyatt
                                       Chairman of the Board,
                                       President, Chief Executive Officer and Director

March 25, 2004                         /s/        
Melvin Hyatt, Director

March 25, 2004                         /s/        
S. Scott Kirkley, Director

March 25, 2004                         /s/        
Melvin E. Meekins, Jr., Director

March 25, 2004                         /s/
Ronald P. Pennington, Director

March 25, 2004                         /s/                        
T. Theodore Schultz, Director

March 25, 2004                         /s/        
Albert W. Shields, Director

March 25, 2004                         /s/        
                                      Louis DiPasquale, Jr., Director

March 25, 2004                         /s/        
                                       Keith Stock, Director

Under 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. Each of the undersigned signatures certifies pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1)     This Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)     The information contained in this Report fairly presents, in all material respects, the financial condition and result of operations of the Registrant.
 
                       SEVERN BANCORP, INC.
Registrant

Date: March 25, 2004                         /s/                
                                     Alan J. Hyatt,  President, Chief Executive Officer    
                                      and Chairman of the Board     (Principal Executive Officer)

Date: March 25, 2004                         /s/
                                      Cecelia Lowman, Chief Financial Officer
                                                        (Principal Financial and Accounting Officer)
 
 
 
 
 
47
 

CODE OF BUSINESS CONDUCT AND ETHICS
for
SEVERN BANCORP

Introduction
 
This Code of Business Conduct and Ethics (this "Code") applies to Severn Bancorp and its subsidiaries (collectively, the "Company").
 
We expect the Company's employees and officers ("employees") and members of its Board of Directors ("directors") to use sound judgment to help us maintain appropriate compliance procedures and to carry out our business with honesty and in compliance with laws and high ethical standards. Each employee and director is expected to read this Code and demonstrate personal commitment to the standards set forth in this Code. Employees and directors who do not comply with the standards set forth in this Code may be subject to discipline in light of the nature of the violation, including termination of employment.
 
Any questions about this Code or the appropriate course of conduct in a particular situation should be directed to the Company's chairperson of the Audit Committee of the Board of Directors, who shall have the authority to consult with outside counsel. Any evidence of improper conduct, violations of laws, rules, regulations or this Code should be reported immediately. The Company will not allow retaliation against an employee or director for such a report made in good faith.
 
Any waiver of the provisions of this Code for executive officers or directors of the Company may be made only by our Board of Directors or a committee thereof and must be promptly disclosed to our stockholders.
 
A copy of this Code of Business Conduct and Ethics will be posted on the Company’s website and will also be mailed to any shareholder who requests it; in addition, this availability will be disclosed annually in the Company’s annual report on Form 10-K filed with the Securities Exchange Commission (“SEC”).
This Code is not intended as a detailed guide for all situations. Employees and directors are also expected to comply with other workplace rules we may from time to time communicate, all of which supplement this Code.
 
Responsibilities
 
I.       Compliance with Laws, Rules and Regulations
 
All employees and directors must respect and obey all laws applicable to the Company’s business, including state and local laws in the geographic areas in which the Company operates. Employees and directors should direct any questions as to the applicability of any law to the Company's chairperson of the Audit Committee of the Board of Directors.
 
 
 
  1  
 
 
II.       Conflicts of Interest
 
A conflict of interest occurs when the private interest of an employee or director interferes in any way – or appears to interfere – with the interests of the Company as a whole. For example, conflicts of interest also arise when an employee or director, or a member of his or her family, receives improper personal benefits as a result of his or her position with the Company. Conflicts of interest also can arise when an employee or director takes action or has interests that may make it difficult to make objective decisions on behalf of the Company or to perform his or her duties objectively and effectively.
 
Except as pre-approved in accordance with Company policy and procedures, transactions that involve a conflict of interest are prohibited as a matter of Company policy. Any employee or director who becomes aware of a conflict or potential conflict, or who has a question about whether a conflict exists, must bring it to the attention of the Company's chairperson of the Audit Committee of the Board of Directors.
 
III.       Company Opportunities
 
Employees and directors are prohibited from (a) taking for themselves personally any opportunities that arise or are discovered through the use of Company property, information or position, (b) using Company property, information or position for personal gain, and (c) directly or indirectly competing with the Company. Employees and directors owe a duty to the Company to advance the Company's legitimate interests when the opportunity to do so arises.
 
IV.       Insider Trading
 
The Company has a securities trading policy and all employees and directors must abide by its terms. This policy, among other things, provides that employees and directors may not buy or sell shares of the Company when they are in possession of material, non-public information. They also are prohibited from passing on such information to others who might make an investment decision based on such information. Employees and directors also may not trade in stocks of other companies about which they learn material, non-public information through the course of their employment or service. Copies of the Company’s Policy on Insider Trading may be obtained from the Company’s chairperson of the Audit Committee of the Board of Directors. Any questions as to whether information is material or has been adequately disclosed should be directed to the Company's chairperson of the Audit Committee of the Board of Directors.
 
 
 
  2  
 
 
V.       Confidentiality
 
Employees and directors should maintain the confidentiality of confidential information entrusted to them by the Company or its customers and suppliers, except when disclosure is authorized or legally mandated. "Confidential information" includes all non-public information that might be of use to competitors, or harmful to the Company or its customers or suppliers, if disclosed. This obligation to protect confidential information does not cease when an employee or director leaves the Company. Any questions about whether information is confidential should be directed to the Company's chairperson of the Audit Committee of the Board of Directors.
 
VI.       Fair Dealing
 
Each employee and director should endeavor to deal fairly with the Company’s competitors, suppliers, customers and employees. No employee or director should take unfair advantage of any other person through manipulation, concealment, abuse of privileged information, misrepresentation of material facts, or any other unfair practice.
 
VII.       Protection and Proper Use of the Company's Assets
 
All employees and directors have a duty to protect the Company's assets and ensure the assets' efficient use. Theft, carelessness and waste have a direct impact on the Company's profitability and financial health. The Company's assets should be used only for legitimate business purposes and employees and directors should take measures to ensure against their theft, damage or misuse. These assets include intellectual property such as patents, trademarks, trade secrets, business and marketing plans, salary information and any unpublished financial data and reports. Any unauthorized use or distribution of this information is a violation of this Code.
 
VIII.       Accuracy of Records and Reporting
 
All of the Company's books, records, accounts and financial statements must be maintained in reasonable detail, must appropriately reflect the matters to which they relate and must conform both to applicable legal requirements and to the Company's system of internal controls. The making of false or misleading records or documentation is strictly prohibited. The Company must operate in compliance with all applicable laws and regulations regarding the preservation of records. Records should be retained or destroyed only in accordance with the Company's document retention policies. Any questions about these policies should be directed to the Company's chairperson of the Audit Committee of the Board of Directors.
 
IX.       Disclosure Controls and Procedures
 
The Company is required to maintain effective "disclosure controls and procedures" so that financial and non-financial information required to be reported to the SEC is timely and accurately reported both to our senior management and in the filings the Company makes. All employees are expected, within the scope of their employment duties, to support the effectiveness of these disclosure controls and procedures. To that end, it is Company policy to promote the full, fair, accurate, timely and understandable disclosure in reports and documents filed with the SEC and otherwise communicate to the public.
 
 
 
  3  
 
 
X.       Improper Influence on Conduct of Audits
 
An employee must not take any action to fraudulently influence, coerce, manipulate, or mislead any independent public or certified accountant engaged in the performance of an audit of the financial statements of the Company. An employee must also not take any action to fraudulently influence, coerce, manipulate, or mislead any member of the Company’s internal auditors engaged in the performance of an internal audit or investigation. An employee must cooperate in any audit or investigation being conducted by the Company’s internal or external auditors.
 
XI.       Interaction with Public Officials and Entertainment and Gratuities
 
When dealing with public officials, employees and directors must avoid any activity that is or appears illegal or unethical. The giving of gifts, including meals, entertainment, transportation and lodging, to government officials in the various branches of United States government, as well as state and local governments, is restricted by law. Employees and directors must obtain pre-approval from the Company's chairperson of the Audit Committee of the Board of Directors, who may consult with outside counsel, before providing anything of value from the Company to a government official or employee. The foregoing does not apply to lawful political contributions from non Company sources.
 
In addition, the United States Foreign Corrupt Practices Act prohibits giving anything of value, directly or indirectly, to officials of foreign governments or foreign political candidates in order to obtain or retain business. Illegal payments to government officials of any country are strictly prohibited.
 
The Company believes that business decisions by its non-governmental customers should be made solely on the basis of the Company’s quality, service, price and other competitive factors. Gifts and entertainment of nominal value are used to create good will with non-governmental customers. If they go beyond that and make the customer feel obligated to offer any special consideration to the Company, they are unacceptable. The Company’s policy is to avoid even the appearance of favoritism based on business entertainment or gratuities.
 
Employees should exercise good judgment and moderation and should only offer gratuities to customers to the extent they are in accordance with reasonable customers in the marketplace.
 
Normal and reasonable entertainment of non-governmental customers and suppliers covered by standard expense account reporting is permissible when not contrary to applicable law or to the non-governmental customer’s or supplier’s own policy.
 
 
 
  4  
 
 
XII.       Environmental Protection
 
The Company fully supports the belief that each employee has a responsibility to protect the environment and human life and health. It is, therefore, imperative that each employee accepts responsibility for compliance with laws and regulations governing the protection of the environment. No individual will knowingly buy for use at the Company, use or dispose of, other than in accordance with the law, any chemical or other substance which it is illegal to use or dispose of. Supervisors and managers are expected to stay current with all relevant laws and regulations concerning the protection of the environment, to seek professional guidance when necessary, and to assure compliance with the laws and regulations. In addition, we must seek alternative to those methods, substances or products which are subject to regulation to assure protection of the environment and personal safety.
 
Individuals who knowingly violate any environmental law or regulation will be subject to discharge and prosecution. Accidental incidents which affect the environment are to be reported immediately, and measures are to be undertaken immediately to minimize environmental impact.
 
XIII.       Use of Electronic Technology Resources
 
The Company’s electronic technical resources – including desktop and portable computer systems, personal digital assistants, fax machines, Internet and World Wide Web (Web) access, voice mail, electronic mail (e-mail), electronic bulletin boards, and intranet, as well as the use of any Company-paid accounts, subscriptions, or other technical sources – enable employees quickly and efficiently to access and exchange information throughout the Company and around the world.
 
These technical resources are provided for the benefit of the Company and its customers and suppliers. They are provided only for use in the pursuit of Company business, unless otherwise authorized. Employees are permitted to use the Company’s technical resources for occasional, non-work, non-prohibited purposes. Nevertheless and other than specific legal exceptions, employees have no right or privacy as to any information or file transmitted or stored on or through the Company’s electronic technical resources. Employees are responsible for ensuring that they use the technical resource privilege in an effective, ethical, and legal manner. Use of the Company’s technical resources may not be used for personal gain, the advancement of individual views, or the solicitation of non-Company business or activities. Your use of the Company’s technical resources must not interfere with your productivity, the productivity of any other employee, or the operation of the Company’s technical resources.
 
Sending, saving, or viewing offensive material using the Company’s technical resources is prohibited. Messages stored or transmitted must not contain content that may reasonably be considered offensive to any employee. Offensive material includes, but is not limited to, sexual comments, jokes or images, racial slurs, gender-specific comments, or any comments or images that would offend someone on the basis of a person’s race, color, creed, sex, age, national origin, or physical or mental disability. Any use of the Company’s technical resources to harass, discriminate or for other prohibited purposes is unlawful and strictly forbidden, and will be subject to discipline, up to and including discharge.
 
 
 
  5  
 
 
Compliance Standards and Procedures
 
We understand that no code or policy can address every scenario or answer every question. To ensure that all employees and directors can obtain prompt answers to their questions and inquiries, we have implemented the following policies and procedures:
 
Compliance
 
The Company's Executive Vice President has been designated with responsibility for overseeing and monitoring compliance with this Code. This officer makes periodic reports to the Company's Audit Committee regarding the implementation and effectiveness of this Code as well as the Company's policies and procedures to ensure compliance with this Code.
 
The Company's Executive Vice President may be reached at 410-268-4554 or mmeekins@severn.hpwsb.com . If you wish to communicate any matter anonymously, the Company will maintain the confidentiality of your communication to the extent possible under applicable laws. Communications intended to be confidential should be mailed in writing, without indicating your name or address, to Severn Bancorp, Attention: Executive Vice President.
 
Reporting Violations
 
All employees are encouraged to speak with their supervisors, managers or other appropriate personnel when in doubt about the best course of action in a particular situation. In most instances, employees and directors should bring any questions regarding this Code to the attention of the Company's chairperson of the Audit Committee of the Board of Directors.
 
We encourage all employees to promptly report to the appropriate Company personnel any actual or apparent violations of this Code or any laws, rules or regulations. The Company does not permit retaliation or discrimination of any kind against employees who reasonably believe there has been possible illegal or unethical conduct and who in good faith report the conduct to us. However, it is a violation of our policy for any employee to communicate a report claiming illegal or unethical conduct which the employee knows to be false.
 
Investigations
 
Reported violations will be promptly investigated. The person reporting the violation should not conduct an investigation on his or her own. However, employees and directors are expected to cooperate fully with any investigation made by the Company or any of its representatives.
 
 
 
  6  
 
 
Accountability
 
Employees and directors who violate this Code may be subject to disciplinary action, including termination of employment. Knowledge of a violation and failure to promptly report or correct the violation may also subject an employee or director to disciplinary action. Some violations of this Code are illegal and may subject the employee or director to civil and criminal liability.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
7
 
 
INDEPENDENT AUDITOR'S REPORT

To the Stockholders and Board of Directors
Severn Bancorp, Inc.
Annapolis, Maryland

We have audited the accompanying consolidated statements of financial condition of Severn Bancorp, Inc. and Subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Severn Bancorp, Inc. and Subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
 
 
March 11, 2004
Baltimore, Maryland

 
F-1
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

ASSETS
December 31,
   
2003

 

 
2002
 
Cash and due from banks
$
4,054,869
 
$
3,756,640
 
Interest bearing deposits in other banks
 
457,825
   
4,190,768
 
Federal funds
 
3,913,688
   
10,712,827
 
Investment securities held to maturity
 
6,000,000
   
4,000,000
 
Mortgage backed securities held to maturity
 
6,721,175
   
5,661,304
 
Loans held for sale, net of unrealized loss of
 
 
   
 
 
$ -0- in 2003 and 2002
 
3,174,954
   
17,481,301
 
Loans receivable, net of allowance for loan losses
 
 
   
 
 
of $4,832,446 and $3,990,600, respectively
 
502,851,450
   
401,343,360
 
Accrued interest receivable
 
2,701,718
   
2,549,425
 
Foreclosed real estate, net
 
-
   
223,911
 
Premises and equipment, at cost, less
 
 
   
 
 
accumulated depreciation
 
5,327,313
   
4,737,936
 
Mortgage servicing rights
 
12,740
   
19,340
 
Federal Home Loan Bank of Atlanta stock at cost
 
3,250,000
   
1,900,000
 
Deferred income taxes
 
1,276,800
   
1,090,356
 
Income taxes receivable
 
-
   
164,255
 
Goodwill
 
333,569
   
333,569
 
Prepaid expenses and other assets
 
395,132
   
249,517
 
 
 
 
Total assets
$
540,471,233
 
$
458,414,509
 
 
 
 

The accompanying notes to consolidated financial statements
are an integral part of these statements.





 
F-2a

 
     
 



 
LIABILITIES AND STOCKHOLDERS' EQUITY

  December 31,

 
2003
   

2002  

 
Liabilities            
Deposits
$
419,726,185
 
$
377,925,041
 
Federal Home Loan Bank of Atlanta advances
 
65,000,000
   
34,000,000
 
Advance payments by borrowers for expenses
 
901,520
   
1,049,408
 
Accounts payable and accrued expenses
 
1,873,335
   
2,258,683
 
 
 
 
Total liabilities
 
487,501,040
   
415,233,132
 
 
 
 
   
 
 
Commitments - (Notes 4 and 5)
 
 
   
 
 
 
 
 
   
 
 
Minority interest – preferred securities of subsidiary
 
4,000,040
   
4,000,040
 
 
 
 
   
 
 
Stockholders' Equity
 
 
   
 
 
Common stock, $.01 par value, 20,000,000 shares
 
 
   
 
 
authorized; 4,159,092 and 4,142,592 issued and
 
 
   
 
 
outstanding in 2003 and 2002, respectively
 
41,591
   
41,426
 
Additional paid-in capital
 
11,516,495
   
11,425,910
 
Retained earnings
 
37,412,067
   
27,714,001
 
 
 
 
Total stockholders' equity
 
48,970,153
   
39,181,337
 
 
 
 
Total liabilities and stockholders' equity
$
540,471,233
 
$
458,414,509
 
 
 
 











F-2b
 
 
     
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF OPERATIONS
 

  Years Ended December 31,

Interest Income  
2003  
   
2002  
   
2001  
 
Interest on loans
$
36,403,402
 
$
32,722,911
 
$
28,617,342
 
Interest on securities available for sale
 
-
   
-
   
43,809
 
Interest on securities held to maturity
 
242,983
   
361,908
   
406,117
 
Interest on mortgage backed securities
 
209,706
   
53,808
   
18,042
 
Other interest income
 
230,915
   
263,372
   
403,914
 
 
 
 
 
Total interest income
 
37,087,006
   
33,401,999
   
29,489,224
 
 
 
 
   
 
   
 
 
Interest Expense
 
 
   
 
   
 
 
Interest on deposits
 
10,961,224
   
12,300,081
   
13,591,440
 
Interest on short term borrowings
 
9,239
   
155,249
   
1,178,202
 
Interest on long term borrowings
 
1,370,614
   
1,343,947
   
1,324,368
 
 
 
 
 
Total interest expense
 
12,341,077
   
13,799,277
   
16,094,010
 
 
 
 
 
Net interest income
 
24,745,929
   
19,602,722
   
13,395,214
 
Provision for loan losses
 
900,000
   
670,000
   
708,669
 
 
 
 
 
Net interest income after provision for loan losses
 
23,845,929
   
18,932,722
   
12,686,545
 
 
 
 
   
 
   
 
 
Other Income
 
 
   
 
   
 
 
Loss on sale of investments
 
-
   
-
   
(145,529
)
Gain on sale of foreclosed real estate
 
169,095
   
-
   
-
 
Gain on sale of loans
 
1,563,105
   
1,263,736
   
982,778
 
Real estate commissions
 
1,159,755
   
1,236,973
   
499,256
 
Real estate management fees
 
368,900
   
383,117
   
213,102
 
Mortgage processing and servicing fees
 
927,594
   
723,702
   
606,587
 
All other income
 
485,189
   
525,157
   
414,089
 
 
 
 
 
Net other income
 
4,673,638
   
4,132,685
   
2,570,283
 
 
 
 
   
 
   
 
 
Non-Interest Expenses
 
 
   
 
   
 
 
Compensation and related expenses
 
6,975,540
   
6,064,850
   
4,572,101
 
Occupancy
 
533,756
   
487,891
   
465,628
 
Net expense of foreclosed real estate
 
-
   
11,053
   
30,786
 
Other
 
2,106,276
   
1,882,839
   
1,519,537
 
 
 
 
 
Total non-interest expenses
 
9,615,572
   
8,446,633
   
6,588,052
 
 
 
 
 
 
 
 
   
 
   
 
 
Income before income tax provision
 
18,903,995
   
14,618,774
   
8,668,776
 
Income tax provision
 
7,574,857
   
5,670,554
   
3,413,206
 
 
 
 
 
Net income
$
11,329,138
 
$
8,948,220
 
$
5,255,570
 
 
 
 
 
Basic earnings per common share
$
2.68
 
$
2.13
 
$
1.38
 
 
 
 
 
Diluted earnings per common share
$
2.67
 
$
2.13
 
$
1.37
 
 
 
 
 
 
The accompanying notes to consolidated financial statements
are an integral part of these statements.
 
F-3
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2003, 2002, and 2001

   
Common Stock
   
Additional Paid-In Capital
   
Retained
Earnings
   
Accumulated Comprehensive Income (Loss)
 
 
Total Stockholders’ Equity
 
   
 
 
 
 
 
Balance - January 1, 2001
 
$
10,798
 
$
5,720,300
 
$
15,684,650
 
$
(86,903
)
$
21,328,845
 
Comprehensive Income
   
 
   
 
   
 
   
 
   
 
 
Net income
   
-
   
-
   
5,255,570
   
-
   
5,255,570
 
Reclassification for gains
   
 
   
 
   
 
   
 
   
 
 
Included in net income
   
 
   
 
   
 
   
 
   
 
 
net of taxes of $54,162
   
-
   
-
   
-
   
86,903
   
86,903
 
Total comprehensive income
   
 
   
 
   
 
   
 
   
5,342,473
 
Exercise of 13,000 options
   
130
   
214,370
   
-
   
-
   
214,500
 
Exercise of 199,592 warrants
   
1,996
   
3,282,817
   
-
   
-
   
3,284,813
 
Issuance of 60,000 shares of
   
 
   
 
   
 
   
 
   
 
 
common stock
   
600
   
1,599,400
   
-
   
-
   
1,600,000
 
Other
   
-
   
-
   
(220,971
)
 
-
   
(220,971
)
Dividends on common stock
   
 
   
 
   
 
   
 
   
 
 
($.56 per share)
   
-
   
-
   
(718,818
)
 
-
   
(718,818
)
   
 
 
 
 
 
                                 
Balance - December 31, 2001
   
13,524
   
10,816,887
   
20,000,431
   
-
   
30,830,842
 
 
   
 
   
 
   
 
   
 
   
 
 
Comprehensive Income
   
 
   
 
   
 
   
 
   
 
 
Net income
   
-
   
-
   
8,948,220
   
-
   
8,948,220
 
Three-for-one stock split in the
   
 
   
 
   
 
   
 
   
 
 
form of a 200% dividend
   
27,047
   
-
   
(27,047
)
 
-
   
-
 
Exercise of 85,500 options
   
855
   
479,295
   
-
   
-
   
480,150
 
Tax benefit of exercised options
   
-
   
129,728
   
-
   
-
   
129,728
 
Other
   
-
   
-
   
(220,972
)
 
-
   
(220,972
)
Dividends on common stock
   
 
   
 
   
 
   
 
   
 
 
($.24 per share)
   
-
   
-
   
(986,631
)
 
-
   
(986,631
)
   
 
 
 
 
 
                                 
Balance - December 31, 2002
   
41,426
   
11,425,910
   
27,714,001
   
-
   
39,181,337
 
 
   
 
   
 
   
 
   
 
   
 
 
Comprehensive Income
   
 
   
 
   
 
   
 
   
 
 
Net income
   
-
   
-
   
11,329,138
   
-
   
11,329,138
 
Exercise of 16,500 options
   
165
   
90,585
   
-
   
-
   
90,750
 
Other
   
-
   
-
   
(220,971
)
 
-
   
(220,971
)
Dividends on common stock
   
 
   
 
   
 
   
 
   
 
 
($.34 per share)
   
-
   
-
   
(1,410,101
)
 
-
   
(1,410,101
)
   
 
 
 
 
 
Balance - December 31, 2003
 
$
41,591
 
$
11,516,495
 
$
37,412,067
   
-
 
$
48,970,153
 
   
 
 
 
 
 

The accompanying notes to consolidated financial statements
are an integral part of these statements.






F-4

 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

CONSOLIDATED STATEMENTS OF CASH FLOWS

Cash Flows from Operating Activities
 
2003
   
2002
   
2001
 
Net income
$
11,329,138
 
$
8,948,220
 
$
5,255,570
 
Adjustments to Reconcile Net Income to Net
 
 
   
 
   
 
 
Cash Provided by Operating Activities
 
 
   
 
   
 
 
Amortization of deferred loan fees
 
(2,417,135
)
 
(2,122,685
)
 
(1,530,021
)
Net (accretion) amortization of discounts and
 
 
   
 
   
 
 
Premiums
 
78,038
   
(3,982
)
 
(8,068
)
Provision for loan losses
 
900,000
   
670,000
   
708,669
 
Provision for losses on foreclosed real estate
 
-
   
-
   
20,000
 
Provision for depreciation
 
290,591
   
260,232
   
227,331
 
Loss (gain) on sale of foreclosed real estate
 
(169,095
)
 
-
   
2,769
 
Gain on disposal of premises and equipment
 
-
   
-
   
(5,656
)
Loss on sale of available for sale securities
 
-
   
-
   
145,529
 
Gain on sale of loans
 
(1,563,105
)
 
(1,263,736
)
 
(982,778
)
Proceeds from loans sold to others
 
135,435,272
   
101,798,171
   
61,258,782
 
Loans originated for sale
 
(119,660,304
)
 
(110,564,769
)
 
(63,564,893
)
Principal collected on loans originated for sale
 
94,484
   
47,967
   
(40,961
)
Tax effect of exercised options
 
-
   
129,728
   
-
 
(Increase) decrease in accrued interest
 
(152,293
)
 
(352,612
)
 
69,553
 
Decrease in mortgage servicing rights
 
6,600
   
6,600
   
6,600
 
Increase in deferred taxes
 
(186,444
)
 
(276,870
)
 
(260,702
)
Decrease (increase) in income taxes receivable
 
164,255
   
(163,305
)
 
21,477
 
(Increase) decrease in prepaid expenses
 
 
   
 
   
 
 
and other assets
 
(145,615
)
 
(77,435
)
 
105,349
 
Decrease in accrued interest payable
 
(4,704
)
 
(8,152
)
 
(8,445
)
(Decrease) increase in other liabilities
 
(541,494
)
 
410,821
   
187,326
 
(Decrease) increase in income taxes payable
 
(64,825
)
 
290,408
   
79,717
 
 
 
 
 
Net cash provided (used) by operating activities
 
23,393,364
   
(2,271,399
)
 
1,687,148
 












F-5
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years Ended Decmeber 31,

Cash Flows from Investing Activities
 
2003
   
2002
   
2001
 
Cash consideration Louis Hyatt, Inc. acquisition, net
 
-
   
-
 
$
(31,340
)
Purchase of investment securities
$
(10,000,000
)
$
(4,000,000
)
 
(4,000,000
)
Proceeds from maturing investment securities
 
8,000,000
   
7,000,000
   
6,497,754
 
Proceeds from sale of available for sale securities
 
-
   
-
   
854,471
 
Purchase of mortgage backed securities
 
(4,484,726
)
 
(5,759,846
)
 
-
 
Principal collected on mortgage backed securities
 
3,317,530
   
307,829
   
67,507
 
Net increase in loans
 
(99,715,668
)
 
(64,543,724
)
 
(60,404,624
)
Loans purchased
 
(246,000
)
 
(197,000
)
 
(3,551,316
)
Proceeds from sale of foreclosed real estate
 
393,006
   
88,207
   
103,941
 
Investment in premises and equipment
 
(879,968
)
 
(355,687
)
 
(2,097,708
)
Proceeds from disposal of premises and equipment
 
-
   
-
   
15,029
 
Purchase of Federal Home Loan Bank of
 
 
   
 
   
 
 
Atlanta stock
 
(1,350,000
)
 
-
   
(700,000
)
Redemption of Federal Home Loan Bank of
 
 
   
 
   
 
 
Atlanta stock
 
-
   
600,000
   
-
 
 
 
 
 
Net cash used by investing activities
 
(104,965,826
)
 
(66,860,221
)
 
(63,246,286
)
 
 
 
   
 
   
 
 
Cash Flows from Financing Activities
 
 
   
 
   
 
 
Net increase in demand deposits, money
 
 
   
 
   
 
 
market, passbook accounts and advances
 
 
   
 
   
 
 
by borrowers for taxes and insurance
 
25,592,459
   
70,812,416
   
44,777,862
 
Net increase in certificates of deposit
 
16,065,501
   
20,245,549
   
13,424,172
 
Decrease in checks outstanding
 
 
   
 
   
 
 
in excess of bank balance
 
-
   
(798,088
)
 
(2,500,270
)
Additional borrowed funds
 
56,000,000
   
37,000,000
   
47,000,000
 
Repayment of borrowed funds
 
(25,000,000
)
 
(45,000,000
)
 
(39,000,000
)
Common stock dividends
 
(1,410,101
)
 
(986,631
)
 
(718,818
)
Proceeds from exercise of options
 
90,750
   
480,150
   
214,500
 
Proceeds from exercise of warrants
 
-
   
-
   
3,393,064
 
 
 
 
 
Net cash provided by financing activities
 
71,338,609
   
81,753,396
   
66,590,510
 
 
 
 
 








F-6
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

CONSOLIDATED STATEMENTS OF CASH FLOWS


 
Years Ended December 31,  
 
 
2003
   
2002
   
2001
 
(Decrease) increase in cash and cash
 
 
   
 
   
 
 
equivalents
$
(10,233,853
)
$
12,621,776
 
$
5,031,372
 
Cash and cash equivalents at beginning of year
 
18,660,235
   
6,038,459
   
1,007,087
 
 
 
 
 
Cash and cash equivalents at end of year
$
8,426,382
 
$
18,660,235
 
$
6,038,459
 
 
 
 
 
The Following is a Summary of Cash and
 
 
   
 
   
 
 
Cash Equivalents
 
 
   
 
   
 
 
Cash
$
4,054,869
 
$
3,756,640
 
$
1,030,867
 
Interest bearing deposits in other banks
 
457,825
   
4,190,768
   
1,058,692
 
Federal funds
 
3,913,688
   
10,712,827
   
3,948,900
 
 
 
 
 
Cash and cash equivalents reflected on the
 
 
   
 
   
 
 
statement of cash flows
$
8,426,382
 
$
18,660,235
 
$
6,038,459
 
 
 
 
 
Supplemental Disclosure of Cash Flows Information:
 
 
   
 
   
 
 
Cash Paid During Year For:
 
 
   
 
   
 
 
Interest
$
12,432,679
 
$
13,804,867
 
$
16,094,010
 
 
 
 
 
Income taxes
$
7,576,913
 
$
5,556,478
 
$
3,282,444
 
 
 
 
 
Transfer from loans to foreclosed real estate
$
-
 
$
-
 
$
485,210
 
 
 
 
 
Transfer from foreclosed real estate to loans
$
223,911
 
$
-
 
$
358,500
 
 
 
 
 
Common stock issued for acquired company
$
-
 
$
-
 
$
1,600,000
 
 
 
 
 

The accompanying notes to consolidated financial statements
are an integral part of these statements.




F-7
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 1 - Summary of Significant Accounting Policies

A.     Principles of Consolidation - The consolidated financial statements include the accounts of Severn Bancorp, Inc. ("the Corporation"), and its wholly-owned subsidiaries, Louis Hyatt, Inc., SBI Mortgage Company and SBI Mortgage Company's subsidiary, Crownsville Development Corporation, and its subsidiary, Crownsville Holdings I, LLC, and Severn Savings Bank, FSB ("the Bank"), and the Bank's subsidiaries, Homeowners Title and Escrow Corporation, Severn Financial Services Corporation, Creekside Commons, LLC, SSB Realty Holdings, LLC, SSB Realty Holdings II, LLC, HS West, LLC and Severn Preferred Capital Corporation ("the Company"). All intercompany accounts and transactions have been eliminated in the accompanying financial statements.
 
Severn Preferred Capital Corporation was organized on April 29, 1997 and commenced operations of July 22, 1997. The Company qualifies as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended.
 
B.       Business - The Bank's primary business activity is the acceptance of deposits from the general public and the use of the proceeds for investments and loan originations. The Bank is subject to competition from other financial institutions. The Bank is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities.

The corporation has no reportable segments. Management does not separately allocate expenses, including the cost of funding loan demand, between the retail and real estate operations of the Corporation.

C.     Estimates - The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the 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 statement of financial condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses and the valuation of foreclosed real estate. See Notes H and K below for a discussion of the determination of that estimate.

D.     Investment Securities Available for Sale – Securities classified as available for sale are those debt securities that the Corporation intends to hold for an indefinite period of time, but not necessarily to maturity. Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of shareholders' equity until realized. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Gains and losses are determined using the specific identification method. The Corporation had no securities classified as available for sale at December 31, 2003 and 2002.
 
F-8
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 1 - Summary of Significant Accounting Policies - Continued

    E.       Investments and Mortgage Backed Securities Held to Maturity - Investments and mortgage backed securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity.
 
F.      Loans Held for Sale - Loans held for sale are carried at lower of cost or market value in the aggregate. Net unrealized losses are  recognized through a valuation allowance by charges to income.

      G.     Loans - Loans are carried at cost since management has the ability and intention to hold them to maturity.

H.     Allowance for Loan Losses - An allowance for loan losses is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. Determining the amount of the allowance for loan losses requires the use of estimates and assumptions, which is permitted under generally accepted accounting principles. Actual results could differ significantly from those estimates. Management believes the allowance for losses on loans is adequate. While management uses available information to estimate losses on loans, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the State of Maryland. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowances for losses on loans. Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Statement of Financial Accounting Standards ("SFAS") No. 114, as amended by SFAS No. 118, addresses the accounting by creditors for impairment of certain loans. It is generally applicable for all loans except large groups of smaller balance homogeneous loans that are collectively evaluated for impairment, including residential mortgage loans and consumer installment loans. It also applies to all loans that are restructured in a troubled debt restructuring involving a modification





F-9
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 1 - Summary of Significant Accounting Policies - Continued
H. Allowance for Loan Losses - Continued

of terms. SFAS No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.

Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of interest is doubtful. When a payment is received on a loan on non-accrual status, the amount received is allocated to principal and interest in accordance with the contractual terms of the loan.

I.     Loan Origination Fees - Loan origination fees and certain direct loan origination costs are deferred and recognized over the contractual life of the related loan as an adjustment of yield using the level-yield method.

J.     Discounts or Premiums - Discounts received or premiums paid in connection with loans purchased are amortized into income over an average loan life using the interest method.

K.     Foreclosed Real Estate - Real estate acquired through or in the process of foreclosure is recorded at the lower of cost or fair value. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using estimates as described under the caption "Allowance for Loan Losses". In the event of a subsequent decline, management provides an additional allowance, to reduce real estate acquired through foreclosure to fair value less estimated disposal cost. Expenses incurred on foreclosed real estate prior to disposition are charged to expense. Gains on the sale of foreclosed real estate are recognized upon disposition of the property.








F-10
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 1 - Summary of Significant Accounting Policies - Continued
 
L.       Loan Servicing - The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using pricing sheets from correspondent purchasers. For purposes of measuring impairment, the rights are stratified based on the following predominant risk characteristics of the underlying loans: fixed rate loans with similar terms (i.e.; fifteen years, twenty years or thirty years amortization) all originated within the same fiscal year. The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceed their fair value.
 
M.       Transfers of Financial Assets – Transfers of financial assets, including loan and loan participation sales, are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

N.     Premises and Equipment - Premises and equipment are carried at cost less accumulated depreciation. Depreciation and amortization of premises and equipment is accumulated by the use of the straight-line method over the estimated useful lives of the assets. Additions and improvements are capitalized, and charges for repairs and maintenance are expensed when incurred. The related cost and accumulated depreciation are eliminated from the accounts when an asset is sold or retired and the resultant gain or loss is credited or charged to income.

O.     Income Taxes - Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities based on enacted tax rates expected to be in effect when such amounts are realized or settled. Deferred tax assets are recognized only to the extent that is more likely than not that such amounts will be realized based on consideration of available evidence. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

P.     Statement of Cash Flows - In the statement of cash flows, cash and cash equivalents include cash, amounts due from banks, Federal Home Loan Bank of Atlanta overnight deposits, federal funds and certificates of deposit with an original maturity date less than ninety days.

Q.     Goodwill - During the year ended December 31, 2001, the Corporation recorded goodwill in the amount of $333,569 as the result of the purchase of Louis Hyatt, Inc. There were no other changes in the carrying amount of goodwill for the years ended December 31, 2003, 2002, and 2001. The Corporation tests the goodwill for impairment in accordance with SFAS 142.
 
F-11
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 1 - Summary of Significant Accounting Policies - Continued

R.     Earnings Per Share - Basic earnings per share of common stock for the years ended December 31, 2003, 2002 and 2001 is computed by dividing net income less preferred stock dividend net of tax by 4,146,566, 4,092,188 and 3,647,451, respectively, the weighted average number of shares of common stock outstanding for each year. Diluted earnings per share of common stock for the years ended December 31, 2003, 2002 and 2001, is computed by dividing net income for each year by 4,157,302, 4,103,223 and 3,683,346, respectively, the weighted average number of diluted shares of common stock. (See Note 12) The above amounts have been retroactively adjusted to give effect to a 3-for-1 stock split in the form of a 200% stock dividend declared in 2002. (See Note 11)

S.     Employee Stock Ownership Plan - The Corporation accounts for its Employee Stock Ownership Plan ("ESOP") in accordance with Statement of Position 93-6 of the Accounting Standards Division of the American Institute of Certified Public Accountants. The Corporation records compensation expense equal to the cash contribution called for under the Plan. All ESOP shares are included in the weighted average shares outstanding for earnings per share computations. All dividends paid on ESOP shares are charged to retained earnings. (See Note 9)

T.     Advertising Cost - Advertising cost is expensed as incurred. For the years ended December 31, 2003, 2002, and 2001 advertising expenses were $131,014, $131,298 and $112,214, respectively.

U.     Reclassification - Certain prior year's amounts have been reclassified to conform to the current year's method of presentation. These reclassifications had no effect on net income.
 
V.     Cash Concentrations - The Bank has a demand deposit account and federal funds with another financial institution in the amount of $6,859,294 and $13,709,768 at December 31, 2003 and 2002, respectively. The balance exceeds the Federal Deposit Insurance Corporation (“FDIC”) insurance level of $100,000 and constitutes a concentration of credit risk.








F-12
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 2 - Investment Securities
 
The amortized cost and fair values of investment securities held to maturity are as follows:
 
 
 
 
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
 
Fair
Value
 
December 31, 2003:
 
 
   
 
   
 
   
 
 
Federal Home Loan Bank
 
 
   
 
   
 
   
 
 
(“FHLB”) Notes
$
6,000,000
 
$
-
 
$
77,600
 
$
5,922,400
 
 
 
 
 
 
December 31, 2002:
 
 
   
 
   
 
   
 
 
Federal Home Loan Bank
 
 
   
 
   
 
   
 
 
(“FHLB”) Notes
$
4,000,000
 
$
48,400
 
$
-
 
$
4,048,400
 
 
 
 
 
 

FHLB Notes in the amount of $2,000,000 are pledged as collateral for its standby letters of credit issued on behalf of various borrowers and developers in favor of Anne Arundel County.
 
The scheduled maturities of investment securities are as follows at December 31, 2003:

   
Held To
Maturity Securities  
   
Amortized
Cost  
   
Fair
Value
 
Due after one year through five years
 
$
4,000,000
 
$
3,933,000
 
More than five to ten years
   
2,000,000
   
1,989,400
 
   
 
 
 
 
$
6,000,000
 
$
5,922,400
 
   
 
 




F-13
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 2 - Investment Securities - Continued

Gross losses of $145,529 and no gross gains were realized on proceeds of $854,471 during the year ended December 31, 2001 on sales of securities available for sale. No gains or losses were realized during the years ended December 31, 2002 and December 31, 2003.

Below is a schedule of securities with unrealized losses as of December 31, 2003. There are no continuous unrealized losses existing for greater than twelve months on any security at December 31, 2003. Unrealized losses are the result of interest rate levels differing from those existing at the time of purchase of the securities and, as to mortgage backed securities, actual and estimated prepayment speeds. These unrealized losses are considered temporary as they reflect market values on December 31, 2003 and are subject to change daily as interest rates fluctuate.


  Continuous Unrealized Losses for   Less than 12 months

 
 
  Fair Value  
   

  Unrealized Losses

 

Investment Securities:
 
 
   
 
 
FHLB Notes (three securities)
$
5,922,400
 
$
77,600
 
 
 
 
Mortgage Backed Securities:
 
 
   
 
 
FNMA (two securities)
 
2,397,735
   
20,342
 
FHLMC Gold (two securities)
 
4,041,440
   
24,933
 
 
 
 
Total Mortgage Backed Securities
 
6,439,175
   
45,275
 
 
 
 
Total
$
12,361,575
 
$
122,875
 
 
 
 













    F-14
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002



Note 3 - Mortgage Backed Securities

The amortized cost and fair values of mortgage backed securities held to maturity are as follows as of December 31:

 
 
Gross Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair
Value
 
   
 

2003  

FNMA
$
2,417,735
   
-
 
$
20,342
 
$
2,397,393
 
FHLMC GOLD
 
4,303,440
 
$
17,701
   
24,933
   
4,296,208
 
 
 
 
 
 
 
$
6,721,175
 
$
17,701
 
$
45,275
 
$
6,693,601
 
 
 
 
 
 
   
 

2002

FHLMC GOLD
$
5,661,304
 
$
13,559
 
$
5,223
 
$
5,669,640
 
 
 
 
 
 


FHLMC GOLD in amount of $2,833,966 is pledged as collateral for its standby letters of credit on behalf of various borrowers and developers in favor of Anne Arundel County.













F-15
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 4 - Loans Receivable

Loans receivable consist of the following:
 

  December 31,

   
2003  
   
2002  
 
Residential mortgage loans
$
187,497,605
 
$
142,341,868
 
Construction, land acquisition and
 
 
   
 
 
development loans
 
240,756,886
   
191,196,444
 
Land loans
 
25,820,590
   
20,109,481
 
Lines of credit
 
19,580,722
   
12,472,108
 
Commercial real estate loans
 
106,823,141
   
90,861,798
 
Commercial non-real estate loans
 
3,813,271
   
3,444,297
 
Second mortgage loans
 
1,220,025
   
3,108,961
 
Home equity loans
 
18,391,185
   
11,196,706
 
Consumer loans
 
783,048
   
425,001
 
Loans secured by deposits
 
360,891
   
444,597
 
 
 
 
 
 
605,047,364
   
475,601,261
 
Less
 
 
   
 
 
Loans in process
 
(94,020,135
)
 
(67,593,187
)
Allowance for loan losses
 
(4,832,446
)
 
(3,990,600
)
Unearned discount on loans purchased
 
-
   
(29,287
)
Deferred loan origination fees
 
(3,343,333
)
 
(2,644,827
)
 
 
 
 
 
(102,195,914
)
 
(74,257,901
)
 
 
 
 
$
502,851,450
 
$
401,343,360
 
 
 
 

Residential lending is generally considered to involve less risk than other forms of lending, although payment experience on these loans is dependent to some extent on economic and market conditions in the Bank's lending area. Multifamily residential, commercial, construction and other loan repayments are generally dependent on the operations of the related properties or the financial condition of its borrower or guarantor. Accordingly, repayment of such loans can be more susceptible to adverse conditions in the real estate market and the regional economy.
 
A substantial portion of the Bank's loans receivable are mortgage loans secured by residential and commercial real estate properties located in the State of Maryland. Loans are extended only after evaluation by management of customers' creditworthiness and other relevant factors on a case-by-case basis. The Bank generally does not lend more than 90% of the appraised value


F-16
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 4 - Loans Receivable - Continued

of a property and requires private mortgage insurance on residential mortgages with loan-to-value ratios in excess of 80%. In addition, the Bank generally obtains personal guarantees of repayment from borrowers and/or others for construction, commercial and multifamily residential loans and disburses the proceeds of construction and similar loans only as work progresses on the related projects.

The following is a summary of the allowance for loan losses for the three years ended December 31:

 
 
2003
   
2002
   
2001
 
Balance at beginning of year
$
3,990,600
 
$
3,353,375
 
$
2,728,004
 
Provision for loan losses
 
900,000
   
670,000
   
708,669
 
Recoveries
 
-
   
-
   
-
 
Charge-offs
 
(58,154
)
 
(32,775
)
 
(83,298
)
 
 
 
 
Balance at end of year
$
4,832,446
 
$
3,990,600
 
$
3,353,375
 
 
 
 
 

There were no Impaired loans as defined by SFAS No. 114 as of December 31, 2003. Impaired loans are summarized as follows for the years ended December 31:

 
 
2003
   
2002

 

 
2001
 
Recorded investment
$
-
 
$
252,780
 
$
300,000
 
Average balances
 
21,065
   
371,725
   
542,628
 
Allowance for loan losses
 
-
   
-
   
-
 

Impaired loans as defined by SFAS No. 114 for which interest income has been reduced are as follows for the year ended December 31:

 
 
2003
   
2002
   
2001
 
Interest income that would have been recorded
$
-
 
$
29,779
 
$
32,909
 
Interest income recognized
$
-
   
21,335
   
25,159
 
 
 
 
 
Interest income not recognized
$
-
 
$
8,444
 
$
7,750
 
 
 
 
 



F-17
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 4 - Loans Receivable - Continued

Nonaccrual loans not subject to SFAS No. 114 amounted to approximately $468,864 and $1,504,706 at December 31, 2003 and 2002, respectively. The Bank had no loans greater than ninety days past due and still accruing at December 31, 2003 and 2002.

Interest income that would have been recorded under the original terms of such loans and the interest income actually recognized for the years ended December 31, are summarized below:

 
 
2003
   
2002
   
2001
 
Interest income that would have been recorded
$
27,878
 
$
126,263
 
$
190,279
 
Interest income recognized
 
16,787
   
59,152
   
145,199
 
 
 
 
 
Interest income not recognized
$
11,091
 
$
67,111
 
$
45,080
 
 
 
 
 

Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of these loans at December 31 are summarized as follows:

 
 
2003
   
2002
 
Mortgage Loan Portfolio Serviced For:
 
 
   
 
 
FHLMC
$
2,531,476
 
$
5,758,947
 
Other investors
 
21,484,664
   
18,175,891
 
 
 
 
 
$
24,016,140
 
$
23,934,838
 
 
 
 

Custodial escrow balances maintained in connection with the foregoing loan servicing were approximately $18,659 and $53,749 at December 31, 2003 and 2002, respectively.

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of financial position. The contract amounts of these instruments express the extent of involvement the Bank has in each class of financial instruments.





F-18
 
 
     
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 4 - Loans Receivable - Continued

The Bank's exposure to credit loss from non-performance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk.

Financial Instruments Whose Contract
Amounts Represent Credit Risk
Contract Amount
At December 31,
 
 
2003
   
2002
 
Standby letters of credit
$
7,981,976
 
$
6,693,732
 
Home equity lines of credit
$
12,142,164
 
$
8,014,492
 
Loan commitments
$
24,520,151
 
$
24,771,785
 
Lines of credit
$
20,435,779
 
$
22,368,021
 
Loans sold and serviced with limited
 
 
   
 
 
repurchase provisions
$
32,876,896
 
$
10,162,735
 

Standby letters of credit are conditional commitments issued by the Bank guaranteeing performance by a customer to various municipalities. These guarantees are issued primarily to support performance arrangements, limited to real estate transactions. The majority of these standby letters of credit expire within the next twelve months. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Bank requires collateral supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of December 31, 2003 for guarantees under standby letters of credit issued is not material.

Home equity lines of credit are loan commitments to individuals as long as there is no violation of any condition established in the contract. Commitments under home equity lines expire ten years after the date the loan closes and are secured by real estate. The Bank evaluates each customer's credit worthiness on a case-by-case basis.

Mortgage loan commitments not reflected in the accompanying statements at December 31, 2003 include $19,007,934 at fixed rates ranging from 4.25% to 9.00% and $5,512,217 at rates ranging from prime to prime plus 1.5%.

Lines of credit are loan commitments to individuals and companies as long as there is no violation of any condition established in the contract. Lines of credit have a fixed expiration date. The Bank evaluates each customer's credit worthiness on a case-by-case basis.
 
F-19
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 4 - Loans Receivable - Continued

The Bank has entered into several agreements to sell mortgage loans to third parties. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within the terms specified by the agreement.

The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. No amount has been recognized in the statement of financial condition at December 31, 2003, as a liability for credit loss.

Note 5 - Premises and Equipment

Premises and equipment at December 31, 2003 and 2002 are summarized by major classification as follows:
 
 
 
December 31,
 
Estimated Useful Lives

 

 
 
2003
   
2002
   
 
 
Land
$
1,923,960
 
$
1,923,960
   
-
 
Building
 
2,642,664
   
2,188,696
   
39 Years
 
Leasehold improvements
 
574,153
   
535,016
   
15-27.5 Years
 
Furniture, fixtures and equipment
 
1,758,717
   
1,756,898
   
3-10 Years
 
 
 
       
Total at cost
 
6,899,494
   
6,404,570
   
 
 
Accumulated depreciation
 
(1,572,181
)
 
(1,666,634
)
 
 
 
 
 
       
 
$
5,327,313
 
$
4,737,936
   
 
 
 
 
       
 
Depreciation expense for the years ended December 31, 2003, 2002 and 2001 was $290,591, $260,232, and $227,331, respectively.

HS West, LLC will construct a building in the Annapolis, Maryland area to serve as the administrative headquarters. A branch office will be included. To date, HS West , LLC has incurred approximately $1,701,854 of costs, which are included in premises and equipment above. The total cost is expected to be approximately $17,000,000, with completion in November 2005.

Interest capitalized during the period ended December 31, 2003 was $38,812. There was no interest capitalized during 2002 and 2001.

The Bank and a subsidiary are obligated under long term leases for their administrative offices. The minimum annual rental payments are as follows:

Years Ended December 31,
 
 
 
2004
$
72,533
 
2005
 
46,354
 
2006
 
25,652
 
 
F-20
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 5 - Premises and Equipment - Continued

Homeowners Title and Escrow Corporation and Louis Hyatt, Inc. are also obligated under a month-to-month lease with no obligation to renew, but they anticipate that they will continue to do so.

Total rent expense was $77,599, $64,853, and $106,868 for the years ended December 31, 2003, 2002 and 2001, respectively.

Note 6 - Investment in Federal Home Loan Bank of Atlanta Stock

The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank of Atlanta ("FHLB") in an amount equal to at least 1% of the unpaid principal balances of the Bank's residential mortgage loans or 1/20 of its outstanding advances from the FHLB, whichever is greater. Purchases and sales of stock are made directly with the FHLB at par value.

Note 7 - Deposits

Deposits in the Bank as of December 31, 2003 and 2002 consisted of the savings programs described below:

 
2003
2002
Category
 
Amount
   
Percent
   
Amount
   
Percent
 
NOW accounts
$
21,219,969
   
5.06
%
$
15,980,589
   
4.23
%
Money market accounts
 
152,412,884
   
36.31
   
132,767,052
   
35.13
 
Passbooks
 
19,190,968
   
4.57
   
18,189,610
   
4.81
 
Certificates
 
226,832,739
   
54.04
   
210,913,461
   
55.81
 
 
 
 
 
 
 
 
419,656,560
   
99.98
   
377,850,712
   
99.98
 
Accrued interest
 
69,625
   
.02
   
74,329
   
.02
 
 
 
 
 
 
Total savings
$
419,726,185
   
100.00
%
$
377,925,041
   
100.00
%
 
 
 
 
 






F-21
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002



Note 7 - Deposits - Continued

At December 31, scheduled maturities of certificates of deposit are as follows:


 
2003
 
 
Amount  
   

%  

 
One year or less
$
125,650,800
   
55.39
 
More than 1 year to 2 years
 
30,261,890
   
13.34
 
More than 2 years to 3 years
 
39,724,600
   
17.51
 
More than 3 years to 4 years
 
19,889,201
   
8.77
 
More than 4 years to 5 years
 
11,306,248
   
4.99
 
More than 5 years
 
-
   
-
 
 
 
 
 
$
226,832,739
   
100.00
 
 
 
 

Interest expense on deposits is summarized as follows:

 
 
For Years Ended December 31,
 
   
2003
   
2002
   
2001
 
NOW accounts
 
$
65,297
 
$
74,814
 
$
66,785
 
Money market accounts
   
2,595,448
   
2,853,484
   
1,579,829
 
Passbooks
   
336,359
   
556,444
   
775,017
 
Certificates
   
7,964,120
   
8,815,339
   
11,169,809
 
   
 
 
 
 
 
$
10,961,224
 
$
12,300,081
 
$
13,591,440
 
   
 
 
 

The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100,000 was approximately $57,879,113 and $50,837,141 at December 31, 2003 and 2002.











F-22
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002



Note 8 - Federal Home Loan Bank Advances and Loan Payable

During 1994, the Federal Home Loan Bank of Atlanta established a Credit Availability Program. The Bank's Credit Availability under the program at December 31, 2003 and 2002 was $134,687,519 and $113,884,235, respectively. Advances outstanding at December 31, 2003 and 2002 were $65,000,000 and $34,000,000, respectively. The maturities of these advances at December 31, 2003 are as follows:

Description
 
Rate
   
Amount
   
Maturity
 
FHLB advances
 
1.15% to 3.64
%
$
11,000,000
   
2004
 
FHLB advances
 
4.52
%
 
2,000,000
   
2005
 
FHLB advances
 
2.99% to 3.24
%
 
10,000,000
   
2006
 
FHLB advances
 
3.55% to 4.01
%
 
10,000,000
   
2007
 
FHLB advances
 
3.33
%
 
5,000,000
   
2008
 
FHLB advances
 
2.57% to 4.48
%
 
27,000,000
   
Thereafter
 
       
       
 
 
 
 
$
65,000,000
   
 
 
       
       


The Bank's stock in the Federal Home Loan Bank of Atlanta is pledged as security for the advances and under a blanket floating lien security agreement with the Federal Home Loan Bank of Atlanta, the Bank is required to maintain as collateral for its advances, qualified home mortgage loans in an amount equal to 175% of the advances.

Note 9 – Employee Benefit Plans

The Bank has a Supplemental Executive Retirement Plan covering selected officers which is funded by life insurance policies. The Bank owns the policies and is the beneficiary. The amount of cost recognized for the years ended December 31, 2003, 2002 and 2001 was $11,753 per year.

The Bank has a 401(k) Retirement Savings Plan. Employees may contribute a percentage of their salary up to a maximum of $12,000 for 2003. The Bank is obligated to contribute 50% of the employee's contribution, not to exceed 6% of the employee's annual salary. All employees who have completed one year of service with the Bank are eligible to participate. The Bank's contribution to this plan was $78,564, $93,415 and $75,174 for the years ended December 31, 2003, 2002 and 2001, respectively.



F-23
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002



Note 9- Employee Benefit Plans - Continued

The Bank has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of participating employees. During the years ended December 31, 2003, 2002 and 2001, the Bank recognized ESOP expense of $140,400, $140,400 and $120,000, respectively.

Note 10- Minority Interest

Minority interest represents the equity attributable to that portion of a consolidated subsidiary (Severn Preferred Capital Corporation) that is owned by parties independent of the Corporation.

Severn Preferred Capital Corporation issued 200,002 shares of preferred stock at $20.00 per share, together with warrants to purchase 200,002 shares of the Corporation’s common stock at $17.00 per share and 200,000 shares of its common stock for $20 per share, par value of $1 per share for gross proceeds of $8,000,080 and net proceeds of $7,891,829. The Bank purchased all of the outstanding common stock. All of the warrants were exercised as of December 31, 2001.

Note 11- Stockholders’ Equity

In 1984, the Bank converted from a state chartered mutual savings and loan to a state chartered stock savings and loan association. At the time of conversion, the Bank established a liquidation account in an amount equal to the Bank's retained earnings as of September 30, 1983. The liquidation account is maintained for the benefit of eligible savings account holders who maintained their savings account in the Bank after conversion. In the event of a complete liquidation (and only in such event), each eligible savings account holder would be entitled to receive a liquidation distribution from the liquidation account in an amount equal to the account holder's then interest in the liquidation account before any liquidation distribution may be made with respect to capital stock. At December 31, 2003 and 2002, the balance of the liquidation account is included in retained earnings.

The shareholders of the Corporation voted to approve an amendment to the corporate charter to increase the number of Common shares authorized to 20,000,000 and increased the authorized number Serial Preferred shares to 1,000,000.

On February 19, 2002, the Corporation’s Board of Directors declared a 3-for-1 stock split in the form of a 200% stock dividend, which was effective for shares outstanding as of March 1, 2002 to be paid March 15, 2002. All per share data in the accompanying financial statements and all share and per share data in the footnotes have been adjusted to give retroactive effect to this transaction.
 
F-24
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 11- Stockholders Equity - Continued

The Bank’s Stock Option Plan (“Plan”) provides for the granting of options to acquire common stock to directors and key employees. Option prices are equal to or greater than fair market value of the common stock at the date of the grant. The Bank granted options to purchase 156,000 shares. The Plan provides for options granted to directors (60,000 shares) to be immediately exercisable for a period of five years from the effective date of November 25, 1997. Additionally, the Plan provides for one-fifth of the remaining options granted to be exercisable on each of the first five anniversaries of the effective date. As of December 31, 2003 all options have been granted. If the participant in the Plan terminates employment for reasons other than death or disability, he or she forfeits all rights to unvested shares.

The following table summarizes the status of and changes in the Bank’s stock option plan.


 
 
Shares
   
Weighted Average Exercise Price
 
 
 
 
   
 
 
Outstanding at January 1, 2001
 
144,000
 
$
5.57
 
Exercised in 2001
 
39,000
   
5.50
 
 
 
 
Outstanding at December 31, 2001
 
105,000
   
5.59
 
Exercised in 2002
 
85,500
   
5.62
 
Forfeited in 2002
 
1,500
   
5.50
 
 
 
 
Outstanding at December 31, 2002
 
18,000
   
5.50
 
Exercised in 2003
 
16,500
   
5.50
 
Forfeited in 2003
 
1,500
   
5.50
 
 
 
 
Outstanding at December 31,2003
 
-
   
-
 
 
 
 
Exercisable at December 31, 2002
 
18,000
   
 
 
 
       
Exercisable at December 31, 2003
 
-
   
 
 
 
       

All share and per share amounts have been retroactively adjusted for the 2002 3-for-1 stock split in the form of a 200% stock dividend.
 
F-25
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 12- Earnings Per Share

Basic EPS is computed based upon income available to common shareholders and the weighted average number of common shares outstanding for the period. Diluted EPS is to reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Corporation.

 
 
For Years Ended December 31,
 
   
2003
   
2002
   
2001
 
Net income
 
$
11,329,138
 
$
8,948,220
 
$
5,255,570
 
Less – minority interest preferred
   
 
   
 
   
 
 
stock dividends, net of tax
   
(220,972
)
 
(220,972
)
 
(220,971
)
   
 
 
 
Net income available to shareholders
 
$
11,108,166
 
$
8,727,248
 
$
5,034,599
 
   
 
 
 
Weighted average shares outstanding
   
 
   
 
   
 
 
basic EPS
   
4,146,566
   
4,092,188
   
3,647,451
 
Effect of Dilutive Shares
   
 
   
 
   
 
 
Stock options
   
10,736
   
11,035
   
35,895
 
   
 
 
 
Adjusted weighted average shares
   
 
   
 
   
 
 
used for dilutive EPS
   
4,157,302
   
4,103,223
   
3,683,346
 
   
 
 
 

All share and per share amounts have been retroactively adjusted for the 2002 3-for-1 stock split in the form of a 200% stock dividend. (See Note 11)

Note 13- Regulatory Matters

The Bank is required to maintain an average daily balance with the Federal Reserve Bank in a non-interest bearing account. The amount in such account at December 31, 2003 was $300,000.

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
F-26
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 13- Regulatory Matters - Continued

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) and risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2003, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2003, the most recent notification from the Office of Thrift Supervision categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and ratios are also presented in the table.

The following table presents the Bank's capital position based on the financial statements.

 
 
       
Actual

For Capital Adequacy Purposes

 

To Be Well
Capitalized Under
Prompt Corrective
Action Provisions      
 
 
Amount
 

%  

   
Amount
 
 

%  

   
Amount
 
 

%  

 
December 31, 2003
 
 
   
 
   
 
   
 
   
 
   
 
 
Tangible (1)
$
49,568,918
   
9.2
%
$
8,095,323
   
1.50
%
 
N/A
   
N/A
 
Tier I capital (2)
 
49,568,918
   
12.0
%
 
N/A
   
N/A
 
$
24,692,400
   
6.00
%
Core (1)
 
49,568,918
   
9.2
%
 
21,587,529
   
4.00
%
 
26,984,411
   
5.00
%
Risk-weighted (2)
 
54,313,918
   
13.2
%
 
32,923,200
   
8.00
%
 
41,154,000
   
10.00
%
 
 
 
   
 
   
 
   
 
   
 
   
 
 
December 31, 2002
 
 
   
 
   
 
   
 
   
 
   
 
 
Tangible (1)
$
39,898,384
   
8.8
%
$
6,837,788
   
1.50
%
 
N/A
   
N/A
 
Tier I capital (2)
 
39,898,384
   
12.1
%
 
N/A
   
N/A
 
$
19,768,800
   
6.00
%
Core (1)
 
39,898,384
   
8.8
%
 
18,234,100
   
4.00
%
 
22,792,625
   
5.00
%
Risk-weighted (2)
 
43,781,865
   
13.3
%
 
26,358,400
   
8.00
%
 
32,948,000
   
10.00
%


(1) To adjusted total assets.
(2) To risk-weighted assets.

F-27
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 13- Regulatory Matters - Continued

The Corporation has no significant source of income other than dividends from the Bank. As a result, the Corporation's dividends will depend primarily upon receipt of dividends from the Bank.

OTS regulations limit the payment of dividends and other capital distributions by the Bank. The Bank is able to pay dividends during a calendar year without regulatory approval to the extent of the greater of (i) an amount which will reduce by one-half its surplus capital ratio at the beginning of the year plus all its net income determined on the basis of generally accepted accounting principles for that calendar year or (ii) 75% of net income for the last four calendar quarters.

The Bank is restricted in paying dividends on its stock to the greater of the restrictions described in the preceding paragraph, or an amount that would reduce its retained earnings below its regulatory capital requirement, the accumulated bad debt deduction, or the liquidation account described in Note 11.

The Bank was allowed a special bad debt deduction at various percentages of otherwise taxable income for various years effectively through December 31, 1987. If the amounts which qualified as deductions for federal income tax purposes prior to December 31, 1987 are later used for purposes other than to absorb loan losses, including distributions in liquidations, they will be subject to federal income tax at the then current corporate rate. Retained earnings at December 31, 2003 and 2002 include $482,000, for which no provision for federal income tax has been provided. The unrecorded deferred income tax liability on the above amount was approximately $186,000.









 



F-28
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 14- Income Taxes

The income tax provision consists of the following for the years ended December 31:

 
For Years Ended December 31,
 
 
2003
   
2002
   
2001
 
Current
 
 
   
 
   
 
 
Federal
$
6,322,163
 
$
4,754,616
 
$
2,891,156
 
State
 
1,300,105
   
1,053,776
   
643,719
 
 
 
 
 
 
 
7,622,268
   
5,808,392
   
3,534,875
 
Deferred
 
 
   
 
   
 
 
Federal
 
(152,650
)
 
(226,686
)
 
(213,450
)
State
 
(33,793
)
 
(50,184
)
 
(47,252
)
 
 
 
 
 
 
(186,443
)
 
(276,870
)
 
(260,702
)
Other
 
 
   
 
   
 
 
Federal
 
113,832
   
113,832
   
113,833
 
State
 
25,200
   
25,200
   
25,200
 
 
 
 
 
 
 
139,032
   
139,032
   
139,033
 
 
 
 
 
 
$
7,574,857
 
$
5,670,554
 
$
3,413,206
 
 
 
 
 

Other income tax provision consists of income tax from preferred stock dividends.

The amount computed by applying the statutory federal income tax rate to income before federal taxes is greater than the taxes provided for the following reasons:

 
 
2003
2002
2001
 
 
 
 
Amount  
   
Percent of Pretax Income
   
 
 
 
Amount
   
Percent of Pretax Income
   
 
 
 
Amount
   
Percent of Pretax Income
 
Statutory federal
   
 
   
 
   
 
   
 
   
 
   
 
 
income tax / rate
 
$
6,427,358
   
34.00
%
$
4,970,383
   
34.00
%
$
2,947,384
   
34.00
%
State tax net of
   
 
   
 
   
 
   
 
   
 
   
 
 
federal income
   
 
   
 
   
 
   
 
   
 
   
 
 
tax benefit
   
839,483
   
4.44
   
689,291
   
4.72
   
410,300
   
4.73
 
Other adjustments
   
308,016
   
1.63
   
10,880
   
.07
   
55,522
   
.64
 
   
 
 
 
 
 
 
 
 
$
7,574,857
   
40.07
%
$
5,670,554
   
38.79
%
$
3,413,206
   
39.37
%
   
 
 
 
 
 
 

F-29
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 14- Income Taxes - Continued

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 are presented below:

 
   
2003
   
2002
 
Deferred Tax Assets:
   
 
   
 
 
Allowances for losses
 
$
1,863,607
 
$
1,541,170
 
Reserve for uncollected interest
   
4,283
   
29,179
 
   
 
 
Total gross deferred tax assets
   
1,867,890
   
1,570,349
 
 
   
 
   
 
 
Deferred Tax Liabilities:
   
 
   
 
 
Federal Home Loan Bank of Atlanta
   
 
   
 
 
stock dividends
   
(79,976
)
 
(79,976
)
Mortgage servicing rights
   
(4,920
)
 
(7,469
)
Accelerated depreciation
   
(506,194
)
 
(392,548
)
   
 
 
Total gross deferred tax liabilities
   
(591,090
)
 
(479,993
)
   
 
 
Net deferred tax assets
 
$
1,276,800
 
$
1,090,356
 
   
 
 


Note 15- Related Party Transactions

During the years ended December 31, 2003, 2002 and 2001, the Bank engaged in the transactions described below with parties that may be deemed affiliated.

The land and building for the office where the Bank's primary operating activities are conducted were leased from a stockholder of the Bank. Rent paid on this property was $ -0-, $ -0- and $32,012 for 2003, 2002 and 2001, respectively. Additionally, two subsidiaries rent property from a director of the Bank. Rent paid on these properties was $49,105, $38,562 and $32,010 for 2003, 2002 and 2001, respectively.

A director of the Bank is a member of a law firm that represents the Bank in certain legal matters. The fees for services rendered by that firm were $166,816, $161,890 and $80,866 for the years ended December 31, 2003, 2002 and 2001, respectively.



F-30
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 15- Related Party Transactions - Continued

In June, 2001 the Corporation purchased Louis Hyatt, Inc. (see Note 17) from Louis Hyatt who is a stockholder of the Corporation and a relative of the Chairman of the Board.

The Corporation purchased HS West, LLC from Louis Hyatt who is a stockholder of the Corporation and a relative of the Chairman of the Board. HS West, LLC had no income or expenses and consisted only of land.

Management believes that the terms in the above mentioned transactions were no less favorable to the Bank than the terms that would have been obtained in transactions with non-affiliated persons or entities.

Note 16- Disclosure About Fair Value of Financial Instruments

The estimated fair values of the Bank's financial instruments are summarized below. The fair values of a significant portion of these financial instruments are estimates derived using present value techniques prescribed by the FASB and may not be indicative of the net realizable or liquidation values. Also, the calculation of estimated fair values is based on market conditions at a specific point in time and may not reflect current or future fair values.

The carrying amount is a reasonable estimate of fair value for cash, federal funds, interest-bearing deposits in other banks, accrued interest receivable, and accrued interest payable due to the short-term nature of these investments. Fair value is based upon market prices quoted by dealers for investment securities and estimates using bid prices published in financial newspapers for mortgage backed securities. The carrying amount of Federal Home Loan Bank of Atlanta stock is a reasonable estimate of fair value. Loans receivable were discounted using a single discount rate, comparing the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.











F-31
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 16- Disclosure About Fair Value of Financial Instruments - Continued

These rates were used for each aggregated category of loans as reported on the Office of Thrift Supervision Quarterly Report. The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered on deposits of similar remaining maturities.

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business, including loan commitments. The loan commitments were a blended rate based on the relative risk of the properties involved and the lines of credit are at adjustable rates.

The estimated fair values of the Bank's financial instruments are as follows:

 
 
December 31, 2003
December 31, 2002
   
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
Financial Assets
   
 
   
 
   
 
   
 
 
Cash, interest bearing deposits in other
   
 
   
 
   
 
   
 
 
banks and federal funds
 
$
8,426,382
 
$
8,426,382
 
$
18,660,235
 
$
18,660,235
 
Investment securities
   
6,000,000
   
5,922,400
   
4,000,000
   
4,048,400
 
Mortgage backed
   
 
   
 
   
 
   
 
 
securities
   
6,721,175
   
6,693,601
   
5,661,304
   
5,669,640
 
FHLB of Atlanta stock
   
3,250,000
   
3,250,000
   
1,900,000
   
1,900,000
 
Loans held for sale
   
3,174,954
   
3,174,954
   
17,481,301
   
17,481,301
 
Loans receivable, net
   
502,851,450
   
457,887,000
   
401,343,360
   
373,532,000
 
Accrued interest receivable
   
2,701,718
   
2,701,718
   
2,549,425
   
2,549,425
 
 
   
 
   
 
   
 
   
 
 
Financial Liabilities
   
 
   
 
   
 
   
 
 
Deposits
 
$
419,656,560
 
$
421,557,000
 
$
377,850,712
 
$
380,038,000
 
FHLB advances
   
65,000,000
   
63,595,276
   
34,000,000
   
33,783,262
 
Accrued interest payable
   
69,625
   
69,625
   
74,329
   
74,329
 
Commitments
   
-
   
-
   
-
   
-
 




F-32
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002



Note 17- Merger

On July 1, 2001, the Corporation acquired Louis Hyatt, Inc. (“LHI”) a real estate sales and management company (see Note 15). “LHI” was 100% owned by Louis Hyatt. The Corporation issued 60,000 shares new shares and transferred 20,000 shares that were previously owned by “LHI” for all the outstanding stock of “LHI”.

The combination was accounted for under the purchase method of accounting, and accordingly, the net assets were recorded at their estimated fair values at the date of acquisition. “LHI’s” assets consisted primarily of fixed assets and, accordingly, the fair market value adjustment of $1,415,829 will be depreciated over the estimated lives of the assets. The excess of the purchase price over the estimated fair value of the underlying net assets of $333,569 was allocated to goodwill.

Unaudited proforma condensed financial statements are not presented because the amounts are not material to the consolidated financial statements.

Note 18- Condensed Financial Information (Parent Company Only)

Information as to the financial position of Severn Bancorp, Inc. as of December 31, 2003 and 2002 and results of operations and cash flows for each of the years ended December 31, 2003, 2002 and 2001 is summarized below.


 
 
December 31,
 
   
2003
   
2002
 
Statement of Financial Condition
   
 
   
 
 
Cash
 
$
464,505
 
$
363,279
 
Equity in net assets of subsidiaries
   
48,835,478
   
39,061,475
 
Taxes receivable
   
49,539
   
11,064
 
   
 
 
 
 
$
49,349,522
 
$
39,435,818
 
   
 
 









F-33
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 18- Condensed Financial Information (Parent Company Only) - Continued
 
 
 
December 31,
 
   
2003
   
2002
 
Taxes payable
 
$
-
 
$
5,925
 
Accounts payable and accrued expenses
   
379,369
   
248,556
 
   
 
 
 
   
379,369
   
254,481
 
Common stock
   
41,591
   
41,426
 
Additional paid-in capital
   
11,516,495
   
11,425,910
 
Retained earnings
   
37,412,067
   
27,714,001
 
 
   
48,970,153
   
39,181,337
 
   
 
 
 
 
$
49,349,522
 
$
39,435,818
 
   
 
 

 
 
For the Years Ended December 31,
 
   
2003
   
2002
   
2001
 
Statement of Operations
   
 
   
 
   
 
 
Dividends received from subsidiaries
 
$
1,410,102
 
$
986,631
 
$
718,818
 
General and administrative expenses
   
95,450
   
137,961
   
27,569
 
   
 
 
 
Net Income before income taxes and equity in undistributed net
   
 
   
 
   
 
 
income of subsidiaries
   
1,314,652
   
848,670
   
691,249
 
Income tax benefit
   
(19,512
)
 
(56,564
)
 
(9,373
)
Equity in undistributed net income of
   
 
   
 
   
 
 
subsidiaries
   
9,994,974
   
8,042,986
   
4,554,948
 
   
 
 
 
Net income
 
$
11,329,138
 
$
8,948,220
 
$
5,255,570
 
   
 
 
 

 
 
December 31,
 
   
2003
   
2002
   
2001
 
Statement of Cash Flows
   
 
   
 
   
 
 
Cash Flows from Operating Activities:
   
 
   
 
   
 
 
Net income
 
$
11,329,138
 
$
8,948,220
 
$
5,255,570
 
Adjustments to Reconcile Net Income to Net
   
 
   
 
   
 
 
Cash Provided by Operating Activities:
   
 
   
 
   
 
 
Equity in undistributed earnings of
   
 
   
 
   
 
 
subsidiaries
   
(9,994,974
)
 
(8,042,986
)
 
(4,554,948
)
Increase in taxes receivable
   
( 38,475
)
 
(11,064
)
 
-
 
Decrease (increase) in other assets
   
-
   
9,550
   
14,824
 
Decrease (increase) in taxes payable
   
(5,925
)
 
511
   
(9,298
)
Increase in accounts payable and
   
 
   
 
   
 
 
accrued expenses
   
130,813
   
57,300
   
53,684
 
Tax benefit of exercised options
   
-
   
129,728
   
-
 
   
 
 
 
Net cash provided by operating activities
   
1,420,577
   
1,091,259
   
759,832
 


F-34
 
 
     
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002


Note 18- Condensed Financial Information (Parent Company Only) - Continued


 
 
December 31,
 
   
2003
   
2002
   
2001
 
Cash Flows From Investing Activities
   
 
   
 
   
 
 
Investment in subsidiaries
 
$
-
 
$
(587,878
)
$
(3,299,313
)
Cash consideration Louis Hyatt, Inc.
   
 
   
 
   
 
 
acquisition - net
   
-
   
-
   
(31,340
)
   
 
 
 
Cash provided by (used) investing activities
   
-
   
(587,878
)
 
(3,330,653
)
 
   
 
   
 
   
 
 
Cash Flows from Financing Activities
   
 
   
 
   
 
 
Dividends paid on capital stock
   
(1,410,101
)
 
(986,631
)
 
(718,818
)
Proceeds from exercise of options
   
90,750
   
480,150
   
214,500
 
Proceeds from exercise of warrants
   
-
   
-
   
3,284,813
 
   
 
 
 
Net cash (used) provided by financing activities
   
(1,319,351
)
 
(506,481
)
 
2,780,495
 
   
 
 
 
(Decrease) increase in cash and cash equivalents
 
$
101,226
 
$
(3,100
)
$
209,674
 
Cash and cash equivalents at beginning of year
   
363,279
   
366,379
   
156,705
 
   
 
 
 
Cash and cash equivalents at end of year
 
$
464,505
 
$
363,279
 
$
366,379
 
   
 
 
 
Supplemental Disclosures of Cash Flows Information:
   
 
   
 
   
 
 
Common stock issued for acquired Company
 
$
-
 
$
-
 
$
1,600,000
 
 

 
There was no cash paid during the years ended December 31, 2003, 2002 and 2001 for income taxes or interest.






F-35
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 19- Recent Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This Interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under certain specified guarantees. Under FIN 45, the Bank does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit, as discussed in Note 4. Adoption of FIN 45 did not have a significant impact on the Bank’s financial condition or results of operations.

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 was revised in December 2003. This Interpretation provides new guidance for the consolidation of variable interest entities (VIEs) and requires such entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among parties involved. The interpretation also adds disclosure requirements for investors that are involved with unconsolidated VIEs. The disclosure requirements apply to all financial statements issued after December 31, 2003. The consolidation requirements apply to companies that have interests in special-purpose entities for periods ending after December 15, 2003. Consolidation of other types of VIEs is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation did not have and is not expected to have an impact on the Corporation’s financial condition or results of operations.

In April 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, “Amendment of Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.” This Statement clarifies the definition of a derivative and incorporates certain decisions made by the Board as part of the Derivatives Implementation Group process. This Statement is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003 and should be applied prospectively. The provisions of the Statement that relate to implementation issues addressed by the Derivatives Implementation Group that have been effective should continue to be applied in accordance with their respective dates. Adoption of this standard did not have an impact on the Corporation’s financial condition or results of operations.

In May 2003, the Financial Accounting Standards Board issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement requires that an issuer classify a financial instrument that is within its scope as a liability. Many of these instruments were previously classified as equity. This Statement was effective for financial instruments entered into or modified after May 31, 2003 and otherwise was effective beginning July 1, 2003. The adoption of this standard did not have an impact on the Corporation’s financial condition or results of operations.

F-36
 
 
     
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 AND 2002

Note 20- Quarterly Financial Data (Unaudited)
 
Summarized unaudited quarterly financial data for the year ended December 31, 2003 is as follows:

Operating Summary:
   
First
Quarter
   
Second Quarter
   
Third
Quarter
   
Fourth
Quarter
 
 
   
 
   
 
   
 
   
 
 
Interest Income
 
$
8,863,214
 
$
9,172,403
 
$
9,459,964
 
$
9,591,425
 
Interest Expense
   
3,137,156
   
3,105,706
   
3,064,482
   
3,033,733
 
   
 
 
 
 
Net Interest Income
   
5,726,058
   
6,066,697
   
6,395,482
   
6,557,692
 
Provision for Loan Losses
   
225,000
   
225,000
   
225,000
   
225,000
 
   
 
 
 
 
Net Interest Income after provision for loan losses
   
5,501,058
   
5,841,697
   
6,170,482
   
6,332,692
 
Other Income
   
1,165,065
   
1,317,817
   
1,319,317
   
871,439
 
Other Expense
   
2,120,847
   
2,602,612
   
2,468,117
   
2,423,996
 
   
 
 
 
 
Income before income tax provision
   
4,545,276
   
4,556,902
   
5,021,682
   
4,780,135
 
Income Taxes
   
1,838,664
   
1,759,484
   
1,935,136
   
2,041,573
 
   
 
 
 
 
Net Income
 
$
2,706,612
 
$
2,797,418
 
$
3,086,546
 
$
2,738,562
 
   
 
 
 
 
Per share data:
   
 
   
 
   
 
   
 
 
Earnings – basic
 
$
.64
 
$
.66
 
$
.73
 
$
.65
 
Earnings – diluted
 
$
.64
 
$
.66
 
$
.73
 
$
.65
 

Summarized unaudited quarterly financial data for the year ended December 31, 2002 is as follows:

Operating Summary:
   
First
Quarter
   
Second Quarter
   
Third Quarter
   
Fourth Quarter
 
 
   
 
   
 
   
 
   
 
 
Interest Income
 
$
7,799,000
 
$
8,167,122
 
$
8,510,349
 
$
8,925,528
 
Interest Expense
   
3,585,497
   
3,349,683
   
3,468,175
   
3,395,922
 
   
 
 
 
 
Net Interest Income
   
4,213,503
   
4,817,439
   
5,042,174
   
5,529,606
 
Provision for Loan Losses
   
105,000
   
135,000
   
205,000
   
225,000
 
   
 
 
 
 
Net Interest Income after provision for loan losses
   
4,108,503
   
4,682,439
   
4,837,174
   
5,304,606
 
Other Income
   
867,306
   
894,455
   
749,465
   
1,621,459
 
Other Expense
   
1,882,313
   
1,994,795
   
1,948,119
   
2,621,406
 
   
 
 
 
 
Income before income tax provision
   
3,093,496
   
3,582,099
   
3,638,520
   
4,304,659
 
Income Taxes
   
1,197,497
   
1,404,558
   
1,404,963
   
1,663,536
 
   
 
 
 
 
Net Income
 
$
1,895,999
 
$
2,177,541
 
$
2,233,557
 
$
2,641,123
 
   
 
 
 
 
 
   
 
   
 
   
 
   
 
 
Per share data
   
 
   
 
   
 
   
 
 
Earnings – basic
 
$
.45
 
$
.52
 
$
.53
 
$
.63
 
Earnings – diluted
 
$
.45
 
$
.51
 
$
.53
 
$
.63
 

F-37

CERTIFICATION

I, Alan J. Hyatt, President, CEO and Chairman of the Board, certify that:

1.     I have reviewed this annual report on Form 10-K of Severn Bancorp, Inc. (the “Company”);

2.     Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3.     Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4.     The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a)     designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b)     evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation;

c)     d isclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.     The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)     all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b)     any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Date:     March 25, 2004                         /s/
                                                     By:  Alan J. Hyatt, Chief Executive Officer   and Chairman of the Board
                                   (Principal Executive Officer)

CERTIFICATION

I, Cecelia Lowman, Chief Financial Officer of Severn Bancorp, Inc., certify that:

1.     I have reviewed this annual report on Form 10-K of Severn Bancorp, Inc.;

2.     Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3.     Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4.     The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a)     designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b)     evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation;

c)     d isclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.     The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)     all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b)     any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Date:     March 25, 2004                         /s/
                                                     Cecelia Lowman, Chief Financial Officer
    (Principal Financial and Accounting Officer)





CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Section 1350 of Chapter 63 of Title 18 of the United States Code) each of the undersigned officers of the Company does hereby certify with respect to the Annual Report of the Company on Form 10-K for the period ended December 31, 2003 (the “Report”) that:

1.      The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2.       The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

 

 
     Date: March 25, 2004                     /s/
Alan J. Hyatt
Chief Executive Officer
 

 
     Date: March 25, 2004                     /s/
Cecelia Lowman
Chief Financial Officer

The foregoing certification is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Section 1350 of Chapter 63 of Title 18 of the United States Code) and is not being filed as part of the Report or as a separate disclosure document.