EX-23 4 exhibit23.htm EXHIBIT23 exhibit23
 
Report of Independent Registered
Public Accounting Firm
 
 
To the Board of Directors and Stockholders
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, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall 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, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
    
                                        
 
Beard Miller Company LLP
Baltimore, Maryland
February 17, 2006





SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands, except per share data)

 
December 31,
 
 
2005
 
 
2004
  
             
ASSETS
    
Cash and due from banks
  
$
4,692
  
$
7,950
  
Interest bearing deposits in other banks
    
301
    
3,259
  
Federal funds sold
    
15,923
    
6,829
  
Cash and cash equivalents
    
20,916
    
18,038
  
Investment securities held to maturity
    
8,290
    
9,955
  
Loans held for sale
    
3,216
    
6,654
  
Loans receivable, net of allowance for loan losses of
$7,505 and $5,935, respectively
    
776,117
    
650,313
  
Premises and equipment, net
    
19,963
    
7,004
  
Federal Home Loan Bank stock at cost
    
8,513
    
5,083
  
Accrued interest receivable and other assets
    
8,680
    
6,569
  
               
Total assets
  
$
845,695
  
$
703,616
  
               
LIABILITIES AND STOCKHOLDERS' EQUITY
              
Liabilities
              
Deposits
  
$
590,814
  
$
527,413
  
Short-term borrowings
    
26,000
    
-
  
Long-term borrowings
    
132,000
    
89,000
  
Subordinated debentures
    
20,619
    
20,619
  
Accrued interest payable and other liabilities
    
3,550
    
2,430
  
               
Total liabilities
    
772,983
    
639,462
  
               
Minority interest - preferred securities of subsidiary
    
-
    
4,000
  
               
Stockholders’ Equity
              
Common stock, $0.01 par value, 20,000,000 shares authorized;
8,318,184 shares issued and outstanding
    
83
    
83
  
Additional paid-in capital
    
11,516
    
11,516
  
Retained earnings
   
61,113
    
48,555
  
               
Total stockholders' equity
    
72,712
    
60,154
  
               
Total liabilities and stockholders' equity
  
$
845,695
  
$
703,616
  

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



F-2


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands, except per share data)

 
Years Ended December 31,
Interest Income
 
 
2005
 
 
2004
 
 
2003
  
Loans
  
$
55,888
  
$
43,881
  
$
36,403
  
Securities, taxable
    
327
    
419
    
453
  
Other
    
688
    
319
    
231
  
Total interest income
    
56,903
    
44,619
    
37,087
  
                     
Interest Expense
                    
Deposits
    
16,274
    
11,292
    
10,961
  
Short-term borrowings
    
853
    
259
    
9
  
Long-term borrowings and subordinated debentures
    
4,828
    
3,080
    
1,371
  
Total interest expense
    
21,955
    
14,631
    
12,341
  
                     
Net interest income
    
34,948
    
29,988
    
24,746
  
Provision for loan losses
    
1,570
    
1,200
    
900
  
Net interest income after provision for loan losses
    
33,378
    
28,788
    
23,846
  
                     
Other Income
                    
Mortgage banking activities
    
1,416
    
1,435
    
2,491
  
Real estate commissions
    
545
    
1,234
    
1,160
 
Real estate management fees
    
426
    
404
    
369
  
Gain on sale of foreclosed real estate
    
-
    
-
    
169
  
Other income
    
593
    
539
    
485
  
Total other income
    
2,980
    
3,612
    
4,674
  
                     
Non-Interest Expenses
                    
Compensation and related expenses
    
9,080
    
8,167
    
6,976
  
Occupancy
    
719
    
610
    
534
  
Other
    
3,079
    
2,434
    
2,106
  
Total non-interest expenses
    
12,878
    
11,211
    
9,616
  
                     
Income before income tax provision
    
23,480
    
21,189
    
18,904
  
Income tax provision
    
8,926
    
8,258
    
7,575
  
                     
Net income
  
$
14,554
  
$
12,931
  
$
11,329
  
Basic earnings per share
  
$
1.75
  
$
1.56
  
$
1.34
  
Diluted earnings per share
  
$
1.75
  
$
1.56
  
$
1.33
  

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, 2005, 2004, and 2003
(dollars in thousands, except per share data)

   
Common
Stock
 
 
Additional Paid-In Capital
 
 
Retained
Earnings
 
 
Total Stockholders’ Equity
  
Balance - December 31, 2002
  
$
41
  
$
11,426
  
$
27,714
  
$
39,181
  
                           
Comprehensive Income
                          
Net income
    
-
    
-
    
11,329
    
11,329
  
Exercise of 16,500 options
    
1
    
90
    
-
    
91
  
Other
    
-
    
-
    
(221
)
  
(221
)
Dividends on common stock
                          
($.17 per share)
    
-
    
-
    
(1,410
)
  
(1,410
)
                           
Balance - December 31, 2003
    
42
    
11,516
    
37,412
    
48,970
  
                           
Comprehensive Income
                          
Net income
    
-
    
-
    
12,931
    
12,931
 
Two-for-one stock split in the
                          
form of a 100% dividend
    
41
    
-
    
(41
)
  
-
  
Dividends on common stock
                          
($.21 per share)
    
-
    
-
    
(1,747
)
  
(1,747
)
     
   
   
   
 
Balance - December 31, 2004
    
83
    
11,516
    
48,555
    
60,154
 
                           
Comprehensive Income
                          
Net income
    
-
    
-
    
14,554
    
14,554
  
Dividends on common stock
                          
($.24 per share)
    
-
    
-
    
(1,996
)
  
(1,996
)
           
   
   
 
Balance - December 31, 2005
  
$
83
  
$
11,516
  
$
61,113
  
$
72,712
  

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
(dollars in thousands)

 
Years Ended December 31,
 
 
2005
 
 
2004
 
 
2003
  
Cash Flows from Operating Activities
                    
Net income
  
$
14,554
  
$
12,931
  
$
11,329
  
Adjustments to reconcile net income to net
                    
cash provided by operating activities:
                    
Amortization of deferred loan fees
    
(3,927
)
  
(3,390
)
  
(2,417
)
Net amortization of premiums and discounts
    
31
    
33
    
78
  
Deferred income taxes
    
213
    
408
    
(186
)
Provision for loan losses
    
1,570
    
1,200
    
900
  
Provision for depreciation
    
377
    
329
    
291
  
Gain on sale of foreclosed real estate
    
-
   
-
    
(169
)
Gain on sale of loans
    
(804
)
  
(791
)
  
(1,563
)
Proceeds from loans sold to others
    
78,008
    
71,664
    
135,435
  
Loans originated for sale
    
(73,766
)
  
(74,352
)
  
(119,566
)
Increase in accrued interest receivable and other assets
    
(2,324
)
  
(2,256
)
  
(127
)
Increase (decrease) in accrued interest payable
                   
and other liabilities
    
1,120
    
(346
)
  
(464
)
                     
Net cash provided by operating activities
    
15,052
    
5,430
    
23,541
  
                     
Cash Flows from Investing Activities
                    
Purchase of investment securities
    
-
    
-
    
(14,485
)
Proceeds from maturing investment securities
    
-
    
1,000
    
8,000
  
Principal collected on mortgage backed securities
   
1,634
    
1,733
    
3,318
  
Net increase in loans
    
(123,447
)
  
(145,271
)
  
(99,716
)
Loans purchased
    
-
    
-
    
(246
)
Proceeds from sale of foreclosed real estate
    
-
    
-
    
393
  
Investment in premises and equipment
    
(13,336
)
  
(2,006
)
  
(880
)
Purchase of FHLB stock
    
(3,430
)
  
(1,833
)
  
(1,350
)
                     
Net cash used in investing activities
    
(138,579
)
  
(146,377
)
  
(104,966
)






F-5


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(dollars in thousands)

 
For the Years Ended December 31,
 
 
2005
 
 
2004
 
 
2003
  
                   
Cash Flows from Financing Activities
                    
                     
Net increase in deposits
  
$
63,401
  
$
107,687
  
$
41,510
  
Net increase (decrease) in short term borrowings
    
26,000
    
(6,000
)
  
6,000
  
Additional borrowed funds, long term
    
50,000
    
35,000
    
35,000
  
Repayment of borrowed funds, long term
    
(7,000
)
  
(5,000
)
  
(10,000
)
Redemption of preferred securities of subsidiary
    
(4,000
)
  
-
    
-
  
Cash dividends paid
    
(1,996
)
  
(1,747
)
  
(1,410
)
Proceeds from exercise of options
    
-
    
-
    
91
  
Proceeds from issuance of subordinated debentures
    
-
    
20,619
    
-
  
                     
Net cash provided by financing activities
    
126,405
    
150,559
    
71,191
  
                     
Increase (decrease) in cash and cash equivalents
    
2,878
    
9,612
    
(10,234
)
Cash and cash equivalents at beginning of year
    
18,038
    
8,426
    
18,660
  
                     
Cash and cash equivalents at end of year
  
$
20,916
  
$
18,038
  
$
8,426
  
                     
                     
Supplemental disclosure of cash flows information:
                    
Cash paid during year for:
                    
                     
Interest
  
$
21,693
  
$
14,587
  
$
12,433
  
                     
Income taxes
  
$
9,624
  
$
8,559
  
$
7,577
  

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

 
F-6


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 

Note 1 - Summary of Significant Accounting Policies

A. Principles of Consolidation - The consolidated financial statements include the accounts of Severn Bancorp, Inc. ("Bancorp"), 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, SSB Realty Holdings, LLC, SSB Realty Holdings II, LLC, HS West, LLC and Severn Preferred Capital Corporation. All intercompany accounts and transactions have been eliminated in the accompanying financial statements.
 
      Severn Preferred Capital Corporation, which qualified as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended, liquidated effective January 31, 2005.

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. In addition, the Bank is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities.

Bancorp 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 Bancorp.

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.

 
F-7


SEVERN BANCORP, INC.  AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies - Continued

D. 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. Declines in the fair value of held to maturity securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

E. 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. Mortgage loans held for sale are generally sold with the mortgage servicing rights released by the Bank. Gains and losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.

F.  
Loans - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.


F-8


SEVERN BANCORP, INC.  AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies - Continued


G.  
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 allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
 
      The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) or the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.


F-9


SEVERN BANCORP, INC.  AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies - Continued

 
     A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment, include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
 
      Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

 
H.
Foreclosed Real Estate - Real estate acquired through or in the process of foreclosure is recorded at 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 or losses 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


Note 1 - Summary of Significant Accounting Policies - Continued
 
I.  
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. Mortgage servicing rights totaled $0 and $6,000 at December 31, 2005 and 2004, respectively, and are included in Other Assets.

J.  
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 Bancorp, (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) Bancorp does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

K. 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.

 
L.
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 it 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.

 
M.
Statement of Cash Flows - In the statement of cash flows, cash and cash equivalents include cash on hand, amounts due from banks, Federal Home Loan Bank of Atlanta overnight deposits, and federal funds sold. Generally, federal funds are sold for one day periods.

 
F-11

 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies - Continued

N. Earnings Per Share - Basic earnings per share of common stock for the years ended December 31, 2005, 2004 and 2003 is computed by dividing net income available to common stockholders by 8,318,184, 8,318,184 and 8,293,132, respectively, the weighted average number of shares of common stock outstanding for each year. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by Bancorp relate solely to outstanding stock options, and are determined using the treasury stock method. Diluted earnings per share of common stock for the years ended December 31, 2005, 2004 and 2003, is computed by dividing net income available to common stockholders for each year by 8,318,184, 8,318,184 and 8,314,604, respectively, the weighted average number of diluted shares of common stock. The above amounts have been retroactively adjusted to give effect to a 2-for-1 stock split in the form of a 100% stock dividend declared in November 2004.

O. Employee Stock Ownership Plan - Bancorp 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. Bancorp 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.

P.  Advertising Cost - Advertising cost is expensed as incurred and totaled $190,000, $240,000 and $131,000 for the years ended December 31, 2005, 2004, and 2003, respectively.

Q.  
Reclassifications - Certain prior year amounts have been reclassified to conform to the current year's method of presentation. These reclassifications had no effect on net income.

R.  
Recent Accounting Pronouncements - In March 2004, the EITF reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS 115 and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. In November 2005, the FASB approved the issuance of FASB Staff Position FAS No. 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The FSP addresses when an investment is considered impaired, whether the impairment is other-than-temporary and the measurement of an impairment loss.


F-12


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies - Continued

The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary. The FSP is effective for reporting periods beginning after December 15, 2005 with earlier application permitted. For Bancorp, the effective date will be the first quarter of fiscal 2006. The adoption of this accounting principle is not expected to have a significant impact on our financial position or results of operations.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123(R), "Share-Based Payment," (FAS 123R). FAS 123(R) revised FAS123 and supersedes APB 25, and its related implementation guidance. FAS 123(R) will require all compensation costs related to share-based payments to be recognized in the income statement (with limited exceptions) based on their fair values and no longer allows pro forma disclosure as an alternative to reflecting the impact of share-based payments on net income and net income per share. The amount of compensation cost will be measured based on the grant-date fair value of the stock-based compensation issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. This statement is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005 and permits public companies to adopt its requirements using one of two methods: modified prospective or modified retrospective. Bancorp currently doesn’t have any stock options outstanding, but plans to adopt FAS 123(R) during the quarter it grants options.

F-13

 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 2 - Investment Securities 

The amortized cost and fair value of investment securities held to maturity are as follows:


   
Amortized
Cost
 
 
Gross Unrealized Gains
    
Gross Unrealized Losses
 
 
Fair
Value
 
 
(dollars in thousands)
December 31, 2005:
                          
                           
Federal Home Loan Bank
                          
(“FHLB”) Notes
  
$
5,000
  
$
-
  
$
158
  
$
4,842
  
Mortgage backed securities
    
3,290
    
4
    
144
    
3,150
  
   
$
8,290
  
$
4
  
$
302
  
$
7,992
  
December 31, 2004:
                          
                           
Federal Home Loan Bank
                          
(“FHLB”) Notes
  
$
5,000
  
$
-
  
$
78
  
$
4,922
  
Mortgage backed securities
    
4,955
    
7
    
70
    
4,892
  
   
$
9,955
  
$
7
  
$
148
  
$
9,814
  



FHLB Notes in the amount of $2,000,000 and mortgage backed securities in the amount of $1,147,000 are pledged as collateral for the Bank’s standby letters of credit issued on behalf of various borrowers and developers in favor of Anne Arundel County.

The scheduled maturities of investment securities held to maturity are as follows at December 31, 2005:

   
Amortized
Cost
 
 
Fair
Value
 
 
(dollars in thousands)
Due after one year through five years
 
$
5,147
  
$
4,966
  
More than five to ten years
    
1,000
   
973
  
Greater than ten years
    
2,143
    
2,053
  
   
$
8,290
  
$
7,992
  


F-14


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 2 - Investment Securities - Continued

The following table shows fair value and unrealized losses, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position as of December 31, 2005 and 2004. Included in the table are two Federal Home Loan Bank notes and four mortgage backed securities. Management believes that the 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 fair values on December 31, 2005 and 2004 and are subject to change daily as interest rates fluctuate.


2005
  
Less than 12 months
12 Months or More
Total
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
(dollars in thousands)
                                     
Federal Home Loan Bank Notes
  
$
973
  
$
27
  
$
3,869
  
$
131
  
$
4,842
  
$
158
  
Mortgage Backed Securities
    
500
    
15
    
2,635
    
129
    
3,135
    
144
  
                                       
Total temporarily impaired securities
  
$
1,473
  
$
42
  
$
6,504
  
$
260
  
$
7,977
  
$
302
  




2004
  
Less than 12 months
12 Months or More
Total
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
(dollars in thousands)
                                     
Federal Home Loan Bank Notes
  
$
1,975
  
$
25
  
$
1,947
  
$
53
  
$
3,922
  
$
78
  
Mortgage Backed Securities
    
4,830
    
70
    
-
    
-
    
4,830
    
70
  
                                       
Total temporarily impaired securities
  
$
6,805
  
$
95
  
$
1,947
  
$
53
  
$
8,752
  
$
148
  
 

 
F-15


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable

Loans receivable consist of the following:
 
 
December 31,
 
 
2005
 
 
2004
 
 
(dollars in thousands)
Residential mortgage
  
$
219,988
  
$
215,767
  
Construction, land acquisition and development
    
390,376
    
343,101
  
Land
    
77,319
    
33,419
  
Lines of credit
    
35,491
    
29,096
  
Commercial real estate
    
163,449
    
127,768
  
Commercial non-real estate
    
3,412
    
3,859
  
Home equity
    
32,974
    
28,101
  
Consumer
    
1,768
    
2,489
  
     
924,777
    
783,600
  
Less
              
Loans in process
    
(136,239
)
  
(123,195
)
Allowance for loan losses
    
(7,505
)
  
(5,935
)
Deferred loan origination fees
    
(4,916
)
  
(4,157
)
               
   
$
776,117
  
$
650,313
  

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 of a property and requires private mortgage insurance on residential mortgages with loan-to-value ratios in excess of 80%.



F-16


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

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:

   
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
Balance at beginning of year
  
$
5,935
  
$
4,832
  
$
3,991
  
Provision for loan losses
    
1,570
    
1,200
    
900
  
Charge-offs
    
-
   
(97
)
  
(59
)
Balance at end of year
  
$
7,505
  
$
5,935
  
$
4,832
  

At December 31, 2005 and 2004, the recorded investment in loans considered to be impaired under FASB Statement No.114 “Accounting by Creditors for Impairment of a Loan” totaled $2,565,000 and $0, respectively. There was no specific valuation reserve for impaired loans at December 31, 2005 and 2004. Impaired loans averaged $2,589,000 during 2005, and $0 during 2004 and 2003. Interest income recognized on these loans totaled $167,000 during 2005, and $0 during 2004 and 2003.

Non-accrual loans amounted to approximately $1,693,000 and $939,000 at December 31, 2005 and 2004, respectively. The Bank had no loans greater than ninety days past due and still accruing at December 31, 2005 and 2004.

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:
 
   
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
Interest income that would have been recorded
  
$
147
  
$
70
  
$
28
  
Interest income recognized
    
64
    
37
    
17
  
Interest income not recognized
  
$
83
  
$
33
  
$
11
  

Mortgage loans serviced for others not included in the accompanying consolidated statements of financial condition totaled $30,080,000 and $23,363,000 at December 31, 2005 and 2004, respectively.
 

F-17


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 3 - Loans Receivable - Continued

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.

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,
 
 
2005
 
 
2004
 
 
(dollars in thousands)
Standby letters of credit
  
$
6,617
  
$
7,866
  
Home equity lines of credit
    
19,802
    
16,497
  
Unadvanced construction commitments
    
136,239
    
123,195
  
Loan commitments
    
19,515
   
18,188
  
Lines of credit
    
33,782
    
24,831
  
Loans sold with limited repurchase provisions
  
$
11,048
  
$
25,709
  

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, 2005 and 2004 for guarantees under standby letters of credit issued is not material.



F-18


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 3 - Loans Receivable - Continued

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, 2005 include $2,806,000 at fixed rates ranging from 6.5% to 9.0% and $16,709,000 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.

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, 2005 and 2004 as a liability for credit loss related to these loans. 
 

F-19


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 4 - Premises and Equipment

Premises and equipment are summarized by major classification as follows:
 
 
December 31,
 
Estimated
 
 
 
2005
 
 
2004
 
 
Useful Lives
 
 
(dollars in thousands)
 
    
Land
  
$
1,924
  
$
1,924
    
-
  
Building
    
2,290
    
2,290
    
39 Years
  
Leasehold improvements
    
597
    
592
    
15-27.5 Years
  
Furniture, fixtures and equipment
    
2,276
    
2,052
    
3-10 Years
  
Construction in progress
    
15,068
    
2,023
    
-
  
Total at cost
    
22,155
    
8,881
        
Accumulated depreciation
    
(2,192
)
  
(1,877
)
      
   
$
19,963
  
$
7,004
        

Depreciation expense for the years ended December 31, 2005, 2004 and 2003 was $377,000, $329,000, and $291,000, respectively.

HS West, LLC is constructing a building in Annapolis, Maryland to serve as Bancorp’s administrative headquarters. A branch office will be included. To date, HS West, LLC has incurred approximately $16,168,000 of costs, which are included in land and construction in progress above. The total cost is expected to be approximately $22,000,000 before interior fit-out, with completion expected October 2006. Interest capitalized during the year ended December 31, 2005, 2004 and 2003 was $179,000, $53,000 and $39,000, respectively.

The Bank is obligated under a long-term lease for a branch office. The minimum annual rental payments are as follows:

Years Ended December 31, (in thousands)
2006
  
$
60
  
2007
    
60
  
2008
    
60
  
2009
    
60
  
2010
    
34
  
 
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 $141,000, $108,000, and $78,000 for the years ended December 31, 2005, 2004 and 2003, respectively.


F-20


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 5 - 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 6 - Deposits

Deposits in the Bank as of December 31, 2005 and 2004 consisted of the following:
 
 
2005
2004
Category
 
 
Amount
 
 
Percent
 
 
Amount
 
 
Percent
  
 
  
(dollars in thousands) 
NOW accounts
  
$
7,683
    
1.30
%
$
4,872
    
0.92
%
Money market accounts
    
99,911
    
16.91
%
  
131,014
    
24.85
%
Passbooks
    
17,505
    
2.96
%
  
18,198
    
3.45
%
Certificates of deposit
    
445,592
    
75.42
%
  
356,447
    
67.58
%
Non-interest bearing accounts
    
20,123
    
3.41
%
  
16,882
    
3.20
%
                           
Total deposits
  
$
590,814
    
100.00
%
$
527,413
    
100.00
%



F-21


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 6 - Deposits - Continued

At December 31, 2005 scheduled maturities of certificates of deposit are as follows:


 Amount
  
 (dollars in thousands
)
One year or less
  
$
322,279
  
More than 1 year to 2 years
    
86,567
  
More than 2 years to 3 years
    
13,338
  
More than 3 years to 4 years
    
7,596
  
More than 4 years to 5 years
    
15,769
  
More than 5 years
    
43
  
   
$
445,592
  

The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100,000 was $179,867,000 and $131,870,000 at December 31, 2005 and 2004, respectively.

Interest expense on deposits is summarized as follows:

 
For Years Ended December 31,
 
 
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
NOW accounts
  
$
55
  
$
59
  
$
65
  
Money market accounts
    
2,250
    
2,350
    
2,596
  
Passbooks
    
289
    
283
    
336
  
Certificates of deposit
    
13,680
    
8,600
    
7,964
  
   
$
16,274
  
$
11,292
  
$
10,961
  




F-22


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 7 - Federal Home Loan Bank Advances

The Bank's credit availability under the FHLB of Atlanta’s credit availability program was $252,386,000 and $210,422,000 at December 31, 2005 and 2004, respectively. Short-term borrowings with the FHLB were $26,000,000 at December 31, 2005 with interest at 4.37%. There were no short-term borrowings at December 31, 2004. Long-term advances outstanding were $132,000,000 and $89,000,000 at December 31, 2005 and 2004, respectively. The maturities of these long-term advances at December 31, 2005 are as follows (dollars in thousands):

Description
    
Rate
 
 
Amount
 
 
Maturity
  
FHLB advances
    
2.99% to 3.24
%
  
10,000
    
2006
  
FHLB advances
    
2.89% to 4.01
%
  
15,000
    
2007
  
FHLB advances
    
3.33
%
  
5,000
    
2008
  
FHLB advances
    
3.09
%
  
5,000
    
2009
  
FHLB advances
    
5.00
%
  
10,000
    
2010
  
FHLB advances
    
2.64% to 4.48
%
  
87,000
    
Thereafter
  
         
$
132,000
        

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 loans in varying amounts depending on the loan type.

Note 8 - Subordinated Debentures

Bancorp has a non-consolidated subsidiary trust, Severn Capital Trust I, of which 100% of the common equity is owned by Bancorp. The trust was formed for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in subordinated debt securities of Bancorp (the debentures). The debentures held by the trust are the sole assets of the trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. Bancorp has entered into an agreement which, taken collectively, fully and unconditionally guarantees the capital securities subject to the terms of the guarantee. The debentures held by Severn Capital Trust I are first redeemable, in whole or in part, by Bancorp on January 7, 2010.

The subordinated debentures from Bancorp to the trust consist of a $20,619,000 note that matures in 2035 and has a floating rate of interest of LIBOR plus 200 basis points, which was 6.54% and 4.56% at December 31, 2005 and 2004, respectively. $17,000,000 of the proceeds from Bancorp’s issuance of the debentures was contributed to the Bank, and qualifies as Tier 1 capital for the Bank under Federal Reserve Board guidelines.

F-23


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 9 - Employee Benefit Plans

The Bank had a Supplemental Executive Retirement Plan covering selected officers, and elected to terminate the plan in January 2005. The plan was funded by Bank owned life insurance policies, of which the Bank was the beneficiary. The amount of cost recognized for the years ended December 31, 2005, 2004 and 2003 was $0, $12,000 and $12,000, respectively.

The Bank has a 401(k) Retirement Savings Plan. Employees may contribute a percentage of their salary up to a maximum of $14,000 for 2005. 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 $114,000, $104,000 and $79,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

The Bank has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of participating employees. The Bank recognized ESOP expense of $140,000 for each of the years ended December 31, 2005, 2004 and 2003.

Note 10- Minority Interest

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

Severn Preferred Capital Corporation issued 200,002 shares of preferred stock at $20.00 per share, which were acquired by independent parties. The Bank purchased all of the outstanding common stock. Severn Preferred Capital Corporation liquidated effective January 31, 2005.

Note 11- Stockholders’ Equity

In November, 2004, Bancorp’s Board of Directors declared a 2-for-1 stock split in the form of a 100% stock dividend, which was effective for shares outstanding as of December 15, 2004 and was distributed December 30, 2004. All per share data in the accompanying financial statements and all share and per share data in the footnotes (except for the stock option disclosures below) have been adjusted to give retroactive effect to this transaction.



F-24


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 11- Stockholders Equity - Continued

The Bank’s Stock Option Plan (“Plan”) provided for the granting of options to acquire common stock to directors and key employees. Option prices were 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, of which all have been exercised as of December 31, 2003.

The following table summarizes the status of and changes in the Bank’s stock option plan.
 
   
Shares
    
Weighted Average Exercise Price
  
             
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
    
-
  
$
-
  

As of December 31, 2005, there were 144,000 options available to be granted under the Plan.
 
Note 12- 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, 2005 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-25


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 12- 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, 2005, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2005, the most recent notification from the regulators 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
 
%
(dollars in thousands)
December 31, 2005
                      
Tangible (1)
$86,354
  
10.3%
 
$12,619
  
1.50%
  
N/A
 
N/A
Tier I capital (2)
86,354
  
12.2%
  
N/A
 
N/A
 
$42,395
 
6.00%
Core (1)
86,354
  
10.3%
  
33,651
  
4.00%
  
42,064
  
5.00%
Total (2)
93,851
  
13.3%
  
56,527
  
8.00%
  
70,659
  
10.00%
                       
December 31, 2004
                      
Tangible (1)
$73,572
  
10.5%
 
$10,521
  
1.50%
  
N/A
 
N/A
Tier I capital (2)
73,572
  
13.4%
  
N/A
 
N/A
 
$33,023
  
6.00%
Core (1)
73,572
  
10.5%
  
28,056
  
4.00%
  
35,070
  
5.00%
Total (2)
79,419
  
14.4%
  
44,031
  
8.00%
  
55,039
  
10.00%


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



F26


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 12- Regulatory Matters - Continued

Bancorp’s main source of income is dividends from the Bank. As a result, Bancorp's dividends to its shareholders 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 stockholders’ equity below its regulatory capital requirement, or the accumulated bad debt deduction.

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 include $482,000, for which no provision for federal income tax has been provided.



F-27


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 13- Income Taxes

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

   
   
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
Current
                    
Federal
  
$
7,241
  
$
6,420
  
$
6,436
  
State
    
1,472
    
1,430
    
1,325
  
     
8,713
    
7,850
    
7,761
  
Deferred
                    
Federal
    
176
    
343
    
(152
)
State
    
37
    
65
    
(34
)
     
213
    
408
    
(186
)
                     
Total income tax provision
  
$
8,926
  
$
8,258
  
$
7,575
  

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:

 
2005
  
2004
  
2003
 
 
Amount
  
Percent of
Pretax Income
  
Amount
  
Percent of Pretax Income
  
Amount
  
Percent of
Pretax Income
 
(dollars in thousands)
Statutory Federal
                      
income tax rate
$8,218
  
35.0%
  
$7,416
  
35.0%
  
$6,616
  
35.0%
State tax net of
                      
Federal income
                      
tax benefit
981
  
4.2%
  
972
  
4.6%
  
840
  
4.4%
Other adjustments
(273)
  
(1.2%)
  
(130)
  
(0.6%)
  
119
  
0.6%
 
$8,926
  
38.0%
  
$8,258
  
39.0%
  
$7,575
  
40.0%




F-28


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Note 13- 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, 2005 and 2004 are presented below:

   
2005
 
 
2004
  
 
(dollars in thousands)
             
Deferred Tax Assets:
              
Allowances for losses
  
$
2,968
  
$
2,341
  
Reserve for uncollected interest
    
11
    
11
 
Total deferred tax assets
    
2,979
    
2,352
  
               
Deferred Tax Liabilities:
              
Federal Home Loan Bank stock dividends
    
(82
)
  
(82
)
Loan origination costs
    
(802
)
  
-
  
Accelerated depreciation
    
(560
)
  
(519
)
Other
    
(63
)
  
(66
)
Total deferred tax liabilities
    
(1,507
)
  
(667
)
               
Net deferred tax assets
  
$
1,472
  
$
1,685
  

 

Note 14- Related Party Transactions

During the years ended December 31, 2005, 2004 and 2003, the Bank engaged in the transactions described below with parties that may be deemed affiliated.

Two subsidiaries rent property from a director of the Bank. Rent paid on these properties was $56,000, $59,000 and $49,000 for 2005, 2004 and 2003, 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 $126,000, $129,000 and $167,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

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.



F-29


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 15- 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 instruments. 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. 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. For FHLB advances and subordinated debentures, fair value is based on currently available rate for borrowings with similar terms and remaining maturities.

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business, including loan commitments. Fair value is estimated using fees currently charged for similar agreements, taking into account the remaining terms of the agreements and the counter parties credit standings. Any fees charged are immaterial.



F-30


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 15- Disclosure About Fair Value of Financial Instruments - Continued


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

 
December 31, 2005
December 31, 2004
   
Carrying
Amount
    
Fair
Value
    
Carrying
Amount
    
Fair
Value
  
 
(dollars in thousands)
Financial Assets
                          
Cash and cash equivalents
  
$
20,916
  
$
20,916
  
$
18,038
  
$
18,038
  
Investment securities
    
8,290
    
7,992
    
9,955
    
9,814
  
FHLB stock
    
8,513
    
8,513
    
5,083
    
5,083
  
Loans held for sale
    
3,216
    
3,216
    
6,654
    
6,654
  
Loans receivable, net
    
776,117
    
765,436
    
650,313
    
644,512
  
Accrued interest receivable
    
4,562
    
4,562
    
3,339
    
3,339
  
                           
Financial Liabilities
                          
Deposits
  
$
590,814
  
$
590,530
  
$
527,413
  
$
527,678
  
FHLB advances
    
158,000
    
153,962
    
89,000
    
85,810
  
Subordinated debentures
    
20,619
    
20,619
    
20,619
    
20,619
  
Accrued interest payable
    
607
    
607
    
166
    
166
  
                           
Off Balance Sheet Commitments
  
$
-
  
$
-
  
$
-
  
$
-
  




F-31


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16- Condensed Financial Information (Parent Company Only)
 
         Information as to the financial position of Severn Bancorp, Inc. as of December 31, 2005 and 2004 and results of operations and cash flows for each of the years ended December 31, 2005, 2004 and 2003 is summarized below.

 
December 31,
 
 
2005
 
 
2004
 
 
(dollars in thousands)
Statements of Financial Condition
              
Cash
  
$
1,828
  
$
3,485
  
Equity in net assets of subsidiaries:
              
Bank
    
86,354
    
73,543
  
Non-Bank
    
3,512
    
3,512
  
Loans
    
1,856
   
-
 
Other assets
    
866
   
732
 
 
Total assets
  
$
94,416
  
$
81,272
  
               
Subordinated debentures
  
$
20,619
  
$
20,619
  
Other liabilities
    
1,085
    
499
  
               
Total liabilities
    
21,704
    
21,118
  
               
Stockholders’ equity
    
72,712
    
60,154
  
               
Total liabilities and stockholders’ equity
  
$
94,416
  
$
81,272
  
 
 
 
For the Years Ended December 31,
 
 
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
Statements of Income
                    
Interest income
 
$
36
  
$
-
  
$
-
  
Interest expense on subordinated debentures
    
1,087
    
34
    
-
  
Net interest expense
    
(1,051
)
  
(34
)
  
-
  
 
Dividends received from subsidiaries
    
2,920
    
1,747
    
1,410
  
General and administrative expenses
    
153
    
125
    
95
  
Income before income taxes and equity in
                    
undistributed net income of subsidiaries
    
1,716
    
1,588
    
1,315
  
                     
Income tax benefit
    
381
    
44
    
19
  
Equity in undistributed net income of subsidiaries
    
12,457
   
11,299
   
9,995
  
                     
Net income
  
$
14,554
  
$
12,931
  
$
11,329
  


F-32


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 16- Condensed Financial Information (Parent Company Only) - Continued

 
For the Years Ended December 31,
 
 
2005
 
 
2004
 
 
2003
 
 
(dollars in thousands)
Statements of Cash Flows
                    
                   
Cash Flows from Operating Activities:
                    
Net income
  
$
14,554
  
$
12,931
  
$
11,329
  
Adjustments to reconcile net income to net
                    
cash provided by operating activities:
                    
Equity in undistributed earnings of subsidiaries
    
(12,811
)
  
(11,299
)
  
(9,995
)
Increase in other assets
    
(134
)
  
(602
)
  
(38
)
Increase in other liabilities
    
586
    
119
    
124
  
                     
Cash provided by operating activities
    
2,195
    
1,149
    
1,420
  
                     
Cash Flows from Investing Activities:
                    
Net increase in loans
    
(1,856
)
  
-
    
-
  
Investment in subsidiaries
    
-
   
(17,000
)
  
-
  
                     
Cash used in investing activities
    
(1,856
)
  
(17,000
)
  
-
  
 
Cash Flows from Financing Activities:
                    
Dividends paid on capital stock
    
(1,996
)
  
(1,747
)
  
(1,410
)
Proceeds from issuance of subordinated debentures
    
-
    
20,619
    
-
  
Proceeds from exercise of options
    
-
    
-
    
91
  
                     
Cash provided by (used in) financing activities
    
(1,996
)
  
18,872
    
(1,319
)
                     
Increase (decrease) in cash and cash equivalents
    
(1,657
)
  
3,021
    
101
  
                     
Cash and cash equivalents at beginning of year
    
3,485
    
464
    
363
  
     
   
   
 
Cash and cash equivalents at end of year
  
$
1,828
  
$
3,485
  
$
464
  



F-33


SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 17- Quarterly Financial Data (Unaudited)
 
 Summarized unaudited quarterly financial data for the year ended December 31, 2005 is as follows:

   
First
Quarter
 
 
Second
Quarter
 
 
Third
Quarter
 
 
Fourth
Quarter
  
 
(dollars in thousands, except per share data)
Interest income
  
$
12,513
  
$
13,729
  
$
14,828
  
$
15,833
  
Interest expense
    
4,503
    
5,227
    
5,860
    
6,365
  
Net interest income
    
8,010
    
8,502
    
8,968
    
9,468
  
Provision for loan losses
    
242
    
453
    
450
    
425
  
 
                          
Net interest income after provision for loan losses
    
7,768
    
8,049
    
8,518
    
9,043
  
Other income
    
706
    
797
    
727
    
750
  
Other expense
    
3,280
    
3,256
    
3,079
    
3,263
  
                           
Income before income tax provision
    
5,194
    
5,590
    
6,166
    
6,530
  
Income tax provision
    
2,044
    
2,054
    
2,270
    
2,558
  
Net income
  
$
3,150
  
$
3,536
  
$
3,896
  
$
3,972
  
                           
Per share data:
                          
Earnings - basic
  
$
.38
  
$
.42
  
$
.47
  
$
.48
  
Earnings - diluted
  
$
.38
  
$
.42
  
$
.47
  
$
.48
  

  Summarized unaudited quarterly financial data for the year ended December 31, 2004 is as follows:

   
First
Quarter
 
 
Second
Quarter
 
 
Third
Quarter
 
 
Fourth
Quarter
  
 
(dollars in thousands, except per share data)
Interest income
  
$
10,032
  
$
10,702
  
$
11,411
  
$
12,474
  
Interest expense
    
3,167
    
3,402
    
3,804
    
4,258
  
Net interest income
    
6,865
    
7,300
    
7,607
    
8,216
  
Provision for loan losses
    
250
    
300
    
350
    
300
  
                           
Net interest income after provision for loan losses
    
6,615
    
7,000
    
7,257
    
7,916
  
Other income
    
754
    
1,115
    
928
    
815
  
Other expense
    
2,492
    
2,798
    
2,846
    
3,075
  
                           
Income before income tax provision
    
4,877
    
5,317
    
5,339
    
5,656
  
Income tax provision
    
1,848
    
2,091
    
2,059
    
2,260
  
Net income
  
$
3,029
  
$
3,226
  
$
3,280
  
$
3,396
  
                           
Per share data
                          
Earnings - basic
  
$
.36
  
$
.39
  
$
.40
  
$
.41
  
Earnings - diluted
  
$
.36
  
$
.39
  
$
.40
  
$
.41
  
 
 
F-34