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

FORM 10-Q
(Mark One)

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

For the quarterly period ended September 30, 2014

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 of incorporation or organization)
 
(I.R.S. employer identification no.)
     
200 Westgate Circle, Suite 200
   
Annapolis, Maryland
 
21401
(Address of principal executive offices)
 
(Zip Code)

410-260-2000
(Registrant’s telephone number, including area code)

N/A
(Former name, former address and formal fiscal year, if changed since last report)

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  þ   No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes   þ  No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer o
 
 
Non- accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company T
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o No þ
 
Number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of the close of business on November 12, 2014: 10,067,379 shares.
 


SEVERN BANCORP, INC. AND SUBSIDIARIES
Table of Contents
 
PART I – FINANCIAL INFORMATION
Page
Item 1.
Financial Statements (Unaudited)
 
     
 
1
 
2
 
3
 
4
 
6
     
Item 2.
40
     
Item 3.
49
     
Item 4.
49
     
PART II – OTHER INFORMATION
 
     
Item 1.
49
     
Item 1A.
50
     
Item 2.
50
     
Item 3.
50
     
Item 4.
50
     
Item 5.
50
     
Item 6.
50
     
51
 
 
PART I– FINANCIAL INFORMATION

Item 1. Financial Statements

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

   
September 30, 2014
   
December 31,
2013
 
ASSETS
   
Cash and due from banks
 
$
25,481
   
$
44,934
 
Interest-bearing deposits in other banks
   
6,137
     
41,269
 
Federal funds sold
   
-
     
12,173
 
Cash and cash equivalents
   
31,618
     
98,376
 
Investment securities held to maturity (fair value: $62,746 at September 30, 2014; $45,213 at December 31, 2013)
   
62,297
     
44,661
 
Loans held for sale
   
9,601
     
3,726
 
Loans receivable, net of allowance for loan losses of $9,282 and $11,739, respectively
   
620,060
     
602,813
 
Premises and equipment, net
   
25,321
     
25,838
 
Foreclosed real estate
   
5,024
     
8,972
 
Federal Home Loan Bank stock, at cost
   
5,936
     
6,190
 
Accrued interest receivable and other assets
   
9,456
     
9,027
 
                 
Total assets
 
$
769,313
   
$
799,603
 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Liabilities
               
Deposits
 
$
537,743
   
$
571,249
 
Long-term borrowings
   
115,000
     
115,000
 
Subordinated debentures
   
24,119
     
24,119
 
Accrued interest payable and other liabilities
   
9,712
     
6,466
 
                 
Total liabilities
   
686,574
     
716,834
 
                 
Stockholders’ Equity
               
Preferred stock, $0.01 par value, 1,000,000 shares authorized:
               
Preferred stock series “A”, 437,500 shares issued and outstanding; $3,500 liquidation preference at September 30, 2014 and December 31, 2013
   
4
     
4
 
Preferred stock series “B”,  23,393 shares issued and outstanding; $23,393 liquidation preference at September 30, 2014 and December 31, 2013
   
-
     
-
 
Common stock, $0.01 par value, 20,000,000 shares authorized; 10,067,379 and 10,066,679 shares issued and outstanding, respectively
   
101
     
101
 
Additional paid-in capital
   
75,733
     
75,374
 
Retained earnings
   
6,901
     
7,290
 
                 
Total stockholders' equity
   
82,739
     
82,769
 
                 
Total liabilities and stockholders' equity
 
$
769,313
   
$
799,603
 

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

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

   
For the Three Months Ended September 30,
   
For the Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Interest Income
               
Loans, including fees
 
$
7,654
   
$
8,069
   
$
22,811
   
$
25,110
 
Securities, taxable
   
281
     
156
     
686
     
456
 
Other
   
65
     
96
     
233
     
243
 
Total interest income
   
8,000
     
8,321
     
23,730
     
25,809
 
                                 
Interest Expense
                               
Deposits
   
968
     
1,170
     
2,924
     
3,634
 
Long-term/short-term borrowings and subordinated debentures
   
1,185
     
1,131
     
3,474
     
3,346
 
Total interest expense
   
2,153
     
2,301
     
6,398
     
6,980
 
                                 
Net interest income
   
5,847
     
6,020
     
17,332
     
18,829
 
Provision for loan losses
   
250
     
12,200
     
431
     
12,820
 
Net interest income (loss) after provision for loan losses
   
5,597
     
(6,180
)
   
16,901
     
6,009
 
                                 
Non-interest Income
                               
Mortgage banking activities
   
306
     
794
     
945
     
3,040
 
Real estate commissions
   
229
     
150
     
678
     
358
 
Real estate management fees
   
167
     
175
     
579
     
531
 
Other
   
543
     
110
     
981
     
590
 
Total non-interest income
   
1,245
     
1,229
     
3,183
     
4,519
 
                                 
Non-Interest Expenses
                               
Compensation and related expenses
   
3,608
     
3,525
     
10,850
     
10,653
 
Occupancy
   
421
     
331
     
1,272
     
1,243
 
Legal
   
55
     
212
     
227
     
634
 
Foreclosed real estate, net
   
52
     
1,367
     
(25
)
   
3,556
 
FDIC assessments and regulatory expense
   
326
     
366
     
1,009
     
1,051
 
Professional fees
   
302
     
419
     
757
     
923
 
Office supplies
   
91
     
170
     
243
     
398
 
Online charges
   
212
     
212
     
729
     
632
 
Credit report and appraisal fees
   
296
     
245
     
737
     
625
 
Other
   
391
     
574
     
2,896
     
1,798
 
Total non-interest expenses
   
5,754
     
7,421
     
18,695
     
21,513
 
Income (loss) before income tax provision
   
1,088
     
(12,372
)
   
1,389
     
(10,985
)
Income tax provision
   
20
     
8,176
     
30
     
8,710
 
Net income (loss)
   
1,068
     
(20,548
)
   
1,359
     
(19,695
)
Amortization of discount on preferred stock
   
(68
)
   
(68
)
   
(203
)
   
(203
)
Dividends on preferred stock
   
(526
)
   
(292
)
   
(1,545
)
   
(877
)
Net income available (loss attributable) to common stockholders
 
$
474
   
$
(20,908
)
 
$
(389
)
 
$
(20,775
)
Basic income (loss) per share
 
$
0.05
   
$
(2.08
)
 
$
(0.04
)
 
$
(2.06
)
Diluted income (loss) per share
 
$
0.05
   
$
(2.08
)
 
$
(0.04
)
 
$
(2.06
)

The accompanying notes to consolidated financial statements are an integral part of these statements.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)
 (dollars in thousands)

Nine Months Ended September 30, 2014

   
 
Preferred
Stock
   
Common
Stock
   
Additional Paid-In Capital
   
Retained
Earnings
   
Total Stockholders’ Equity
 
Balance - December 31, 2013
 
$
4
   
$
101
   
$
75,374
   
$
7,290
   
$
82,769
 
                                         
Net Income
   
-
     
-
     
-
     
1,359
     
1,359
 
Stock-based compensation
   
-
     
-
     
153
     
-
     
153
 
Dividend declared on Series B preferred stock
   
-
     
-
     
-
     
(1,545
)
   
(1,545
)
Amortization of discount on Series B preferred stock
                   
203
     
(203
)
   
-
 
Exercised Options (700 shares)
   
-
     
-
     
3
     
-
     
3
 
                                         
Balance – September 30, 2014
 
$
4
   
$
101
   
$
75,733
   
$
6,901
   
$
82,739
 
 
Nine Months Ended September 30, 2013

   
 
Preferred
Stock
   
Common
Stock
   
Additional Paid-In Capital
   
Retained
Earnings
   
Total Stockholders’ Equity
 
Balance - December 31, 2012
 
$
4
   
$
101
   
$
74,996
   
$
33,895
   
$
108,996
 
                                         
Net (Loss)
   
-
     
-
     
-
     
(19,695
)
   
(19,695
)
Stock-based compensation
   
-
     
-
     
72
     
-
     
72
 
Dividend declared on Series B preferred stock
   
-
     
-
     
-
     
(877
)
   
(877
)
Amortization of discount on preferred stock
   
-
     
-
     
203
     
(203
)
   
-
 
                                         
Balance - September 30, 2013
 
$
4
   
$
101
   
$
75,271
   
$
13,120
   
$
88,496
 
 
The accompanying notes to consolidated financial statements are an integral part of these statements.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(dollars in thousands)

   
For the Nine Months Ended
September 30,
 
   
2014
   
2013
 
         
Cash Flows from Operating Activities
       
         
Net income (loss)
 
$
1,359
   
(19,695
)
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
               
Amortization of deferred loan fees
   
(719
)
   
(703
)
Net amortization of premiums and discounts
   
168
     
144
 
Provision for loan losses
   
431
     
12,820
 
Provision for depreciation
   
833
     
793
 
Provision for foreclosed real estate losses
   
-
     
2,424
 
Gain on sale of mortgage loans
   
(1,383
)
   
(3,155
)
(Gain) loss on sale of foreclosed real estate
   
(300
)
   
88
 
Loss on disposal of fixed assets
   
-
     
134
 
Proceeds from loans sold to others
   
56,899
     
105,680
 
Loans originated for sale
   
(61,391
)
   
(97,070
)
Stock-based compensation expense
   
153
     
72
 
Deferred income tax expense
   
-
     
8,708
 
Increase in accrued interest receivable and other assets
   
(429
)
   
(515
)
Increase in accrued interest payable and other liabilities
   
1,701
     
1,182
 
                 
Net cash (used in) provided by operating activities
   
(2,678
)
   
10,907
 
                 
Cash Flows from Investing Activities
               
                 
Purchase of investment securities
   
(21,549
)
   
(7,135
)
Proceeds from maturing investment securities held to maturity
   
3,000
     
3,000
 
Principal collected on mortgage-backed securities held to maturity
   
745
     
123
 
Proceeds from sale of loans
   
-
     
23,260
 
Net (increase) decrease in loans
   
(17,672
)
   
10,134
 
Proceeds from sale of foreclosed real estate
   
4,961
     
5,676
 
Investment in foreclosed real estate
   
-
     
(925
)
Investment in premises and equipment
   
(316
)
   
(488
)
Redemption of FHLB stock
   
254
     
330
 
                 
Net cash (used in) provided by investing activities
   
(30,577
)
   
33,975
 

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

   
For the Nine Months Ended
September 30,
 
   
2014
   
2013
 
         
Cash Flows from Financing Activities
       
         
Net decrease in deposits
   
(33,506
)
   
(18,479
)
Proceeds from exercise of options
   
3
     
-
 
Net cash used in financing activities
   
(33,503
)
   
(18,479
)
 
(Decrease) increase in cash and cash equivalents
   
(66,758
)
   
26,403
 
Cash and cash equivalents at beginning of year
   
98,376
     
93,392
 
                 
Cash and cash equivalents at end of period
 
$
31,618
   
$
119,795
 
                 
Supplemental disclosure of cash flows information:
               
                 
Cash paid during period for:
               
                 
Interest
 
$
5,887
   
$
6,594
 
                 
Income taxes
 
$
8
   
$
1,361
 
                 
Transfer of loans to foreclosed real estate
 
$
713
   
$
9,699
 

The accompanying notes to consolidated financial statements are an integral part of these statements.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1 - Principles of Consolidation

The unaudited consolidated financial statements include the accounts of Severn Bancorp, Inc. (“Bancorp”), and its wholly-owned subsidiaries, 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, Louis Hyatt, Inc., Homeowners Title and Escrow Corporation, Severn Financial Services Corporation, SSB Realty Holdings, LLC, SSB Realty Holdings II, LLC, and HS West, LLC.  All intercompany accounts and transactions have been eliminated in the accompanying consolidated financial statements.

Note 2 - Basis of Presentation

Bancorp follows accounting standards set by the Financial Accounting Standards Board, commonly referred to as the “FASB”.  The FASB sets generally accepted accounting principles in the United States (“GAAP”) that Bancorp follows. References to GAAP issued by the FASB in these footnotes are to the FASB Accounting Standards Codification, sometimes referred to as the Codification or ASC.

The accompanying unaudited consolidated financial statements have been prepared in accordance with GAAP for interim financial information and in accordance with the instructions to Form 10-Q.  Accordingly, they do not include all of the disclosures required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments necessary for a fair presentation of the results of operations for the interim periods presented have been made. Such adjustments were of a normal recurring nature.  The results of operations for the nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2014 or any other interim period.  The unaudited consolidated financial statements for the nine months ended September 30, 2014 should be read in conjunction with the audited consolidated financial statements and related notes, which were included in Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013.  These consolidated financial statements consider events that occurred through the date the consolidated financial statements were issued.

Note 3 - Cash Flow Presentation

In the statements of cash flows, cash and cash equivalents include cash on hand, amounts due from banks, Federal Home Loan Bank of Atlanta (“FHLB Atlanta”) overnight deposits, and federal funds sold. Generally, federal funds are sold for one-day periods.

Note 4 – Reclassifications

Amounts in the prior year’s consolidated financial statements have been reclassified whenever necessary to conform to the current year’s presentation.  Such reclassifications had no impact on net income.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 5 -  Earnings Per Share

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for each period.  Diluted earnings per share reflect 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 to outstanding stock options, warrants, and convertible preferred stock, and are determined using the treasury stock method.

Not included in the diluted earnings per share calculation for the three and nine month periods ended September 30, 2014, because they were anti-dilutive, were 125,000 shares of common stock issuable upon exercise of outstanding stock options, 556,976 shares of common stock issuable upon the exercise of a warrant and 437,500 shares of common stock issuable upon conversion of Bancorp’s Series A Preferred Stock.  There was no dilution during the 2013 periods, as dilution does not apply to loss periods.

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Common shares – weighted average (basic)
   
10,067,379
     
10,066,679
     
10,067,379
     
10,066,679
 
Common share equivalents – weighted average
   
34,066
     
-
     
35,968
     
-
 
Common shares – weighted average (diluted)
   
10,101,445
     
10,066,679
     
10,103,347
     
10,066,679
 

Note 6 - Guarantees

Bancorp does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit.  See Note 10.

Note 7 -  Regulatory Matters

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 Bancorp’s consolidated 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. The following table presents the Bank’s capital position:

   
Actual
at September 30 2014
   
Actual
at December 31, 2013
   
To Be Well Capitalized Under
Prompt Corrective Provisions
 
Tangible (1)
   
13.7
%
   
12.9
%
   
N/A
 
Tier 1 Capital (2)
   
19.0
%
   
18.6
%
   
6.0
%
Core (1)
   
13.7
%
   
12.9
%
   
5.0
%
Total Capital (2)
   
20.3
%
   
19.8
%
   
10.0
%
 
(1) To adjusted total assets.
(2) To risk-weighted assets.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 7 -  Regulatory Matters - Continued

On April 23, 2013, the Bank was notified by the Office of the Comptroller of the Currency (“OCC”) that the OCC established minimum capital ratios for the Bank requiring it to immediately maintain a Tier 1 Leverage Capital Ratio to Adjusted Total Assets of at least 10% and a Total Risk-Based Capital to Risk-Weighted Assets ratio of at least 15%.  The Bank was in compliance with these requirements as of September 30, 2014.

Federal banking agencies have adopted proposals that will substantially amend the regulatory capital rules applicable to Bancorp and the Bank.  The amendments implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act.  The amended rules establish new higher capital ratio requirements, narrow the definitions of capital, impose new operating restrictions on banking organizations with insufficient capital buffers and increase the risk weighting of certain assets.  The amended rules will be effective with respect to Bancorp and the Bank in January 2015, with certain requirements to be phased in beginning in 2016.

Note 8 -  Stock-Based Compensation

Bancorp has a stock-based compensation plan for directors, officers, and other key employees of Bancorp.  The aggregate number of shares of common stock that may be issued with respect to the awards granted under the plan is 500,000 plus any shares forfeited under Bancorp’s old stock-based compensation plan.  Under the terms of the stock-based compensation plan, Bancorp has the ability to grant various stock compensation incentives, including stock options, stock appreciation rights, and restricted stock.  The stock-based compensation is granted under terms and conditions determined by the Compensation Committee of the Board of Directors.  Under the stock-based compensation plan, stock options generally have a maximum term of ten years, and are granted with an exercise price at least equal to the fair market value of the common stock on the date the options are granted.  Generally, options granted to directors of Bancorp vest immediately, and options granted to officers and employees vest over a five-year period, although the Compensation Committee has the authority to provide for different vesting schedules.

Bancorp follows FASB ASC 718, “Compensation – Stock Compensation”, to account for stock-based compensation.  FASB ASC 718 requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the statement of operations at fair value.  FASB ASC 718 requires an entity to recognize the expense of employee services received in share-based payment transactions and measure the expense based on the grant date fair value of the award.  The expense is recognized over the period during which an employee is required to provide service in exchange for the award.

The stock-based compensation expense amounts were derived using the Black-Scholes option-pricing model.  The following weighted average assumptions were used to value options granted for the nine months ended September 30, 2013:

Expected life of options
 
5.0 years
 
Risk-free interest rate
   
1.48
%
Expected volatility
   
70.02
%
Expected dividend yield
   
0.00
%
Weighted average fair value of options granted
 
$
2.12
 

The expected life of options amount is based on the term of the options granted.  The risk-free interest rate is based on the US Treasury’s five year Treasury note rate at the time of the option grant.  The expected volatility is based on the closing common stock price of Bancorp over a five year period.  The expected dividend yield is based on Bancorp’s current policy of not paying a common stock dividend.  In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 8 -  Stock-Based Compensation - Continued

There were no options granted during the nine months ended September 30, 2014 and 125,000 options granted during the nine months ended September 30, 2013.

Stock-based compensation expense for the three and nine months ended September 30, 2014 totaled $47,000 and $153,000, respectively. Stock-based compensation expense for the three and nine months ended September 30, 2013 totaled $24,000 and $72,000, respectively. There were 700 options exercised during the nine months ended September 30, 2014 and no options exercised during the nine months ended September 30, 2013.

Information regarding Bancorp’s stock-based compensation plan as of and for the nine months ended September 30, 2014 is as follows:
 
   
2014
 
   
 
Shares
   
Weighted Average
Price
 
Options outstanding, December 31, 2013
   
319,000
   
$
4.23
 
Options granted
   
-
     
-
 
Options exercised
   
(700
)
 
$
3.37
 
Options forfeited
   
(27,500
)
 
$
3.86
 
Options outstanding, September 30, 2014
   
290,800
   
$
4.26
 
Options exercisable, September 30, 2014
   
119,893
   
$
4.14
 

The aggregate intrinsic value of the options outstanding as of September 30, 2014 and December 31, 2013 was $129,281 and $187,640, respectively.  The aggregate intrinsic value of the options exercisable as of September 30, 2014 and December 31, 2013 was $56,809 and $58,153, respectively.

The following table summarizes the nonvested options in Bancorp’s stock-based compensation plan as of September 30, 2014.

   
 
 
 
Shares
   
Weighted
Average
Grant Date
Exercise Price
 
Nonvested options outstanding, December 31, 2013
   
236,383
   
$
4.29
 
Nonvested options granted
   
-
     
-
 
Nonvested options vested
   
(37,976
)
 
$
4.33
 
Nonvested options forfeited
   
(27,500
)
 
$
3.86
 
Nonvested options outstanding, September 30, 2014
   
170,907
   
$
4.35
 
 
As of September 30, 2014, there was $535,000 of total unrecognized stock-based compensation expense related to nonvested stock options, which is expected to be recognized over a period of fifty-one months.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 9 -  Investment Securities

 
The amortized cost and fair value of investment securities held to maturity are as follows (dollars in thousands):

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
September 30, 2014:
               
 
US Treasury securities
 
$
29,162
   
$
539
   
$
30
   
$
29,671
 
US Agency securities
   
17,060
     
100
     
69
     
17,091
 
US Government sponsored mortgage-backed securities
   
16,075
     
44
     
135
     
15,984
 
Total
 
$
62,297
   
$
683
   
$
234
   
$
62,746
 
                                 
December 31, 2013:
                               
                                 
US Treasury securities
 
$
31,235
   
$
665
   
$
69
   
$
31,831
 
US Agency securities
   
11,123
     
44
     
101
     
11,066
 
US Government sponsored mortgage-backed securities
   
2,303
     
27
     
14
     
2,316
 
Total
 
$
44,661
   
$
736
   
$
184
   
$
45,213
 

As of September 30, 2014 and December 31, 2013, there were $5,248,000 and $3,263,000, respectively, of US Treasury securities or mortgage-backed securities pledged by Bancorp as collateral for borrowers’ letters of credit with Anne Arundel County.

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 September 30, 2014 and December 31, 2013. Included in the table are seven US Treasury securities, nine Agency securities and four Mortgage-backed securities in a gross unrealized loss position at September 30, 2014.  Seven US Treasury securities, eight Agency securities and two Mortgage-backed securities were in a gross unrealized loss position at December 31, 2013. Management believes that the unrealized losses in 2014 and 2013 were the result of interest rate levels differing from those existing at the time of purchase of the securities and actual and estimated prepayment speeds.  The Bank does not consider any of these securities to be other than temporarily impaired at September 30, 2014 and December 31, 2013, because the unrealized losses were related primarily to changes in market interest rates and widening of sector spreads and were not necessarily related to the credit quality of the issuers of the securities.

In addition, the Bank does not intend to sell, nor does it believe it will be more likely than not that it will be required to sell, any impaired securities prior to a recovery of amortized cost.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 9 -  Investment Securities – Continued

 
Less than 12 months
 
12 Months or More
 
Total
 
   
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
September 30, 2014:
(dollars in thousands)
 
             
US Treasury securities
 
$
6,950
   
$
30
   
$
-
   
$
-
   
$
6,950
   
$
30
 
US Agency securities
   
8,970
     
69
     
-
     
-
     
8,970
     
69
 
US Government sponsored mortgage-backed securities
   
13,886
     
135
     
-
     
-
     
13,886
     
135
 
Total
 
$
29,806
   
$
234
   
$
-
   
$
-
   
$
29,806
   
$
234
 
 
 
 
Less than 12 months
 
12 Months or More
 
Total
 
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
December 31, 2013:
(dollars in thousands)
 
             
US Treasury securities
 
$
6,907
   
$
69
   
$
-
   
$
-
   
$
6,907
   
$
69
 
US Agency securities
   
7,934
     
101
     
-
     
-
     
7,934
     
101
 
US Government sponsored mortgage-backed securities
   
1,931
     
14
     
-
     
-
     
1,931
     
14
 
Total
 
$
16,772
   
$
184
   
$
-
   
$
-
   
$
16,772
   
$
184
 

The amortized cost and estimated fair value of debt securities at September 30, 2014, by contractual maturity are shown in the following table.  Actual maturities may differ from contractual maturities, because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
Held to Maturity
(dollars in thousands)
 
   
Amortized Cost
   
Estimated Fair Value
 
         
Due in one year or less
 
$
6,002
   
$
6,054
 
Due from one year to five years
   
35,334
     
35,618
 
Due from five years to ten years
   
4,886
     
5,090
 
US Government sponsored mortgage-backed securities
   
16,075
     
15,984
 
   
$
62,297
   
$
62,746
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 -  Loans Receivable
 
Loans receivable, included unfunded commitments consist of the following:
 
   
September 30
   
December 31
 
   
2014
   
2013
 
   
(dollars in thousands)
 
Residential mortgage, total
 
$
295,656
   
$
258,919
 
Individually evaluated for impairment
   
28,959
     
35,064
 
Collectively evaluated for impairment
   
266,697
     
223,855
 
                 
Construction, land acquisition and development, total
   
79,105
     
75,539
 
Individually evaluated for impairment
   
916
     
2,808
 
Collectively evaluated for impairment
   
78,189
     
72,731
 
                 
Land, total
   
31,965
     
34,429
 
Individually evaluated for impairment
   
2,061
     
1,263
 
Collectively evaluated for impairment
   
29,904
     
33,166
 
                 
Lines of credit, total
   
17,968
     
21,598
 
Individually evaluated for impairment
   
454
     
304
 
Collectively evaluated for impairment
   
17,514
     
21,294
 
                 
Commercial real estate, total
   
205,275
     
220,160
 
Individually evaluated for impairment
   
6,174
     
4,672
 
Collectively evaluated for impairment
   
199,101
     
215,488
 
                 
Commercial non-real estate, total
   
9,358
     
8,583
 
Individually evaluated for impairment
   
303
     
-
 
Collectively evaluated for impairment
   
9,055
     
8,583
 
                 
Home equity, total
   
28,966
     
30,339
 
Individually evaluated for impairment
   
1,638
     
1,777
 
Collectively evaluated for impairment
   
27,328
     
28,562
 
                 
Consumer, total
   
1,061
     
1,185
 
Individually evaluated for impairment
   
13
     
-
 
Collectively evaluated for impairment
   
1,048
     
1,185
 
Total Loans
   
669,354
     
650,752
 
Less
               
Unfunded commitments included above
   
(36,854
)
   
(34,069
)
   
$
632,500
   
$
616,683
 
Individually evaluated for impairment
   
40,518
     
45,888
 
Collectively evaluated for impairment
   
591,982
     
570,795
 
     
632,500
     
616,683
 
Allowance for loan losses
   
(9,282
)
   
(11,739
)
Deferred loan origination fees and costs, net
   
(3,158
)
   
(2,131
)
Net Loans
 
$
620,060
   
$
602,813
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - Continued

The inherent credit risks within the portfolio vary depending upon the loan class as follows:
 
Residential mortgage loans are secured by one to four family dwelling units. The loans have limited risk as they are secured by first mortgages on the unit, which are generally the primary residence of the borrower, at a loan to value ratio of 80% or less.

Construction, land acquisition and development loans are underwritten based upon a financial analysis of the developers and property owners and construction cost estimates, in addition to independent appraisal valuations. These loans will rely on the value associated with the project upon completion. These cost and valuation estimates may be inaccurate. Construction loans generally involve the disbursement of substantial funds over a short period of time with repayment substantially dependent upon the success of the completed 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. Sources of repayment of these loans typically are permanent financing expected to be obtained upon completion or sales of developed property. These loans are closely monitored by onsite inspections and are considered to be of a higher risk than other real estate loans due to their ultimate repayment being sensitive to general economic conditions, availability of long-term financing, interest rate sensitivity, and governmental regulation of real property.

Land loans are underwritten based upon the independent appraisal valuations as well as the estimated value associated with the land upon completion of development. These cost and valuation estimates may be inaccurate. These loans are considered to be of a higher risk than other real estate loans due to their ultimate repayment being sensitive to general economic conditions, availability of long-term financing, interest rate sensitivity, and governmental regulation of real property.

Line of credit loans are subject to the underwriting standards and processes similar to commercial non-real estate loans, in addition to those underwriting standards for real estate loans. These loans are viewed primarily as cash flow dependent and secondarily as loans secured by real-estate and/or other assets. Repayment of these loans is generally dependent upon the successful operation of the property securing the loan or the principal business conducted on the property securing the loan. Line of credit loans may be adversely affected by conditions in the real estate markets or the economy in general. Management monitors and evaluates line of credit loans based on collateral and risk-rating criteria.

Commercial real estate loans are subject to the underwriting standards and processes similar to commercial and industrial loans, in addition to those underwriting standards for real-estate loans. These loans are viewed primarily as cash flow dependent and secondarily as loans secured by real estate. Repayment of these loans is generally dependent upon the successful operation of the property securing the loan or the principal business conducted on the property securing the loan. Commercial real estate loans may be adversely affected by conditions in the real estate markets or the economy in general. Management monitors and evaluates commercial real estate loans based on collateral and risk-rating criteria. The Bank also utilizes third-party experts to provide environmental and market valuations. The nature of commercial real estate loans makes them more difficult to monitor and evaluate.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - Continued

Commercial non-real estate loans are underwritten after evaluating historical and projected profitability and cash flow to determine the borrower's ability to repay their obligation as agreed. Commercial and industrial loans are made primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral supporting the loan facility. Accordingly, the repayment of a commercial and industrial loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.
 
Home equity loans are subject to the underwriting standards and processes similar to residential mortgages and are secured by one to four family dwelling units. Home equity loans have greater risk than residential mortgages as a result of the Bank being in a second lien position in the event collateral is liquidated.

Consumer loans consist of loans to individuals through the Bank's retail network and are typically unsecured or secured by personal property. Consumer loans have a greater credit risk than residential loans because of the difference in the underlying collateral, if any. The application of various federal and state bankruptcy and insolvency laws may limit the amount that can be recovered on such loans.
 
The loan portfolio segments and loan classes disclosed above are the same because this is the level of detail management uses when the original loan is recorded and is the level of detail used by management to assess and monitor the risk and performance of the portfolio.  Management has determined that this level of detail is adequate to understand and manage the inherent risks within each portfolio segment and loan class.
 
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 collectability 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 GAAP. 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 periodically review the Bank's allowance for losses on loans as an integral part of their examination process.  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 and general components.  The specific component relates to loans that are classified as impaired.  When a real estate secured loan becomes impaired, a decision is made as to whether an updated certified appraisal of the real estate is necessary.  This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property.  Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value.  The discounts also include estimated costs to sell the property.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - Continued

For loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices.  Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

For such loans that are classified as impaired, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs is lower than the carrying value of that loan.  For loans that are not solely collateral dependent, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  The general component relates to loans that are classified as doubtful, substandard or special mention that are not considered impaired, as well as non-classified loans. The general reserve is based on historical loss experience adjusted for qualitative factors. These qualitative factors include:

· Levels and trends in delinquencies and nonaccruals;
· Inherent risk in the loan portfolio;
· Trends in volume and terms of the loan;
· Effects of any change in lending policies and procedures;
· Experience, ability and depth of management;
· National and local economic trends and conditions;
· Effect of any changes in concentration of credit; and
· Industry conditions.

A loan is considered impaired if it meets either of the following two criteria:

· Loans that are 90 days or more in arrears (nonaccrual loans); or
· Loans where, based on current information and events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement.

Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss.  Loans classified special mention have potential weaknesses that deserve management’s close attention.  If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects.  Loans classified substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable.  Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses.  Loans not classified are rated pass.

A loan is considered a troubled debt restructuring when for economic or legal reasons relating to the borrowers financial difficulties Bancorp grants a concession to the borrower that it would not otherwise consider.  Loan modifications made with terms consistent with current market conditions that the borrower could obtain in the open market are not considered troubled debt restructurings.

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 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.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - Continued

With respect to all loan segments, management does not charge off a loan, or a portion of a loan, until one of the following conditions have been met:
 
· The loan has been foreclosed on. Once the loan has been transferred from the Loans Receivable to Foreclosed Real Estate, a charge off is recorded for the difference between the recorded amount of the loan and the net value of the underlying collateral.
 
· An agreement to accept less than the recorded balance of the loan has been made with the borrower.  Once an agreement has been finalized, and any proceeds from the borrower are received, a charge off is recorded for the difference between the recorded amount of the loan and the net value of the underlying collateral.
 
· The loan is considered to be impaired collateral dependent and its collateral valuation is less than the recorded balance.  The loan is written down for accounting purposes by the amount of the difference between the recorded balance and collateral value.
 
Prior to the above conditions, a loan is assessed for impairment when: (i) a loan becomes 90 days or more in arrears or (ii) based on current information and events, it is probable that the borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement.  If a loan is considered to be impaired, it is then determined to be either cash flow or collateral dependent. For a cash flow dependent loan, if based on management’s calculation of discounted cash flows, a reserve is needed, a specific reserve is recorded.  That reserve is included in the Allowance for Loan Losses in the Consolidated Statement of Financial Condition.

Over the last several years, Bancorp has experienced an increase in the number of extension requests for commercial real estate and construction loans, some of which have related repayment guarantees. An extension may be granted to allow for the completion of the project, marketing or sales of completed units, or to provide for permanent financing, and is based on a re-underwriting of the loan and management's assessment of the borrower's ability to perform according to the agreed-upon terms. Typically, at the time of an extension, borrowers are performing in accordance with contractual loan terms. Extension terms generally do not exceed 12 to 18 months and typically require that the borrower provide additional economic support in the form of partial repayment, additional collateral or guarantees. In cases where the fair value of the collateral or the financial resources of the borrower are deemed insufficient to repay the loan, reliance may be placed on the support of a guarantee, if applicable. However, such guarantees are not relied on when evaluating a loan for impairment and never considered the sole source of repayment.

Bancorp evaluates the financial condition of guarantors based on the most current financial information available. Most often, such information takes the form of (i) personal financial statements of net worth, cash flow statements and tax returns (for individual guarantors) and (ii) financial and operating statements, tax returns and financial projections (for legal entity guarantors). Bancorp’s evaluation is primarily focused on various key financial metrics, including net worth, leverage ratios, and liquidity. It is Bancorp's policy to update such information annually, or more frequently as warranted, over the life of the loan.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable – Continued

While Bancorp does not specifically track the frequency with which it has pursued guarantor performance under a guarantee, its underwriting process, both at origination and upon extension, as applicable, includes an assessment of the guarantor's reputation, creditworthiness and willingness to perform. Historically, when Bancorp has found it necessary to seek performance under a guarantee, it has been able to effectively mitigate its losses. As stated above, Bancorp’s ability to seek performance under a guarantee is directly related to the guarantor's reputation, creditworthiness and willingness to perform. When a loan becomes impaired, repayment is sought from both the underlying collateral and the guarantor (as applicable). In the event that the guarantor is unwilling or unable to perform, a legal remedy is pursued.

Construction loans are funded, at the request of the borrower, typically not more than once per month, based on the extent of work completed, and are monitored, throughout the life of the project, by independent professional construction inspectors and Bancorp's commercial real estate lending department. Interest is advanced to the borrower, upon request, based upon the progress of the project toward completion. The amount of interest advanced is added to the total outstanding principal under the loan commitment. Should the project not progress as scheduled, the adequacy of the interest reserve necessary to carry the project through to completion is subject to close monitoring by management. Should the interest reserve be deemed to be inadequate, the borrower is required to fund the deficiency. Similarly, once a loan is fully funded, the borrower is required to fund all interest payments.

Construction loans are reviewed for extensions upon expiration of the loan term. Provided the loan is performing in accordance with contractual terms, extensions may be granted to allow for the completion of the project, marketing or sales of completed units, or to provide for permanent financing. Extension terms generally do not exceed 12 to 18 months.

In general, Bancorp's construction loans are used to finance improvements to commercial, industrial or residential property. Repayment is typically derived from the sale of the property as a whole, the sale of smaller individual units, or by a take-out from a permanent mortgage. The term of the construction period generally does not exceed two years. Loan commitments are based on established construction budgets which represent an estimate of total costs to complete the proposed project including both hard (direct) costs (building materials, labor, etc.) and soft (indirect) costs (legal and architectural fees, etc.). In addition, project costs may include an appropriate level of interest reserve to carry the project through to completion. If established, such interest reserves are determined based on (i) a percentage of the committed loan amount, (ii) the loan term, and (iii) the applicable interest rate. Regardless of whether a loan contains an interest reserve, the total project cost statement serves as the basis for underwriting and determining which items will be funded by the loan and which items will be funded through borrower equity. Bancorp has not advanced additional interest reserves to keep a loan from becoming nonperforming.

Bancorp recognized $29,000 and $8,000 of interest income from its loan portfolio from interest reserves during the nine months ended September 30, 2014 and 2013, respectively.  None of the loans where interest reserves were recorded as capitalized interest were non-performing.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following is a summary of the allowance for loan losses for the nine and three month periods ended September 30, 2014 (dollars in thousands):

   
 
 
Total
   
 
 
Residential Mortgage
   
Construction
Acquisition
Development
   
 
 
Land
   
 
 
Lines of Credit
   
Commercial
 Real
Estate
   
 
Commercial
Non-Real Estate
   
 
 
Home Equity
   
 
 
Consumer
 
Nine months ended September 30, 2014
                                   
 
Beginning Balance
 
$
11,739
   
$
6,291
   
$
414
   
$
1,346
   
$
36
   
$
2,512
   
$
135
   
$
1,003
   
$
2
 
Provision
   
431
     
(1,213
)
   
8
     
(842
)
   
1,282
     
58
     
1,300
     
(157
)
   
(5
)
Charge-offs
   
(3,680
)
   
(704
)
   
(62
)
   
-
     
(1,313
)
   
(92
)
   
(1,311
)
   
(198
)
   
-
 
Recoveries
   
792
     
257
     
-
     
349
     
-
     
25
     
156
     
-
     
5
 
Ending Balance
 
$
9,282
   
$
4,631
   
$
360
   
$
853
   
$
5
   
$
2,503
   
$
280
   
$
648
   
$
2
 
 
Ending balance related to:
                                                                       
 
Loans individually evaluated for impairment
 
$
2,464
   
$
2,160
   
$
-
   
$
56
   
$
-
   
$
229
   
$
17
   
$
-
   
$
2
 
Loans collectively evaluated for impairment
 
$
6,818
   
$
2,471
   
$
360
   
$
797
   
$
5
   
$
2,274
   
$
263
   
$
648
   
$
-
 
                                                                         
Three months ended September 30, 2014
                                                                       
                                                                         
Beginning Balance
 
$
10,828
   
$
5,167
   
$
480
   
$
987
   
$
621
   
$
2,514
   
$
324
   
$
731
   
$
4
 
Provision
   
250
     
(459
)
   
(120
)
   
(134
)
   
697
     
81
     
275
     
(83
)
   
(7
)
Charge-offs
   
(1,858
)
   
(111
)
   
-
     
-
     
(1,313
)
   
(92
)
   
(342
)
   
-
     
-
 
Recoveries
   
62
     
34
     
-
     
-
     
-
     
-
     
23
     
-
     
5
 
Ending Balance
 
$
9,282
   
$
4,631
   
$
360
   
$
853
   
$
5
   
$
2,503
   
$
280
   
$
648
   
$
2
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following is a summary of the allowance for loan losses for the nine and three month periods ended September 30, 2013 (dollars in thousands):

   
 
 
Total
   
 
Residential
Mortgage
   
Construction
Acquisition
Development
   
 
 
Land
   
 
Lines of
Credit
   
 
Commercial
Real Estate
   
Commercial
Non-Real
Estate
   
 
 
Home Equity
   
 
 
Consumer
 
Nine months ended September 30, 2013
                                   
 
Beginning Balance
 
$
17,478
   
$
8,418
   
$
2,120
   
$
2,245
   
$
87
   
$
3,295
   
$
46
   
$
1,254
   
$
13
 
Provision
   
12,820
     
243
     
687
     
3,045
     
387
     
8,254
     
186
     
(16
)
   
34
 
Charge-offs
   
(19,115
)
   
(2,821
)
   
(2,338
)
   
(4,506
)
   
(485
)
   
(8,246
)
   
(109
)
   
(564
)
   
(46
)
Recoveries
   
1,087
     
51
     
10
     
947
     
20
     
54
     
5
     
-
     
-
 
Ending Balance
 
$
12,270
   
$
5,891
   
$
479
   
$
1,731
   
$
9
   
$
3,357
   
$
128
   
$
674
   
$
1
 
 
Ending balance related to:
                                                                       
 
Loans individually evaluated for impairment
 
$
2,767
   
$
2,450
   
$
-
   
$
71
   
$
-
   
$
246
   
$
-
   
$
-
   
$
-
 
Loans collectively evaluated for impairment
 
$
9,503
   
$
3,441
   
$
479
   
$
1,660
   
$
9
   
$
3,111
   
$
128
   
$
674
   
$
1
 
                                                                         
Three months ended September 30, 2013
                                                                       
                                                                         
Beginning Balance
 
$
12,765
   
$
6,032
   
$
1,203
   
$
1,582
   
$
51
   
$
2,970
   
$
117
   
$
810
   
$
-
 
Provision
   
12,200
     
884
     
450
     
2,104
     
436
     
8,130
     
8
     
187
     
1
 
Charge-offs
   
(13,680
)
   
(1,034
)
   
(1,174
)
   
(2,902
)
   
(485
)
   
(7,762
)
   
-
     
(323
)
   
-
 
Recoveries
   
985
     
9
     
-
     
947
     
7
     
19
     
3
     
-
     
-
 
Ending Balance
 
$
12,270
   
$
5,891
   
$
479
   
$
1,731
   
$
9
   
$
3,357
   
$
128
   
$
674
   
$
1
 
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The accrual of interest on loans is discontinued at the time the loan is 90 days past due.  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. Bancorp’s policy for recording payments received on non-accrual financing receivables is to record the payment towards principal and interest on a cash basis until such time as the loan is returned to accrual status.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize impaired loans at September 30, 2014 and December 31, 2013 (dollars in thousands):

   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No Specific Allowance
   
 
Total Impaired Loans
 
   
Recorded Investment
   
Related Allowance
   
Recorded Investment
   
Recorded Investment
   
Unpaid Principal Balance
 
September 30, 2014
                   
Residential mortgage
 
$
14,162
   
$
2,160
   
$
14,797
   
$
28,959
   
$
29,781
 
Construction, acquisition and development
   
-
     
-
     
916
     
916
     
915
 
Land
   
357
     
56
     
1,704
     
2,061
     
2,103
 
Lines of credit
   
-
     
-
     
454
     
454
     
545
 
Commercial real estate
   
2,543
     
229
     
3,631
     
6,174
     
6,398
 
Commercial non-real estate
   
282
     
17
     
21
     
303
     
812
 
Home equity
   
-
     
-
     
1,638
     
1,638
     
2,298
 
Consumer
   
13
     
2
     
-
     
13
     
13
 
Total impaired loans
 
$
17,357
   
$
2,464
   
$
23,161
   
$
40,518
   
$
42,866
 

   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No Specific Allowance
   
 
Total Impaired Loans
 
   
Recorded Investment
   
Related Allowance
   
Recorded Investment
   
Recorded Investment
   
Unpaid Principal Balance
 
December 31, 2013
                   
Residential mortgage
 
$
16,910
   
$
2,749
   
$
18,154
   
$
35,064
   
$
39,149
 
Construction, acquisition and development
   
-
     
-
     
2,808
     
2,808
     
3,453
 
Land
   
363
     
67
     
900
     
1,263
     
1,380
 
Lines of credit
   
-
     
-
     
304
     
304
     
395
 
Commercial real estate
   
2,092
     
241
     
2,580
     
4,672
     
4,685
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
 
Home equity
   
491
     
246
     
1,286
     
1,777
     
2,239
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Total impaired loans
 
$
19,856
   
$
3,303
   
$
26,032
   
$
45,888
   
$
51,301
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize average impaired loans for the nine month and three month periods ended September 30, 2014 and 2013 (dollars in thousands):

   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No
Specific Allowance
   
Total Impaired Loans
 
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
Nine months ended September 30, 2014
                       
Residential mortgage
 
$
14,361
   
$
455
   
$
17,567
   
$
517
   
$
31,928
   
$
972
 
Construction, acquisition and development
     -      
 -
     
2,044
     
45
     
2,044
     
45
 
Land
   
360
     
10
     
1,802
     
65
     
2,162
     
75
 
Lines of credit
   
799
     
15
     
612
     
34
     
1,411
     
49
 
Commercial real estate
   
2,043
     
92
     
4,701
     
171
     
6,744
     
263
 
Commercial non-real estate
   
252
     
4
     
542
     
23
     
794
     
27
 
Home equity
   
-
     
-
     
1,678
     
44
     
1,678
     
44
 
Consumer
   
13
     
-
     
-
     
-
     
13
     
-
 
Total impaired loans
 
$
17,828
   
$
576
   
$
28,945
   
$
899
   
$
46,774
   
$
1,475
 
 
 
   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No
Specific Allowance
   
Total Impaired Loans
 
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                         
Three months ended September 30, 2014
                       
Residential mortgage
 
$
14,188
   
$
147
   
$
14,846
   
$
139
   
$
29,034
   
$
286
 
Construction, acquisition and development
   
-
     
-
     
1,191
     
11
     
1,191
     
11
 
Land
   
358
     
3
     
1,725
     
24
     
2,083
     
27
 
Lines of credit
   
-
     
-
     
454
     
7
     
454
     
7
 
Commercial real estate
   
2,549
     
34
     
3,709
     
44
     
6,258
     
78
 
Commercial non-real estate
   
285
     
1
     
7
     
10
     
292
     
11
 
Home equity
   
-
     
-
     
1,639
     
15
     
1,639
     
15
 
Consumer
   
13
     
-
     
-
     
-
     
13
     
-
 
Total impaired loans
 
$
17,393
   
$
185
   
$
23,571
   
$
250
   
$
40,964
   
$
435
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize average impaired loans for the nine and three month periods ended September 30, 2013 (dollars in thousands):

   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No
Specific Allowance
   
Total Impaired Loans
 
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
Nine months ended September 30, 2013
                       
Residential mortgage
 
$
16,681
   
$
551
   
$
31,600
   
$
884
   
$
48,281
   
$
1,435
 
Construction, acquisition and development
   
1,267
     
44
     
5,649
     
137
     
6,916
     
181
 
Land
   
2,462
     
55
     
1,645
     
94
     
4,107
     
149
 
Lines of credit
   
-
     
-
     
431
     
22
     
431
     
22
 
Commercial real estate
   
6,898
     
245
     
11,145
     
261
     
18,043
     
506
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
2,504
     
42
     
2,504
     
42
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total impaired loans
 
$
27,308
   
$
895
   
$
52,974
   
$
1,440
   
$
80,282
   
$
2,335
 
 
 
   
Impaired Loans with
Specific Allowance
   
Impaired Loans with No
Specific Allowance
   
Total Impaired Loans
 
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                         
Three months ended September 30, 2013
                       
Residential mortgage
 
$
16,608
   
$
168
   
$
30,968
   
$
571
   
$
47,576
   
$
739
 
Construction, acquisition and development
   
816
     
11
     
4,610
     
32
     
5,426
     
43
 
Land
   
1,763
     
16
     
1,415
     
22
     
3,178
     
38
 
Lines of credit
   
-
     
-
     
381
     
7
     
381
     
7
 
Commercial real estate
   
5,517
     
81
     
9,720
     
100
     
15,237
     
181
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
2,406
     
8
     
2,406
     
8
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total impaired loans
 
$
24,704
   
$
276
   
$
49,500
   
$
740
   
$
74,204
   
$
1,016
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Bancorp recognized $435,000 and $1,475,000 of interest income on impaired loans using a cash-basis method of accounting for the three months and nine months ended September 30, 2014. Bancorp did not record any interest income attributable to the change in present value attributable to the passage of time.  Bancorp evaluates its impaired loans and assesses them based on either discounted cash flows or if it deems its loans to be collateral based, assesses impairment based on the net value of the underlying collateral.

Included in the above impaired loans amount at September 30, 2014 was $29,720,000 of loans that are not in non-accrual status.  In addition, there was a total of $28,959,000 of residential real estate loans included in impaired loans at September 30, 2014, of which $24,058,000 were to consumers and $4,901,000 to builders. The collateral supporting impaired collateral dependent loans is individually reviewed by management to determine its estimated fair market value, less estimated disposal cost and a charge off is taken, if necessary, for the difference between the carrying amount of any loan and the estimated fair value of the collateral less estimated disposal cost.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following table presents the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk rating system as of September 30, 2014 and December 31, 2013.  Included in the Pass column were $36,854,000 and $34,069,000 in unfunded commitments at September 30, 2014 and December 31, 2013, respectively (dollars in thousands):

   
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Total
 
                     
September 30, 2014
                   
Residential mortgage
 
$
279,031
   
$
2,976
   
$
13,649
   
$
-
   
$
295,656
 
Construction, acquisition and development
   
77,487
     
-
     
1,618
     
-
     
79,105
 
Land
   
31,822
     
-
     
143
     
-
     
31,965
 
Lines of credit
   
14,850
     
2,479
     
639
     
-
     
17,968
 
Commercial real estate
   
189,441
     
5,758
     
10,076
     
-
     
205,275
 
Commercial non-real estate
   
9,096
     
-
     
262
     
-
     
9,358
 
Home equity
   
27,464
     
-
     
1,502
     
-
     
28,966
 
Consumer
   
1,061
     
-
     
-
     
-
     
1,061
 
Total loans
 
$
630,252
   
$
11,213
   
$
27,889
   
$
-
   
$
669,354
 
 
 
   
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Total
 
                     
December 31, 2013
                   
Residential mortgage
 
$
240,325
   
$
3,454
   
$
15,140
   
$
-
   
$
258,919
 
Construction, acquisition and development
   
72,104
     
250
     
3,185
     
-
     
75,539
 
Land
   
33,804
     
480
     
145
     
-
     
34,429
 
Lines of credit
   
19,152
     
568
     
1,878
     
-
     
21,598
 
Commercial real estate
   
205,063
     
6,775
     
8,322
     
-
     
220,160
 
Commercial non-real estate
   
8,583
     
-
     
-
     
-
     
8,583
 
Home equity
   
28,447
     
115
     
1,777
     
-
     
30,339
 
Consumer
   
299
     
-
     
886
     
-
     
1,185
 
Total loans
 
$
607,777
   
$
11,642
   
$
31,333
   
$
-
   
$
650,752
 

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due.  Included in the Current column were $36,854,000 and $34,069,000 in unfunded commitments at September 30, 2014 and December 31, 2013, respectively. The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans as of September 30, 2014 and December 31, 2013 (dollars in thousands):
 
   
30-59
Days Past Due
   
60-89
Days Past Due
   
90+
Days Past Due
   
Total
Past Due
   
Current
   
Total Loans
   
Non-
Accrual
 
September 30, 2014
                           
Residential mortgage
 
$
2,517
   
$
470
   
$
3,654
   
$
6,641
   
$
289,015
   
$
295,656
   
$
5,273
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
79,105
     
79,105
     
113
 
Land
   
-
     
-
     
6
     
6
     
31,959
     
31,965
     
829
 
Lines of credit
   
-
     
-
     
-
     
-
     
17,968
     
17,968
     
454
 
Commercial real estate
   
250
     
1,138
     
410
     
1,798
     
203,477
     
205,275
     
1,033
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
9,358
     
9,358
     
1,806
 
Home equity
   
821
     
-
     
1,115
     
1,936
     
27,030
     
28,966
     
1,290
 
Consumer
   
-
     
-
     
-
     
-
     
1,061
     
1,061
     
-
 
Total loans
 
$
3,588
   
$
1,608
   
$
5,185
   
$
10,381
   
$
658,973
   
$
669,354
   
$
10,798
 


   
30-59
Days Past Due
   
60-89
Days Past Due
   
90+
Days Past Due
   
Total
Past Due
   
Current
   
Total Loans
   
Non-
Accrual
 
December 31, 2013
                           
Residential mortgage
 
$
3,644
   
$
4,471
   
$
5,506
   
$
13,621
   
$
245,298
   
$
258,919
   
$
6,802
 
Construction, acquisition and development
   
-
     
-
     
814
     
814
     
74,725
     
75,539
     
814
 
Land
   
29
     
-
     
183
     
212
     
34,217
     
34,429
     
183
 
Lines of credit
   
419
     
-
     
66
     
485
     
21,113
     
21,598
     
304
 
Commercial real estate
   
724
     
28
     
851
     
1,603
     
218,557
     
220,160
     
1,155
 
Commercial non-real estate
   
1
     
-
     
-
     
1
     
8,582
     
8,583
     
-
 
Home equity
   
1,199
     
138
     
607
     
1,944
     
28,395
     
30,339
     
1,777
 
Consumer
   
1
     
-
     
-
     
1
     
1,184
     
1,185
     
-
 
Total loans
 
$
6,017
   
$
4,637
   
$
8,027
   
$
18,681
   
$
632,071
   
$
650,752
   
$
11,035
 

Bancorp did not have any greater than 90 days and still accruing loans as of the periods ended September 30, 2014 and December 31, 2013.

SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Bancorp offers a variety of modifications to borrowers.  The modification categories offered can generally be described in the following categories:

Rate Modification – A modification in which the interest rate is changed.
Term Modification – A modification in which the maturity date, timing of payments or frequency of payments is changed.
Interest Only Modification – A modification in which the loan is converted to interest only payments for a period of time.
Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification above.
Loan Balance Modification – A modification in which a portion of the outstanding loan balance is forgiven.
Combination Modification – Any other type of modification, including the use of multiple categories above.
 
Bancorp has not purchased, sold or reclassified any loans to held for sale during the periods discussed.  Only mortgage loans originated specifically for sale are recorded as held for sale at the period ended September 30, 2014 and December 31, 2013.

Bancorp considers a modification of a loan term a troubled debt restructuring or “TDR” if Bancorp for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the debtor that it would not otherwise consider.  Prior to entering into a loan modification, Bancorp assesses the borrower’s financial condition to determine if the borrower has the means to meet the terms of the modification.  This includes obtaining a credit report on the borrower as well as the borrower’s tax returns and financial statements.
 
There were no TDR’s that subsequently defaulted within 12 months of restructuring during the three and nine months ended September 30, 2014.  There were four TDR’s that subsequently defaulted within 12 months of restructuring during the three and nine months ended September 30, 2013.
 
There was a pre-modification and a post-modification balance of $0 for defaulted loans for the 12 months ended September 30, 2014 compared to the pre-modification balance of $1,757,000 and the post-modification balance of $1,050,000 for the four defaulted loans for the 12 months ended September 30, 2013.
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
 
The following tables present loans that were restructured during the nine and three months ended September 30, 2014 (dollars in thousands):

   
Nine months ended September 30, 2014
 
   
Rate Modification
   
Contracts
   
Combination Modifications
   
Contracts
   
Total
   
Total Contracts
 
 
Pre-Modification Outstanding Recorded Investment:
                 
                         
Residential mortgage
   
-
     
-
   
$
598
     
2
   
$
598
     
2
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
696
     
8
     
696
     
8
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
20
     
1
     
20
     
1
 
Total loans
   
-
     
-
   
$
1,314
     
11
   
$
1,314
     
11
 
                                 
Post-Modification Outstanding Recorded Investment:
                                 
                                                 
Residential mortgage
   
-
     
-
   
$
446
     
2
   
$
446
     
2
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
638
     
8
     
638
     
8
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
13
     
1
     
13
     
1
 
Total loans
   
-
     
-
   
$
1,097
     
11
   
$
1,097
     
11
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
 
   
Three months ended September 30, 2014
 
   
Rate Modification
   
Contracts
   
Combination Modifications
   
Contracts
   
Total
   
Total Contracts
 
 
Pre-Modification Outstanding Recorded Investment:
                 
                         
Residential mortgage
   
-
     
-
     
-
     
-
     
-
     
-
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
-
     
-
   
$
-
     
-
   
$
-
     
-
 
                                 
Post-Modification Outstanding Recorded Investment:
                                 
                                                 
Residential mortgage
   
-
     
-
     
-
     
-
     
-
     
-
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
-
     
-
   
$
-
     
-
   
$
-
     
-
 

In addition, the TDR is evaluated for impairment.  A determination is made as to whether an impaired TDR is cash flow or collateral dependent.  If the TDR is cash flow dependent, an allowance for loan losses specific reserve is calculated based on the difference in net present value of future cash flows between the original and modified loan terms.  If the TDR is collateral dependent, the collateral securing the TDR, which is always real estate, is evaluated for impairment based on either an appraisal or broker price opinion.  If a TDR’s collateral valuation is less than its current loan balance, the TDR is written down for accounting purposes by the amount of the difference between the current loan balance and the collateral value.  If the borrower performs under the terms of the modification, generally six consecutive months, and the ultimate collectability of all amounts contractually due under the modified terms is not in doubt, the loan is returned to accrual status.  There are no loans that have been modified due to the financial difficulties of the borrower that are not considered a TDR.
 
 SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
 
The following tables present loans that were restructured that occurred during the nine and three months ended September 30, 2013 (dollars in thousands):

   
Nine months ended September 30, 2013
 
   
Rate Modification
   
Contracts
   
Combination Modifications
   
Contracts
   
Total
   
Total Contracts
 
 
Pre-Modification Outstanding Recorded Investment:
                 
                         
Residential mortgage
 
$
990
     
1
   
$
4,667
     
7
   
$
5,657
     
8
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
1,250
     
1
     
1,250
     
1
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
990
     
1
   
$
5,917
     
8
   
$
6,907
     
9
 
                                 
Post-Modification Outstanding Recorded Investment:
                                 
                                                 
Residential mortgage
 
$
818
     
1
   
$
3,672
     
7
   
$
4,490
     
8
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
1,239
     
1
     
1,239
     
1
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
818
     
1
   
$
4,911
     
8
   
$
5,729
     
9
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

   
Three months ended September 30, 2013
 
   
Rate Modification
   
Contracts
   
Combination Modifications
   
Contracts
   
Total
   
Total Contracts
 
 
Pre-Modification Outstanding Recorded Investment:
                 
                         
Residential mortgage
 
$
-
     
-
   
$
1,409
     
1
   
$
4,667
     
1
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
1,250
     
1
     
1,250
     
1
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
-
     
-
   
$
2,659
     
2
   
$
2,659
     
2
 
                                 
Post-Modification Outstanding Recorded Investment:
                                 
                                                 
Residential mortgage
 
$
-
     
-
   
$
1,158
     
1
   
$
1,158
     
1
 
Construction, acquisition and development
   
-
     
-
     
-
     
-
     
-
     
-
 
Land
   
-
     
-
     
-
     
-
     
-
     
-
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
-
     
-
     
1,239
     
1
     
1,239
     
1
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
 
$
-
     
-
   
$
2,397
     
2
   
$
2,397
     
2
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Interest on TDRs was accounted for under the following methods as of September 30, 2014 and December 31, 2013 (dollars in thousands):
 
   
 
Number of
Contracts
   
 
Accrual
Status
   
 
Number
of Contracts
   
 
Non- Accrual Status
   
Total
Number of
Contracts
   
 
Total
Modifications
 
September 30, 2014
                       
Residential mortgage
   
58
   
$
23,218
     
5
   
$
1,612
     
63
   
$
24,830
 
Construction, acquisition and development
   
2
     
803
     
-
     
-
     
2
     
803
 
Land
   
5
     
997
     
1
     
6
     
6
     
1,003
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
6
     
3,642
     
1
     
109
     
7
     
3,751
 
Commercial non-real estate
   
5
     
155
     
2
     
126
     
7
     
281
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
1
     
13
     
-
     
-
     
1
     
13
 
Total loans
   
77
   
$
28,828
     
9
   
$
1,853
     
86
   
$
30,681
 
 
December 31, 2013
                                               
Residential mortgage
   
66
   
$
28,966
     
5
   
$
856
     
71
   
$
29,822
 
Construction, acquisition and development
   
3
     
1,994
     
1
     
705
     
4
     
2,699
 
Land
   
5
     
1,080
     
2
     
6
     
7
     
1,086
 
Lines of credit
   
-
     
-
     
-
     
-
     
-
     
-
 
Commercial real estate
   
5
     
3,199
     
1
     
112
     
6
     
3,311
 
Commercial non-real estate
   
-
     
-
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
     
-
 
Total loans
   
79
   
$
35,239
     
9
   
$
1,679
     
88
   
$
36,918
 

Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk (dollars in thousands).
 
Financial Instruments Whose Contract
 
Contract Amount At
 
Amounts Represent Credit Risk
 
September 30, 2014
   
December 31, 2013
 
Standby letters of credit
 
$
12,214
   
$
14,719
 
Home equity lines of credit
   
8,732
     
12,345
 
Unadvanced construction commitments
   
36,955
     
34,023
 
Mortgage loan commitments
   
4,104
     
4,193
 
Lines of credit
   
20,985
     
30,965
 
Loans sold with limited repurchase provisions
   
20,531
     
28,134
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

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 September 30, 2014 and December 31, 2013 for guarantees under standby letters of credit issued was $1,326,000 and $0, respectively.

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.

Unadvanced construction commitments are loan commitments made to borrowers for both residential and commercial projects that are either in process or are expected to begin construction shortly.

Mortgage loan commitments not reflected in the accompanying statements of financial condition at September 30, 2014 included $4,104,000 at a fixed range of 3.875% to 4.750% and none at floating interest rates, and at December 31, 2013 included $4,193,000 at a fixed interest rate range of 3.625% to 5.250% and none at floating interest rates.

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. The loans sold under these agreements for the nine month period ended September 30, 2014 and year ended December 31, 2013 were $61,391,000 and $116,788,000, respectively. 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.

Except for the liability recorded for standby letters of credit at September 30, 2014, liabilities for credit loss associated with these commitments were not material at September 30, 2014 and December 31, 2013.
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments

A fair value hierarchy that prioritizes the inputs to valuation methods is used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair market hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2:  Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

Level 3:  Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported with little or no market activity).

An asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following information should not be interpreted as an estimate of the fair value of Bancorp since a fair value calculation is only provided for a limited portion of Bancorp’s assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between Bancorp’s disclosures and those of other companies may not be meaningful.  The following methods and assumptions were used to estimate the fair values of Bancorp’s financial instruments at September 30, 2014 and December 31, 2013.

Impaired Loans:
Impaired loans are carried at the lower of cost or the present value of expected future cash flows of the loan.  If it is determined that the repayment of the loan will be provided solely by the underlying collateral, and there are no other available and reliable sources of repayment, the loan is considered collateral dependent.  Impaired loans that are considered collateral dependent are carried at the lower of cost or the fair value of the underlying collateral.  Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable.  The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and impaired loans are therefore classified within level 3 of the fair value hierarchy.

For such loans that are classified as impaired, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  For such loans that are classified as collateral dependent impaired loans, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan.  Once the net collateral value has been determined, a charge-off is taken for the difference between the net collateral value and the carrying value of the loan.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued

Impaired loans are those for which Bancorp has measured impairment based on the present value of expected future cash flows or on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements. The fair value consisted of the loan balances of $17,357,000 and $19,856,000 at September 30, 2014 and December 31, 2013, respectively, less their valuation allowances of $2,464,000 and $3,303,000 at September 30, 2014 and December 31, 2013, respectively.

Foreclosed Real Estate:
Real estate acquired through foreclosure is included in the following disclosure at the lower of carrying value or fair value less estimated disposal costs. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using current estimates of fair value. In the event of a subsequent decline, management provides a specific 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.

The following table sets forth financial assets that were accounted for at fair value on a nonrecurring and recurring basis by level within the fair value hierarchy as of September 30, 2014 and December 31, 2013:

       
September 30, 2014
Fair Value Measurement Using:
 
   
September 30, 2014
   
Quoted Prices in Active Markets
For Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant Unobservable
Inputs
(Level 3)
 
   
(dollars in thousands)
 
Nonrecurring fair value measurements
               
Impaired loans
 
$
14,893
   
$
-
   
$
-
   
$
14,893
 
Foreclosed real estate
   
1,157
     
-
     
-
     
1,157
 
Total nonrecurring fair value measurements
 
$
16,050
   
$
-
   
$
-
   
$
16,050
 
                                 
Recurring fair value measurements
                               
Mortgage servicing rights
 
$
708
   
$
-
   
$
-
     
708
 
Rate lock commitments
   
277
     
-
     
277
     
-
 
Mandatory forward contracts
   
63
     
-
     
63
     
-
 
Total recurring fair value measurements
 
$
1,048
   
$
-
   
$
340
   
$
708
 
           
December 31, 2013
Fair Value Measurement Using:
 
   
December 31, 2013
   
Quoted Prices in Active Markets
For Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant Unobservable
Inputs
(Level 3)
 
   
(dollars in thousands)
 
Nonrecurring fair value measurements
                               
Impaired loans
 
$
16,553
   
$
-
   
$
-
   
$
16,553
 
Foreclosed real estate
   
8,972
     
-
     
-
     
8,972
 
Total nonrecurring fair value measurements
 
$
25,525
   
$
-
   
$
-
   
$
25,525
 
Recurring fair value measurements
                               
Mortgage servicing rights
 
$
723
   
$
-
   
$
-
   
$
723
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments - Continued
 
There were no liabilities that were required to be re-measured on a nonrecurring basis at September 30, 2014 or December 31, 2013.

The following table presents additional quantitative information about assets measured at fair value on a recurring basis and for which Bancorp has utilized Level 3 inputs to determine fair value:

   
Quantitative Information about Level 3 Fair Value Measurements
 
   
Fair Value Estimate
 
Valuation Techniques
Unobservable Input
 
Range (Weighted Average)
 
September 30, 2014
           
Mortgage servicing rights
 
$
708
 
Market approach
Weighted average prepayment speed
   
8.81
%
                     
December 31, 2013
                   
Mortgage servicing rights
 
$
723
 
Market approach
Weighted average prepayment speed
   
8.30
%

All appraisals are reviewed by the credit department; however, no modifications or adjustments are made to the appraisals received.

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which Bancorp has utilized Level 3 inputs to determine fair value:

   
Quantitative Information about Level 3 Fair Value Measurements
 
   
Fair Value Estimate
 
Valuation Techniques
Unobservable Input
 
Range (Weighted Average)
 
September 30, 2014
           
Impaired loans
 
$
14,893
 
Present value of future cash flows (1)
Discount rate
   
-6.00
%
                     
Foreclosed real estate
 
$
1,157
 
Appraisal of  collateral (2),(4)
Appraisal adjustments (3)
 
-6.00% to -24.83%
(-15.43%)
 
                     
December 31, 2013
                   
Impaired loans
 
$
15,942
 
Present value of future cash flows (1)
Discount rate
   
-6.00
%
 
$
611
 
Appraisal of collateral (2)
Liquidation expenses (3)
   
-6.00
%
                     
Foreclosed real estate
 
$
8,972
 
Appraisal of  collateral (2),(4)
Appraisal adjustments (3)
 
-6.00% to -44.08%
(-12.69%)
 

(1) Cash flow which generally include various level 3 inputs which are not identifiable.
(2) Fair value is generally determined through independent appraisals for the underlying collateral, which generally include various level 3 inputs which are not identifiable.
(3) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.
(4) Includes qualitative adjustments by management and estimated liquidation expenses.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued

The estimated fair values of Bancorp's financial instruments as of September 30, 2014 and December 31, 2013 were as follows:

       
Fair Value Measurement at
September 30, 2014
 
   
Carrying
Amount
   
Fair
Value
   
Quoted Prices in Active Markets
For Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant Unobservable
Inputs
(Level 3)
 
Financial Assets
 
(dollars in thousands)
 
Cash and cash equivalents
 
$
31,618
   
$
31,618
   
$
31,618
   
$
-
   
$
-
 
Investment securities (HTM)
   
62,297
     
62,746
     
-
     
62,746
     
-
 
Loans held for sale
   
9,601
     
9,857
     
-
     
9,857
     
-
 
Loans receivable, net
   
620,060
     
634,676
     
-
     
-
     
634,676
 
FHLB stock
   
5,936
     
5,936
     
-
     
5,936
     
-
 
Accrued interest receivable
   
2,392
     
2,392
     
-
     
2,392
     
-
 
Mortgage servicing rights
   
708
     
708
     
-
     
-
     
708
 
Rate lock commitments
   
277
     
277
     
-
     
277
     
-
 
Mandatory forward contracts
   
63
     
63
     
-
     
63
     
-
 
                                         
Financial Liabilities
                                       
Deposits
 
$
537,743
   
$
538,664
     
-
     
538,664
     
-
 
FHLB advances
   
115,000
     
108,744
     
-
     
108,744
     
-
 
Subordinated debentures
   
24,119
     
24,119
     
-
     
-
     
24,119
 
Accrued interest payable
   
1,886
     
1,886
     
-
     
1,886
     
-
 
                                         
Off Balance Sheet Commitments
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 

       
Fair Value Measurement At
December 31, 2013
 
   
Carrying
Amount
   
Fair
Value
   
Quoted Prices in Active Markets
For Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant Unobservable
Inputs
(Level 3)
 
Financial Assets
 
(dollars in thousands)
 
Cash and cash equivalents
 
$
98,376
   
$
98,376
   
$
98,376
   
$
-
   
$
-
 
Investment securities (HTM)
   
44,661
     
45,213
     
-
     
45,213
     
-
 
Loans held for sale
   
3,726
     
3,825
     
-
     
3,825
     
-
 
Loans receivable, net
   
602,813
     
610,335
     
-
     
-
     
610,335
 
FHLB stock
   
6,190
     
6,190
     
-
     
6,190
     
-
 
Accrued interest receivable
   
2,353
     
2,353
     
-
     
2,353
     
-
 
Mortgage servicing rights
   
723
     
723
     
-
     
-
     
723
 
                                         
Financial Liabilities
                                       
Deposits
 
$
571,249
   
$
573,371
     
-
     
573,371
     
-
 
FHLB advances
   
115,000
     
106,876
     
-
     
106,876
     
-
 
Subordinated debentures
   
24,119
     
24,119
     
-
     
-
     
24,119
 
Accrued interest payable
   
1,375
     
1,375
     
-
     
1,375
     
-
 
                                         
Off Balance Sheet Commitments
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued

The following methods and assumptions were used to measure the fair value of financial instruments recorded at cost on Bancorp’s consolidated balance sheet:

Cash and cash equivalents:
The carrying amount reported in the consolidated statements of financial condition for cash and cash equivalents approximate those assets’ fair values.

Investment Securities:
Bancorp utilizes a third party source to determine the fair value of its securities.  The methodology consists of pricing models based on asset class and includes available trade, bid, other market information, broker quotes, proprietary models, various databases and trading desk quotes.  All Bancorp’s investments are considered Level 2.

Loans held for sale:
The fair value of loans held for sale is based primarily on investor quotes.

Loans receivable:
The fair values of loans receivable were estimated using discounted cash flow analyses, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. These rates were used for each aggregated category of loans as reported on the Office of the Comptroller of the Currency Quarterly Report.

FHLB stock:
The carrying amount of FHLB stock approximates fair value based on the redemption provisions of the FHLB.  There have been no identified events or changes in circumstances that may have a significant adverse effect on the FHLB stock.  Based on our evaluation, we have concluded that our FHLB stock was not impaired at September 30, 2014 and December 31, 2013.

Accrued interest receivable and payable:
The carrying amounts of accrued interest receivable and accrued interest payable approximates their fair values.

Derivative Instruments:
Mortgage banking derivatives used in the ordinary course of business primarily consist of mandatory forward sales contracts (“forward contract”) and rate lock commitments.  The fair value of Bancorp’s derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants.  The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by Bancorp.  Forward contracts and rate lock loan commitments are classified as Level 2 in the fair value hierarchy.

Mortgage servicing rights:
The fair value of mortgage servicing rights is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income.  The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income and other ancillary income such as late fees.  Management reviews all significant assumptions on a monthly basis.  Mortgage loan prepayment speed, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal.  The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the required rate of return investors in the market would require for an asset with similar risk.  Both assumptions can, and generally will, change as market conditions and interest rates change.
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued
 
Deposit liabilities:
The fair values disclosed for demand deposit accounts, savings accounts and money market deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

FHLB advances:
Fair values of long-term debt are estimated using discounted cash flow analysis, based on rates currently available for advances from the FHLB with similar terms and remaining maturities.

Subordinated debentures:
Current economic conditions have rendered the market for this liability inactive.  As such, Bancorp is unable to determine a good estimate of fair value.  Since the rate paid on the debentures held is lower than what would be required to secure an interest in the same debt at year end and we are unable to obtain a current fair value, Bancorp has disclosed that the carrying value approximates the fair value.

Off-balance sheet financial instruments:
Fair values for Bancorp’s off-balance sheet financial instruments (lending commitments and letters of credit) are not significant and are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Note 12 - Recent Accounting Pronouncements

Under ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, a creditor will be considered to have physical possession of residential real estate property that is collateral for a residential mortgage loan and therefore should reclassify the loan to other real estate owned when either (a) the creditor obtains legal title to the property upon completion of a foreclosure, or (b) the borrower conveys all interest in the real estate property to the lender to satisfy that loan even though legal title may not have passed.  The amendments are effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014.  Early adoption is permitted.  An entity can elect to adopt the amendments in this update using either a modified retrospective transition method or a prospective transition method.  Bancorp has evaluated the effect of ASU 2014-04 and believes adoption will not have a material effect on the Consolidated Financial Statements.

Under ASU 2014-09, Revenue from Contracts with Customers, establishes a comprehensive revenue recognition standard for virtually all industries under U.S. GAAP, including those that previously followed industry-specific guidance.  The revenue standard’s core principal is built on the contract between a vendor and a customer for the provision of goods and services.  It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled.  The new standard applies to all public entities for annual periods beginning after December 15, 2016.  Early adoption is prohibited under U.S. GAAP.  Bancorp has evaluated the effect of ASU 2014-09 and believes adoption will not have a material effect on the Consolidated Financial Statements.
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Company

Bancorp is a savings and loan holding company chartered as a corporation in the state of Maryland in 1990.  It conducts business primarily through two subsidiaries, Severn Savings Bank, FSB (“Bank”) and SBI Mortgage Company (“SBI”).  The Bank’s principal subsidiary Louis Hyatt, Inc. (“Hyatt Commercial”), conducts business as Hyatt Commercial, a commercial real estate brokerage and property management company.  SBI holds mortgages that do not meet the underwriting criteria of the Bank, and is the parent company of Crownsville Development Corporation (“Crownsville”), which is doing business as Annapolis Equity Group, which acquires real estate for syndication and investment purposes.  The Bank has four branches in Anne Arundel County, Maryland, which offer a full range of deposit products, and originate mortgages in its primary market of Anne Arundel County, Maryland and, to a lesser extent, in other parts of Maryland, Delaware and Virginia.

Bank Competition

The Annapolis, Maryland 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 money market mutual funds and corporate and government securities funds and investments.  The Bank also faces increased competition for deposits from other financial institutions such as brokerage firms and insurance companies.  The Bank is a community-oriented financial institution serving its market area with a wide selection of mortgage loan products.  Management considers the Bank’s reputation and customer service to be a major competitive advantage in attracting and retaining customers in its market area.  The Bank also believes it benefits from its community orientation.

Forward Looking Statements

In addition to the historical information contained herein, the discussion in this report contains forward-looking statements that involve risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements.  The forward-looking statements contained herein include, but are not limited to, those with respect to the Bank’s strategy; management’s determination of the amount of the loan loss allowance; the effect of changes in interest rates;  changes in deposit insurance premiums; ability to meet obligations; and legal proceedings.  The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “will,” “would,” “could,” “should,” “guidance,” “potential,” “continue,” “project,” “forecast,” “confident,” and similar expressions are typically used to identify forward-looking statements.  Bancorp’s 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 general economic conditions and political conditions and by governmental monetary and fiscal policies; changes in the economic conditions of the geographic areas in which Bancorp conducts business; changes in interest rates; a downturn in the real estate markets in which Bancorp conducts business; the high degree of risk exhibited by Bancorp’s loan portfolio; environmental liabilities with respect to properties Bancorp has title; changes in federal and state regulation; the effects of the supervisory agreements entered into by each of Bancorp and the Bank; Bancorp’s ability to estimate loan losses; competition; breaches in security or interruptions in Bancorp’s information systems; Bancorp’s ability to timely develop and implement technology; Bancorp’s ability to retain its management team; perception of Bancorp in the market place; Bancorp’s ability to maintain effective internal controls over financial reporting and disclosure controls and procedures; and terrorist attacks and threat of actual war; and other factors detailed from time to time in Bancorp’s filings with the Securities and Exchange Commission (the “SEC”), including “Item 1A. Risk Factors” contained in Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013.
 
Critical Accounting Policies

Bancorp’s significant accounting policies are set forth in Note 1 of the audited consolidated financial statements as of December 31, 2013 which were included in Bancorp’s Annual Report on Form 10-K.  Of these significant accounting policies, Bancorp considers its policies regarding the allowance for loan losses and the fair value of foreclosed real estate to be its most critical, because they require management’s most subjective and complex judgments.  In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and the fair value of foreclosed real estate and therefore on the provision for loan losses and the provision for losses on foreclosed real estate and, ultimately, on results of operations.  Bancorp has developed policies and procedures for assessing the adequacy of the allowance for loan losses and the fair value of foreclosed real estate, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio and estimated value of foreclosed real estate.  Bancorp’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.

Overview

Bancorp provides a wide range of personal and commercial banking services. Personal services include various lending services as well as checking, individual retirement accounts, money market, savings and time deposit accounts. Commercial services include commercial secured and unsecured lending services as well as business internet banking, corporate cash management services and deposit services. Bancorp also provides ATMs, debit cards, internet banking including on-line bill pay, mortgage lending, safe deposit boxes, and telephone banking, among other products and services.

Bancorp had net income of $1,359,000 for the nine months ended September 30, 2014, compared to a net loss of ($19,695,000) for the nine months ended September 30, 2013.  The 2013 net loss was primarily due to management’s decision to establish a valuation allowance on its deferred tax asset and the loss on the sale of certain non-performing commercial loans during the quarter ended September 30, 2013.  Bancorp is beginning to experience stronger loan demand and an improved interest rate spread from the levels experienced during the economic downturn.  However, Bancorp continues to experience strong competition among financial institutions for loans and deposits.  While the housing market has improved, it is still significantly below levels experienced in prior economic recoveries.

If interest rates increase, demand for borrowing may decrease and Bancorp’s interest rate spread could decrease.  Bancorp will continue to manage loan and deposit pricing against the risks of rising costs of its deposits and borrowings.  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 mortgage loans and deposits, as will Bancorp’s continued focus on maintaining a low overhead.

If the volatility in the market and the economy continues or worsens, our business, financial condition, results of operations, access to funds and the price of our stock could be materially and adversely impacted.

Results of Operations

Net income increased by $21,616,000 to a net income of $1,068,000 for the third quarter of 2014, compared to a net loss of ($20,548,000) for the third quarter of 2013.  Basic and diluted income (loss) per share was $0.05 for the third quarter of 2014 compared to a loss of ($2.08) for the third quarter of 2013. Net income increased by $21,054,000 to net income of $1,359,000 for the nine months ended September 30, 2014, compared to a net loss of ($19,695,000) for the nine months ended September 30, 2013.  Basic and diluted loss per share was ($0.04) for the nine months ended September 30, 2014 compared to ($2.06) for the nine months ended September 30, 2013. The increase in net income and basic and diluted earnings per share over last year was primarily due to management’s decision in 2013 to establish a valuation allowance on its deferred tax asset and the loss on the sale of certain non-performing commercial loans during the quarter ended September 30, 2013.
 
Net interest income, which is interest earned net of interest expense, decreased by $173,000, or 2.9%, to $5,847,000 for the third quarter of 2014, compared to $6,020,000 for the third quarter of 2013.  Net interest income decreased $1,497,000, or 8.0%, to $17,332,000 for the nine months ended September 30, 2014, compared to $18,829,000 for the nine months ended September 30, 2013. The primary reason for these decreases in net interest income was a decrease in the net yield on Bancorp’s loan portfolio, partially offset by an increase in the loan portfolio.

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.  Bancorp monitors its loan delinquencies at least monthly.  All loans that are delinquent and all loans within the various categories of Bancorp’s portfolio as a group are evaluated.  Bancorp’s Board, with the advice and recommendation of Bancorp’s management, estimates an allowance to be set aside for loan losses.  Included in determining the calculation are such factors as historical losses for each loan portfolio, current market value of the loan’s underlying collateral, 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 collectability.

The provision for loan losses decreased by $11,950,000, or 98.0%, to $250,000 for the third quarter of 2014, compared to $12,200,000 for the third quarter of 2013.   The provision for loan losses decreased by $12,389,000, or 96.6%, to $431,000 for the nine months ended September 30, 2014, compared to $12,820,000 for the same period in 2013. These decreases are primarily due to the loss on the sale of certain non-performing commercial loans during the quarter ended September 30, 2013.  The loss on the sale reduced the allowance for loan losses, requiring a $12,200,000 provision for loan losses during the quarter ended September 30, 2013.

Total non-interest income increased by $16,000, or 1.3%, to $1,245,000 for the third quarter of 2014, compared to $1,229,000 for the third quarter of 2013.  The primary reason for this increase in non-interest income was an increase in other non-interest income from the unrealized gain recorded on certain mortgage banking derivatives and an increase in real estate commissions, partially offset by a decrease of mortgage banking activities for the quarter.  Total non-interest income decreased by $1,336,000, or 29.6%, to $3,183,000 for the nine months ended September 30, 2014, compared to $4,519,000 for the same period in 2013.  The primary reason for this decrease in non-interest income was a decrease in mortgage banking activities partially offset by an increase in real estate commissions and other non-interest income.  Mortgage banking activities decreased $488,000, or 61.5%, to $306,000 for the third quarter of 2014, compared to $794,000 for the third quarter of 2013.  Mortgage banking activities decreased $2,095,000, or 68.9%, to $945,000 for the nine months ended September 30, 2014, compared to $3,040,000 for the same period in 2013.    These decreases in activity were the result of a general slowdown in residential loan originations and in the sale of loans.  Real estate commissions increased by $79,000, or 52.7%, to $229,000 for the third quarter of 2014, compared to $150,000 for the third quarter of 2013.  Real estate commissions increased $320,000, or 89.4%, to $678,000 for the nine months ended September 30, 2014, compared to $358,000 for the same period in 2013.  The increase in real estate commissions was due to increased sales and leasing activity in 2014 compared to 2013. Real estate management fees decreased by $8,000, or 4.6%, to $167,000 for the third quarter of 2014, compared to $175,000 for the third quarter of 2013.    Real estate management fees increased $48,000, or 9.0%, to $579,000 for the nine months ended September 30, 2014, compared to $531,000 for the same period in 2013.  Other non-interest income increased $433,000, or 393.6%, to $543,000 for the third quarter of 2014, compared to $110,000 for the third quarter 2013.  Other non-interest income increased $391,000, or 66.3%, to $981,000 for the nine months ended September 30, 2014, compared to $590,000 for the for the same period in 2013.  The primary reason for the increase was an increase in the unrealized gain recorded on certain mortgage commitment derivatives. Mortgage banking derivatives used in the ordinary course of business primarily consist of mandatory forward sales contracts ("forward contracts") and rate lock commitments, which are recorded at fair value.
 
Total non-interest expenses decreased $1,667,000, or 22.5%, to $5,754,000 for the third quarter of 2014, compared to $7,421,000 for the third quarter of 2013.  Total non-interest expenses decreased $2,818,000, or 13.1%, to $18,695,000 for the nine months ended September 30, 2014, compared to $21,513,000 for the same period in 2013.  The primary reason for this decrease in non-interest expense was a decrease in foreclosed real estate expenses.  Compensation and related expenses increased by $83,000, or 2.4%, to $3,608,000 for the third quarter of 2014, compared to $3,525,000 for the same period in 2013. Compensation and related expenses increased by $197,000, or 1.8%, to $10,850,000 for the nine months ended September 30, 2014, compared to $10,653,000 for the same period in 2013.  Net occupancy costs increased by $90,000, or 27.2%, to $421,000 for the third quarter of 2014, compared to $331,000 for the third quarter of 2013.  Net occupancy costs increased by $29,000, or 2.3%, to $1,272,000 for the nine months ended September 30, 2014, compared to $1,243,000 for the same period in 2013.  These increases were primarily the result of an increase in maintenance costs.  Legal fees decreased by $157,000, or 74.1%, to $55,000 for the third quarter of 2014, compared to $212,000 for the third quarter of 2013.  Legal fees decreased $407,000, or 64.2%, to $227,000 for the nine months ended September 30, 2014, compared to $634,000 for the same period in 2013. These decreases were primarily due to a reduced need for services from outside legal firms in 2014 compared to 2013. Foreclosed real estate expense decreased by $1,315,000, or 96.2%, to $52,000 for the third quarter of 2014 compared to $1,367,000 for the second quarter of 2013 due to a decrease in foreclosure activity.  Foreclosed real estate expenses decreased by $3,581,000, or 100.7%, to ($25,000) for the nine months ended September 30, 2014, compared to $3,556,000 for the same period in 2013.  These decreases were primarily due to net gains realized in 2014 on real estate owned or “REO” properties sold, significant REO write-down taken in 2013, and lower expenses incurred on a reduced number of properties held in 2014, compared to 2013.  There was a reduction of 19 REO properties at September 30, 2014 compared to the number at September 30, 2013.    FDIC assessments and regulatory expense decreased by $40,000, or 10.9% to $326,000 for the third quarter of 2014, compared to $366,000 for the third quarter of 2013.  FDIC assessments and regulatory expense decreased by $42,000, or 4.0% to $1,009,000 for the nine months ended September 30, 2014, compared to $1,051,000 for the same period in 2013.  These decreases were primarily due to a decrease in the risk-based assessment charged by the FDIC.  Professional fees decreased by $117,000, or 27.9%, to $302,000 for the third quarter of 2014, compared to $419,000 for the third quarter of 2013.  Professional fees decreased by $166,000, or 18.0% to $757,000 for the nine months ended September 30, 2014, compared to $923,000 for the same period in 2013.  These decreases were primarily due to a decrease in consulting related fees in 2014.  Office supplies decreased $79,000, or 46.5%, to $91,000 for the third quarter of 2014, compared to $170,000 for the third quarter of 2013.  Office supplies decreased by $155,000, or 38.9% to $243,000 for the nine months ended September 30, 2014, compared to $398,000 for the same period in 2013.  These decreases were primarily due to a decrease in supplies used in 2014.  Online charges stayed the same at $212,000 for the third quarter of 2014, compared to $212,000 for the third quarter of 2013.  Online charges increased by $97,000, or 15.3% to $729,000 for the nine months ended September 30, 2014, compared to $632,000 for the same period in 2013.  This increase was primarily due to a general increase in processing charges in 2014.  Credit report and appraisal fees increased $51,000, or 20.8%, to $296,000 for the third quarter of 2014, compared to $245,000 for the third quarter of 2013.  Credit report and appraisal fees increased by $112,000, or 17.9% to $737,000 for the nine months ended September 30, 2014, compared to $625,000 for the same period in 2013.  These increases were primarily due to higher fees paid for credit reports and appraisals.  Other non-interest expenses decreased by $183,000, or 31.9%, to $391,000 for the third quarter of 2014 compared to $574,000 for the third quarter of 2013.  Other non-interest expenses increased by $1,098,000, or 61.1% to $2,896,000 for the nine months ended September 30, 2014, compared to $1,798,000 for the same period in 2013.  This was primarily due to a $1,400,000 reserve recorded for contingent liabilities related to standby letters of credit during the quarter ended June 30, 2014 and a reversal of approximately $74,000 of that accrual during the quarter ended September 30, 2014.

Income Taxes

Income tax provision decreased by $8,156,000, or 99.8%, to $20,000 for the third quarter of 2014, compared to $8,176,000 for the third quarter of 2013.  Income tax provision decreased by $8,680,000, or 99.7%, to $30,000 for the nine months ended September 30, 2014, compared to $8,710,000 for the same period in 2013. These decreases were primarily due to management’s decision to record a non-cash charge in the third quarter of 2013 of approximately $9,086,000 to provide a valuation allowance for its net deferred tax asset as of June 30, 2013, and in addition, to not record an approximately $3,978,000 deferred tax benefit for the taxable loss incurred during the quarter ended September 30, 2013.
 
Analysis of Financial Condition

Total assets decreased $30,290,000, or 3.8%, to $769,313,000 at September 30, 2014, compared to $799,603,000 at December 31, 2013.  The decrease was primarily due to a reduction in cash and cash equivalents partially offset by an increase in investments and the loan portfolio.  Cash and cash equivalents decreased by $66,758,000, or 67.9%, to $31,618,000 at September 30, 2014, compared to $98,376,000 at December 31, 2013.  This decrease was primarily due to the purchase of securities for the investment portfolio, an increase in loan originations, and decreases in deposits. Loans receivable increased $17,247,000 or 2.9%, to $620,060,000 at September 30, 2014, compared to $602,813,000 at December 31, 2013.  Loans held for sale increased $5,875,000, or 157.7%, to $9,601,000 at September 30, 2014, compared to $3,726,000 at December 31, 2013.  This increase was primarily due to a higher demand for loans and the timing of loans sold as of September 30, 2014.  Foreclosed real estate decreased $3,948,000, or 44.0%, to $5,024,000 at September 30, 2014 compared to $8,972,000 at December 31, 2013. This decrease was the result of more properties sold than foreclosed on during the nine months ended September 30, 2014.  Total deposits decreased $33,506,000, or 5.9%, to $537,743,000 at September 30, 2014 compared to $571,249,000 at December 31, 2013.  This decrease was primarily the result of Bancorp’s continued monitoring of the deposit portfolio and allowing higher rate deposits to run-off.  Long-term borrowings remained at $115,000,000 at September 30, 2014 and December 31, 2013.  These borrowings do not mature until 2016 or later and would incur prepayment penalties if paid earlier.  Accrued interest payable and other liabilities increased $3,246,000, or 50.2% to $9,712,000 at September 30, 2014 compared to $6,466,000 at December 31, 2013.  The primary reasons was a reserve recorded for contingent liabilities related to standby letters of credit during the nine months ended September 30, 2014 and the accruals for cumulative dividends due on of its Series B Fixed Rate Cumulative Perpetual Preferred Stock and interest due on its Junior Subordinated Debt Securities Due 2035.

Stockholders’ Equity

Total stockholders’ equity decreased $30,000 to $82,739,000 at September 30, 2014 compared to $82,769,000 as of December 31, 2013.  This decrease was primarily due to dividends declared on the Series B Fixed Rate Cumulative Perpetual Preferred Stock, partially offset by net income.

Liquidity

Bancorp’s liquidity is determined by its ability to raise funds through several sources including borrowed funds, capital, deposits, loan repayments, maturing investments and the sale of loans.

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 or to permit Bancorp to take advantage of business opportunities.

Management believes Bancorp has sufficient cash flow and liquidity to meet its current commitments through the next 12 months.  Certificates of deposit, which are scheduled to mature in less than one year, totaled $150,979,000 at September 30, 2014.  Based on past experience, management believes that a significant portion of such deposits will remain with Bancorp. At September 30, 2014, Bancorp had commitments to originate mortgage loans of $4,104,000, unadvanced home equity lines of credit of $8,732,000, unadvanced construction commitments of $36,955,000, unused lines of credit of $20,985,000 and commitments under standby letters of credit of $12,214,000.  Bancorp has the ability to reduce its commitments for new loan originations, adjust other cash outflows, and borrow from FHLB Atlanta should the need arise.  As of September 30, 2014, outstanding FHLB Atlanta borrowings totaled $115,000,000, and Bancorp had available to it an additional $41,910,000 in borrowing availability from FHLB Atlanta.

Net cash from operating activities decreased $13,585,000 to cash used by operating activities of $2,678,000 for the nine months ended September 30, 2014, compared to cash provided by operating activities of $10,907,000 for the same period in 2013. This decrease was primarily the result of a decrease in proceeds from loans sold to others net of loans originated for sale in 2014 and an increase in other liabilities.  Net cash from investing activities decreased $64,552,000 to cash used in investing activities of $30,577,000 for the nine months ended September 30, 2014, compared to cash provided by investing activities of $33,975,000 for the same period in 2013.  This decrease was primarily due to the $20,554,000 purchase of mortgaged-backed and investment securities in the second quarter of 2014 and a net increase in funds used for new loan originations compared to a net decrease for the same period in 2013.  Net cash used in financing activities increased $15,024,000 to $33,503,000 for the nine months ended September 30, 2014, compared to $18,479,000 for the same period in 2013This increase was primarily due to a larger decrease in deposits in 2014 compared to the decrease in deposits during the same period in 2013.
 
Federal Home Loan Bank of Atlanta Line of Credit

The Bank has an available line of credit, secured by various loans in its portfolio, in the amount of twenty percent of its total assets, with the FHLB Atlanta.  As of September 30, 2014, the total available line of credit with the FHLB Atlanta was approximately $156,910,000, of which $115,000,000 was outstanding in the form of long-term borrowings.  The Bank, from time to time, utilizes the line of credit when interest rates are more favorable than obtaining deposits from the public.

The following table sets forth information concerning the interest rates and maturity dates of the advances from the FHLB Atlanta as of September 30, 2014 (dollars in thousands):
 
Principal Amount
   
Rate
   
Maturity
 
$
15,000
   
1.81% to 1.83%
     
2016
 
 
70,000
   
2.43% to 4.05%
     
2017
 
 
15,000
   
2.58% to 3.43%
     
2018
 
 
15,000
     
4.00
%
   
2019
 
$
115,000
                 
 
Subordinated Debentures

As of September 30, 2014, Bancorp had outstanding $20,619,000 principal amount of Junior Subordinated Debt Securities Due 2035 (the “2035 Debentures”).  The 2035 Debentures were issued pursuant to an Indenture dated as of December 17, 2004 (the “2035 Indenture”) between Bancorp and Wells Fargo Bank, National Association, as Trustee.  The 2035 Debentures pay interest quarterly at a floating rate of interest of LIBOR (0.23% as of September 30, 2014) plus 200 basis points, and mature on January 7, 2035.  Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of Bancorp, as defined in the 2035 Indenture.  The 2035 Debentures became redeemable, in whole or in part, by Bancorp on January 7, 2010.

The 2035 Debentures were issued and sold to Severn Capital Trust I (the “Trust”), 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 (“Capital Securities”) to third-party investors and using the proceeds from the sale of such Capital Securities to purchase the 2035 Debentures.  The 2035 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 2035 Debentures.  The Capital Securities are subject to mandatory redemption, in whole or in part, upon repayment of the 2035 Debentures.  Bancorp has entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee.  Under the terms of the 2035 Indenture, Bancorp is permitted to defer the payment of interest on the 2035 Debentures for up to 20 consecutive quarterly periods provided that no event of default has occurred and is continuing.  As of September 30, 2014, Bancorp has deferred the payment of ten quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,226,000.

Under the terms of Bancorp’s 2035 Indenture, if Bancorp has deferred payments of interest on the 2035 Debentures, Bancorp may not, among other things, declare or pay any dividends or distributions on, or redeem, purchase, acquire, or make a liquidation payment with respect to, any of its capital stock, including common stock until all such deferred interest has been paid.  Accordingly, Bancorp will not be able to pay dividends on its common stock until the deferred interest on the 2035 Debentures has been paid in full.
 
On November 15, 2008, Bancorp completed a private placement offering consisting of a total of 70 units, at an offering price of $100,000 per unit, for gross proceeds of $7.0 million. Each unit consists of 6,250 shares of Bancorp's Series A 8.0% Non-Cumulative Convertible Preferred Stock and Bancorp's Subordinated Note in the original principal amount of $50,000.

The aggregate principal amount of Subordinated Notes outstanding at September 30, 2014 was $3,500,000.  The Subordinated Notes earn interest at an annual rate of 8.0%, payable quarterly in arrears on the last day of March, June, September and December commencing December 31, 2008.  The Subordinated Notes are redeemable in whole or in part at the option of Bancorp at any time beginning on December 31, 2009 until maturity, which is December 31, 2018.  Debt issuance costs totaled $245,000 and are being amortized over 10 years.  Interest payments on the Subordinated Notes are current as of September 30, 2014.

Preferred Stock
 
Bancorp issued a total of 437,500 shares of its Series A 8.0% Non-Cumulative Convertible Preferred Stock (“Series A Preferred Stock”) as part of the private placement offering completed on November 15, 2008.  The liquidation preference is $8.00 per share.  Each share of Series A Preferred Stock is convertible at the option of the holder into one share of Bancorp’s common stock, subject to adjustment upon certain corporate events. The initial conversion rate is equivalent to an initial conversion price of $8.00 per share of Bancorp’s common stock. At the option of Bancorp, on and after December 31, 2013, at any time and from time to time, some or all of the Series A Preferred Stock may be converted into shares of Bancorp’s common stock at the then-applicable conversion rate.  Costs related to the issuance of the preferred stock totaled $247,000 and were netted against the proceeds.

If declared by Bancorp's board of directors, cash dividends at an annual rate of 8.0% will be paid quarterly in arrears on the last day of March, June, September and December commencing December 31, 2008. Dividends will not be paid on Bancorp’s common stock in any quarter until the dividend on the Series A Preferred Stock has been paid for such quarter; however, there is no requirement that Bancorp's board of directors declare any dividends on the Series A Preferred Stock and any unpaid dividends shall not be cumulative.  Dividends on the Series A Preferred Stock have not been declared since the first quarter of 2012.

On November 21, 2008, Bancorp entered into an agreement with the United States Department of the Treasury (“Treasury”), pursuant to which Bancorp issued and sold (i) 23,393 shares of its Series B Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share and liquidation preference $1,000 per share, (the “Series B Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 556,976 shares of Bancorp’s common stock, par value $0.01 per share, for an aggregate purchase price of $23,393,000.  Costs related to the issuance of the preferred stock and warrants totaled $45,000 and were netted against the proceeds.  On September 25, 2013, the Treasury sold all of its 23,393 shares of Series B Preferred Stock to outside investors as part of their ongoing efforts to wind down and recover its remaining investments under the Troubled Asset Relief Program (“TARP’).  The terms of the Series B Preferred Stock remain the same.  The Treasury continues to hold a warrant to purchase 556,976 shares of Bancorp’s common stock.

The Series B Preferred Stock qualifies as Tier 1 capital and pays cumulative compounding dividends at a rate of 5% per annum for the first five years, and 9% per annum effective November 21, 2013. The Series B Preferred Stock may be redeemed by Bancorp.

The Series B Preferred Stock has no maturity date and ranks pari passu with Bancorp’s existing Series A Preferred Stock, in terms of dividend payments and distributions upon liquidation, dissolution and winding up of Bancorp.
 
The Series B Preferred Stock is non-voting, other than class voting rights on certain matters that could adversely affect the Series B Preferred Stock. If dividends on the Series B Preferred Stock have not been paid for an aggregate of six quarterly dividend periods or more, whether consecutive or not, Bancorp’s authorized number of directors will be automatically increased by two and the holders of the Series B Preferred Stock, voting together with holders of any then outstanding voting parity stock, will have the right to elect those directors at Bancorp’s next annual meeting of stockholders or at a special meeting of stockholders called for that purpose. These preferred share directors will be elected annually and serve until all accrued and unpaid dividends on the Series B Preferred Stock have been paid.  In connection with the sale by the Treasury of the Series B Preferred Stock, the Federal Reserve obtained waivers from the outside investors who purchased the Series B Preferred Stock in which such investors agreed not to exercise their right to elect directors, and certain other voting or control rights, without the prior approval of the Federal Reserve.

The Warrant has a 10-year term and is immediately exercisable at an exercise price of $6.30 per share of Common Stock.   The exercise price and number of shares subject to the Warrant are both subject to anti-dilution adjustments.  Pursuant to the Purchase Agreement, Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant.

Bancorp’s ability to declare dividends on its common stock are limited by the terms of Bancorp’s Series A preferred stock and Series B preferred stock.  Bancorp may not declare or pay any dividend on, make any distributions relating to, or redeem, purchase, acquire or make a liquidation payment relating to, or make any guarantee payment with respect to its common stock in any quarter until the dividend on the Series A Preferred Stock has been declared and paid for such quarter, subject to certain minor exceptions.  Additionally Bancorp may not declare or pay any dividend or distribution on its common stock, and Bancorp may not purchase, redeem or otherwise acquire for consideration any of its common stock, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Series B Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside), subject to certain minor exceptions.  Dividends on the Series A Preferred Stock and Series B Preferred Stock have not been paid since the first quarter of 2012 because Bancorp did not receive approval from the Federal Reserve Bank of Richmond to pay such dividends.  As of September 30, 2014, Bancorp has unpaid cumulative dividends and interest in arrears on the Series B Preferred Stock of $3,829,000.  Accordingly, Bancorp will not be able to pay dividends on its common stock until the dividend in arrearage on its Series B Preferred Stock has been paid in full.

On November 23, 2009, Bancorp and the Bank entered into supervisory agreements with their respective regulators.  Bancorp is currently under its original agreement which is now enforced by the Federal Reserve Bank of Richmond.  On April 23, 2013, the Bank entered into a new agreement with the OCC, which superseded and terminated the supervisory agreement entered into on November 23, 2009.  The agreements require, among other things, that Bancorp and the Bank must obtain prior regulatory approval before any dividends or capital distributions can be made.
 
Effects of Inflation

The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation.  Unlike industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature.  As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation.

Average Balance Sheet

The following table presents Bancorp’s distribution of the average consolidated balance sheets and net interest analysis for the nine months ended September 30, 2014 and September 30, 2013:
 
 
   
Nine Months Ended September 30, 2014
   
Nine Months Ended September 30, 2013
 
   
Average
Volume
   
Interest
   
Yield/Cost
   
Average
Volume
   
Interest
   
Yield/Cost
 
   
(dollars in thousands)
 
ASSETS
                       
Loans (1)
 
$
617,855
   
$
22,811
     
4.92
%
 
$
658,069
   
$
25,110
     
5.09
%
Held to maturity securities (2)
   
51,778
     
686
     
1.77
%
   
33,099
     
456
     
1.83
%
Other interest-earning assets (3)
   
42,393
     
233
     
0.73
%
   
63,695
     
243
     
0.51
%
                                                 
Total interest-earning assets
   
712,026
     
23,730
     
4.44
%
   
754,863
     
25,809
     
4.56
%
                                                 
Non-interest earning assets
   
77,619
                     
86,457
                 
                                                 
Total assets
 
$
789,645
                   
$
841,320
                 
                                                 
LIABILITIES AND STOCKHOLDERS' EQUITY
                                               
Savings and checking deposits
 
$
265,782
     
288
     
0.14
%
 
$
273,217
     
625
     
0.31
%
Certificates of deposit
   
293,635
     
2,636
     
1.20
%
   
313,424
     
3,009
     
1.28
%
Borrowings
   
139,119
     
3,474
     
3.33
%
   
139,119
     
3,346
     
3.21
%
                                                 
Total interest-bearing liabilities
   
698,536
     
6,398
     
1.22
%
   
725,760
     
6,980
     
1.28
%
                                                 
Non-interest bearing liabilities
   
9,417
                     
7,190
                 
                                                 
Stockholders' equity
   
81,692
                     
108,370
                 
                                                 
Total liabilities and stockholders’ equity
 
$
789,645
                   
$
841,320
                 
                                                 
Net interest income and interest rate spread
         
$
17,332
     
3.22
%
         
$
18,829
     
3.28
%
                                                 
Net interest margin
                   
3.25
%
                   
3.33
%
 
Average interest-earning assets to average interest-bearing liabilities
101.93
%
104.01
%
 
(1) Non-accrual loans are included in the average balances and in the computation of yields.
(2) Bancorp does not have any tax-exempt securities.
(3) Other interest-earning assets include interest-bearing deposits in other banks, federal funds sold and FHLB stock investments.
 
Recent Accounting Pronouncements

For information concerning recent accounting pronouncements, see Note 12 to the unaudited Consolidated Financial Statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There has been no material change in market risk since December 31, 2013, as reported in Bancorp’s Form 10-K filed with the SEC on March 18, 2014.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

Under the supervision and with the participation of Bancorp's management, including its Chief Executive Officer and Chief Financial Officer, Bancorp has evaluated the effectiveness of its disclosure controls and procedures as of September 30, 2014.  Disclosure controls and procedures are defined in Rule 13a-15(e) under the Securities Exchange Act as those controls and other procedures of an issuer that are designed to ensure that the information required to be disclosed by the issuer in the reports it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.  Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, Bancorp’s disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

Bancorp’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of Bancorp’s internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f), to determine whether any changes occurred during the quarter ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, Bancorp’s internal control over financial reporting.  Based on that evaluation, there were no such changes during the quarter ended September 30, 2014.

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.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
 
PART II – OTHER INFORMATION

Item 1.
Legal Proceedings

There are various claims pending involving Bancorp, arising in the normal course of business.  Management believes, based upon consultation with legal counsel, that liabilities arising from these proceedings, if any, will not be material to Bancorp’s consolidated financial condition and consolidated results of operations.
 
Item 1A. Risk Factors

The risk factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 should be carefully considered by you. If any of the risks actually occur, Bancorp’s business, financial condition or results of operations could be materially and adversely affected.  The risks described in our Annual Report on Form 10-K are not the only risks facing Bancorp.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or results of operations.  This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties.  Bancorp’s actual results could differ materially from those anticipated in the forward-looking statements as a result of many factors, including the risks faced by Bancorp described in Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

As noted above, Bancorp and the Bank entered into formal agreements with the regulators that require, among other things, that Bancorp and Bank obtain prior regulatory approval before paying any dividends or distributions.  During the third quarter of 2014, Bancorp did not receive approval from the Federal Reserve Bank of Richmond to pay dividends on the cumulative Series B Preferred Stock in the amount of $526,000 due on August 15, 2014 and the non-cumulative Series A Preferred Stock in the amount of $70,000 due on September 30, 2014.  As of September 30, 2014, Bancorp has unpaid cumulative dividends and interest in arrears on the Series B Preferred Stock of $3,829,000 and $0 on the Series A Preferred Stock.

Also as noted above, as permitted under the terms of the 2035 Indenture, as of September 30, 2014, Bancorp has deferred the payment of ten quarters of interest on its 2035 Debentures and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,226,000.

Bancorp and Bank continue to work with the regulators to obtain approval for dividends and interest payments.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits
 
Exhibit No.
Description
   
31.1
Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
31.2
Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
32
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101
The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10-Q as of September 30, 2014 and for the nine months ended September 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Operations; (iii) The Consolidated Statements of Stockholders’ Equity for the nine Months Ended September 30, 2014 and 2013; (iv) the Consolidated Statements of Cash Flows; and (v) the Notes to Consolidated Financial Statements.
 
SIGNATURES

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

 
SEVERN BANCORP, INC.
   
November 12, 2014
Alan J. Hyatt
 
Alan J. Hyatt, Chairman of the Board, President and
Chief Executive Officer
 
(Principal Executive Officer)
   
November 12, 2014
Thomas G. Bevivino
 
Thomas G. Bevivino,
 
Executive Vice President, Chief Financial Officer
 
(Principal Financial and Accounting Officer)
 
Exhibit Index

Exhibit No.
Description
   
Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101
The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10-Q as of September 30, 2014 and for the three months ended September 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2014 and 2013; (iv) the Consolidated Statements of Cash Flows; and (v) the Notes to Consolidated Financial Statements.
 
 
52