Severn Bancorp Inc.
Annual Report 2016

Plain-text annual report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☑ ☐ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2016 or 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 (State or other jurisdiction of incorporation or organization) 52-1726127 (I.R.S. Employer Identification Number) 200 Westgate Circle, Suite 200, Annapolis, Maryland (Address of principal executive offices) 21401 (Zip Code) Registrant’s telephone number, including area code: (410) 260-2000 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Common Stock, par value $.01 per share The Nasdaq Stock Market, LLC Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☑ Yes ☐ No ☑ Note - Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 of 15(d) of the Exchange Act from their obligations under those Sections. 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 ☑ No ☐ 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 ☑ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐ 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 the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ Accelerated filer ☐ Smaller reporting company ☑ Non-accelerated filer ☐ (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Act). Yes ☐ No ☑ The aggregate market value of the 8,258,193 shares of common stock held by non-affiliates of the registrant, based on the closing sale price of the registrant’s common stock on June 30, 2016 of $6.00 per share was $49,549,158. (APPLICABLE ONLY TO CORPORATE REGISTRANTS) Indicate the number of shares outstanding for each of the registrant’s classes of common stock, as of the latest practicable date. As of March 22, 2017, there were issued and outstanding 12,124,965 shares of the registrant’s common stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Definitive Proxy Statement for its 2016 Annual Meeting of Stockholders, which Definitive Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the registrant’s fiscal year-ended December 31, 2016, are incorporated by reference into Part III of this Form 10-K; provided, however, that the Audit Committee Report and any other information in such proxy statement that is not required to be included in this Annual Report on Form 10-K, shall not be deemed to be incorporated herein by reference or filed as a part of this Annual Report on Form 10-K. Table of Contents Section PART I Item 1 Item 1A Item 1B Item 2 Item 3 Item 4 PART II Item 5 Item 6 Item 7 Item 7A Item 8 Item 9 Item 9A Item 9B PART III Item 10 Item 11 Item 12 Item 13 Item 14 PART IV Table of Contents Page No. Business Risk Factors Unresolved Staff Comments Properties Legal Proceedings Mine Safety Disclosures Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Selected Financial Data Management’s Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures About Market Risk Financial Statements and Supplementary Data Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Controls and Procedures Other Information Directors, Executive Officers and Corporate Governance Executive Compensation Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Certain Relationships and Related Transactions, and Director Independence Principal Accounting Fees and Services Item 15 Item 16 Exhibits, Financial Statement Schedules Form 10-K Summary SIGNATURES i 1 33 41 41 42 42 42 43 47 56 57 57 57 58 58 59 59 59 60 60 61 62 Table of Contents SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Severn Bancorp, Inc. (the “Company”) may from time to time make written or oral “forward-looking statements”, (as defined in the Securities Exchange Act of 1934, as amended, and the regulations thereunder) including statements contained in the Company’s filings with the Securities and Exchange Commission (including this Annual Report on Form 10-K and the exhibits thereto), in its reports to stockholders and in other communications by the Company, pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, but are not limited to: · · · · Statements contained in “Item 1A. Risk Factors;” Statements contained in “Business” concerning strategy, competitive strengths, liquidity and business plans; Statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the notes to the Company’s consolidated financial statements, such as statements concerning allowance for loan losses, liquidity, capital adequacy requirements, unrealized losses, guarantees, the Bank being well-capitalized, and impact of accounting pronouncements; and Statements as to trends or the Company’s or management’s beliefs, expectations and opinions. 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. These statements are based on assumptions and assessments made by management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate. Any forward-looking statements are not guarantees of the Company’s future performance and are subject to risks and uncertainties and may be affected by various factors that may cause actual results, developments and business decisions to differ materially from those in the forward-looking statements. Some of the factors that may cause actual results, developments and business decisions to differ materially from those contemplated by such forward-looking statements include the risk factors discussed under “Item 1A. Risk Factors” and the following: · Changes in general economic and political conditions and by governmental monetary and fiscal policies; · Changes in the economic conditions of the geographic areas in which the Company conducts business; · Changes in interest rates; · A downturn in the real estate markets in which the Company conducts business; · · The high degree of risk exhibited by the Company’s loan portfolio; Environmental liabilities with respect to properties of which the Company has title; · Changes in federal and state regulation, including recent changes in capital requirements; · The Company’s ability to estimate loan losses; · Competition; · Breaches in security or interruptions in the Company’s information systems, including cyber security risks; · · The Company’s ability to timely develop and implement technology; The Company’s ability to retain its management team; ii Table of Contents · · · Perception of the Company in the marketplace; The Company’s ability to maintain effective internal controls over financial reporting and disclosure controls and procedures; and Terrorist attacks and threats or actual war. The Company can give no assurance that any of the events anticipated by the forward-looking statements will occur or, if any of them does, what impact they will have on the Company’s results of operations and financial condition. The Company disclaims any intent or obligation to publicly update or revise any forward-looking statements, regardless of whether new information becomes available, future developments occur or otherwise. iii Table of Contents Item 1. Business General PART I The Company 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 five 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. The Bank operated under a Formal Agreement dated April 13, 2013, (the “Formal Agreement”), with the Office of the Comptroller of the Currency (the “OCC”). This agreement replaced the former Supervisory Agreement dated November 23, 2009 that the Bank had with the now defunct Office of Thrift Supervision (the “OTS”). The Bank satisfied all of the conditions of the Formal Agreement and on October 15, 2015 it was notified by the OCC that the agreement was terminated. The Company previously operated under a Supervisory Agreement dated November 23, 2009, (the “Supervisory Agreement”) with the now defunct OTS. Upon the abolishment of the OTS on July 21, 2011, the Federal Reserve Bank assumed the regulation of the Company. The Company satisfied all of the conditions of the Supervisory Agreement and on January 21, 2016 it was notified by the Federal Reserve Bank that the Supervisory Agreement was terminated. On April 23, 2013, the Bank was notified by the OCC that the OCC established minimum capital ratios for the Bank requiring it to immediately maintain a Tier I 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%. On October 15, 2015, the Bank was notified by the OCC that these additional minimum capital ratios were no longer required. As of December 31, 2016 the Bank was well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain the following minimum ratios: Total Risk-Based Capital – 10.0%, Common Equity Tier 1 Capital – 6.5%, Tier 1 Capital (to risk-weighted assets) – 8%, Tier 1 Capital (to adjusted total assets) – 5.0%. As of December 31, 2016, the Company had consolidated total assets of $787,485,000, total deposits of $571,946,000, and total stockholders’ equity of $87,930,000. The Company’s net income for the year ended December 31, 2016 was $15,540,000. For more information, see “Item 6. Selected Financial Data.” The Company’s internet address is www.severnbank.com. The Company makes available free of charge on www.severnbank.com its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC. 1 Table of Contents In addition, we will provide, at no cost, paper or electronic copies of our reports and other filings made with the SEC. Requests should be directed to: Paul B. Susie Executive Vice President Severn Bancorp, Inc. 200 Westgate Circle, Suite 200 Annapolis, Maryland 21401 The information on the website listed above, is not and should not be considered part of this Annual Report on Form 10-K and is not incorporated by reference in this document. This website is and is only intended to be an inactive textual reference. 2 Table of Contents Business of the Bank The Bank was organized in 1946 in Baltimore, Maryland as Pompeii Permanent Building and Loan Association. It relocated to Annapolis, Maryland in 1980 and its name was changed to Severn Savings Association. Subsequently, the Bank obtained a federal charter and changed its name to Severn Savings Bank, FSB. The Bank operates five full-service branch offices and one administrative office. The Bank operates as a federally chartered savings bank whose principal business is attracting deposits from the general public and investing those funds in mortgage and commercial loans. The Bank also uses advances, or loans, from the Federal Home Loan Bank of Atlanta, (“FHLB-Atlanta”) to fund its lending activities. The Bank provides a wide range of personal and commercial banking services. Personal services include mortgage lending and various other lending services as well as checking, savings, money market, time deposit and individual retirement accounts. Commercial services include commercial secured and unsecured lending services as well as business internet banking, corporate cash management services and deposit services. The Bank also provides safe deposit boxes, ATMs, debit cards, credit cards, personal internet banking including on-line bill pay, mortgage lending, and telephone banking, among other products and services. The Bank’s revenues are derived principally from interest earned on mortgage, commercial and other loans, and fees charged in connection with the loans and banking services. The Bank’s primary sources of funds are deposits, advances from the FHLB-Atlanta, proceeds from loans sold on the secondary market, and repayments and principal prepayment of its loans. The principal executive offices of the Bank are maintained at 200 Westgate Circle, Suite 200, Annapolis Maryland, 21401. Its telephone number is 410-260-2000 and its website address is www.severnbank.com. 3 Table of Contents Earnings The Bank’s earnings depend primarily on the difference between the income from interest-earning assets, such as loans and investments, and interest paid on interest-bearing liabilities such as deposits and borrowings. The Bank also originates and sells residential mortgages into the secondary market, generating gains on the loans sold. Rapid changes in interest rates may adversely affect the Bank’s earnings. The Bank monitors and manages this risk through its asset/liability committee. 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. Many of the Bank’s competitors have higher legal lending limits than the Bank. The Bank’s most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks, and credit unions. The Bank faces additional competition for deposits from short-term money market funds and other corporate and government securities funds. The Bank also faces increased competition for deposits from other financial institutions such as brokerage firms, insurance companies and mutual funds. The Bank is a community-oriented financial institution serving its market area with a wide selection of mortgage loans and other consumer and commercial financial products and services. Management considers the Bank’s reputation for financial strength and customer service as its major competitive advantage in attracting and retaining customers in its market area. The Bank also believes it benefits from its community engagement activities. Net Interest Income Net interest income increases during periods when the spread between the Company’s weighted average rate at which new interest-earning assets such as loans and securities are originated or purchased and the weighted average cost of interest-bearing liabilities widens. Market factors such as interest rates, competition, consumer preferences, the supply of and demand for housing, and the availability of funds affect the Bank’s ability to originate loans. The Company has supplemented its interest income through purchases of investments when appropriate. This activity is intended to generate positive interest rate spreads on large principal balances with minimal administrative expense. Interest Rate and Volume of Interest-Related Assets and Liabilities Both changes in rate and changes in the composition of the Company’s interest-earning assets and interest-bearing liabilities can have a significant effect on net interest income. For information concerning the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected the Company’s interest income and expense during the fiscal years ended December 31, 2016 and 2015, refer to Item 6, “Selected Financial Data - Rate Volume Table”. 4 Table of Contents Market Area The Bank’s market area is primarily Anne Arundel County, Maryland and nearby areas, and its five branch locations are all located in Anne Arundel County. The Bank continues to expand its business relationship banking department by focusing on the needs of the business community in Anne Arundel County, Maryland. In addition, the Bank increased its offerings to businesses and consumers, including additional commercial lending products, business internet banking, and an expanded line of consumer deposit products. The Bank has traditionally focused its lending activities on first mortgage loans secured by real estate for the purpose of purchasing, refinancing, developing and constructing one-to-four family residences and commercial properties in and near Anne Arundel County, Maryland. The Bank originates residential mortgage loans for sale into the secondary market. It generally sells the loans with the servicing rights released. However, for loans sold to Federal National Mortgage Association (“FNMA”) or Federal Home Loan Mortgage Corporation (“FHLMC”), the servicing rights have been retained. 5 Table of Contents Loan Portfolio Composition The following table sets forth the composition of the Company’s loan portfolios by type of loan at the dates indicated. The table includes a reconciliation of total net loans receivable, including loans held for sale, after consideration of undisbursed portion of loans, deferred loan fees and discounts, and allowance for loan losses as of December 31: 2016 2015 2014 2013 2012 Amount Percent Amount Percent Amount Percent (dollars in thousands) Amount Percent Amount Percent Residential mortgage Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Loans held for sale $ 260,603 40.77% $ 285,930 45.00% $ 309,461 44.91% $ 258,919 39.56% $ 269,405 38.60% 57,166 48,664 29,657 195,710 16,811 19,129 1,210 10,307 8.94% 77,478 7.61% 28,677 4.64% 20,188 30.62% 174,912 2.63% 9,296 2.99% 24,529 0.19% 1,224 1.61% 13,203 12.19% 84,325 4.51% 30,426 3.18% 19,251 27.53% 198,539 1.46% 10,167 3.86% 28,750 1,040 0.19% 7,165 2.08% 12.24% 75,539 4.42% 34,429 2.79% 21,598 28.81% 220,160 1.47% 8,583 4.17% 30,339 1,185 0.15% 3,726 1.04% 11.54% 71,523 5.26% 50,900 3.30% 31,428 33.64% 222,038 1.31% 6,120 4.64% 34,609 0.18% 858 0.57% 11,116 10.25% 7.29% 4.50% 31.81% 0.88% 4.96% 0.12% 1.59% Total gross loans 639,257 100.00% 635,437 100.00% 689,124 100.00% 654,478 100.00% 697,997 100.00% Deferred loan origination fees and costs, net (2,944) (2,719) (2,480) (2,131) (2,047) Loans in process (15,728) (21,101) (36,162) (34,069) (15,647) Allowance for loan losses (8,969) (8,758) (9,435) (11,739) (17,478) Total loans net $ 611,616 $ 602,859 $ 641,047 $ 606,539 $ 662,825 6 Table of Contents Lending Activities General The Bank originates mortgage loans of all types, including residential, home equity and lines of credit, residential-construction, commercial-construction, commercial, land and residential lot loans. The Bank also originates non-mortgage loans, which include consumer, lines of credit and commercial loans. These loans constitute less than 8 percent of the Bank’s portfolio. The Bank originated and funded $345,437,000 and $282,828,000 of loans for the years ended December 31, 2016 and 2015, respectively. Loan Origination The following table contains information on the activity of the Bank’s loans held for sale and its loans held for investment in its portfolio: 2016 For the Years Ended December 31, 2015 (dollars in thousands) 2014 Held for Sale: Beginning balance Originations Net sales Ending balance Held for investment: Beginning balance Originations and purchases Transfers to foreclosed real estate Repayments/payoffs $ $ $ 13,203 $ 147,094 (149,990) 7,165 $ 163,347 (157,309) 3,726 93,999 (90,560) 10,307 $ 13,203 $ 7,165 622,234 $ 198,343 (1,575) (190,052) 681,959 $ 119,481 (2,234) (176,972) 650,752 138,782 (847) (106,728) Ending balance $ 628,950 $ 622,234 $ 681,959 The Bank originates residential mortgage loans that are to be held in the Bank’s loan portfolio as well as loans that are intended for sale in the secondary market. Loans sold in the secondary market are primarily sold to investors with which the Bank maintains a correspondent relationship. These loans are made in conformity with standard underwriting criteria per the investors to assure maximum eligibility for possible resale in the secondary market, and are approved either by the Bank’s underwriter or the correspondent’s underwriter. Loans considered for the Bank’s portfolio with borrowers that have lending relationships less than $500,000 are approved by any of the Bank’s Officers, which includes the Chief Executive Officer, the Chief Financial Officer, the Chief Credit Officer and the Chief Lending Officer. Loans considered for the Bank’s portfolio with borrowers that have lending relationships of $500,000 or greater are approved by the Bank’s Directors Loan Committee. Meetings of the Directors Loan Committee are open to attendance by any member of the Bank’s Board of Directors who wishes to attend. The loan committee reports to and consults with the Board of Directors in interpreting and applying the Bank’s lending policy. Single loans greater than $2,000,000, or loans to one borrower aggregating more than $4,000,000, up to $14,846,000 (the maximum amount of loans to one borrower as of December 31, 2016), must also have Board of Directors’ approval. 7 Table of Contents Loans that are sold into the secondary market are typically residential long-term (15 or more years) with fixed, and occasionally variable, rates of interest. Loans retained for the Company’s portfolio typically include construction loans, commercial loans and loans that periodically reprice or mature prior to the end of an amortized term. Generally, loans are sold with servicing released, however for loans sold to FHLMC or FNMA, the servicing has been retained. As of December 31, 2016, the Bank was servicing $18,288,000 in loans for FHLMC, $39,095,000 in loans for FNMA and $17,844,000 in loans for other investors. The following table contains information, as of December 31, 2016, on the percentage of fixed-rate single-family loans serviced for others by the Bank, by interest rate category. Interest rate range Less than 5.00% 5.00 – 6.00% 6.01 – 7.00% 7.01 – 8.00% Over 8.00% Percentage of Portfolio 92.4% 7.4% 0.1% 0.0% 0.1% 100.0% The Bank’s mortgage loan approval process is intended to assess the borrower’s ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan. The authority of the Directors Loan Committee to approve loans is established by the Board of Directors and currently is commensurate with the Bank’s limitation on loans to one borrower. The Bank’s maximum amount of loans to one borrower currently is equal to 15% of the Bank’s unimpaired capital, or $14,846,000 as of December 31, 2016. Loans greater than this amount require participation by one or more additional lenders. Letters of credit are subject to the same limitations as direct loans. The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate. The Bank requires borrowers to maintain fire and casualty insurance on its secured properties. The procedure for approval of construction loans is the same for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs. The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer. In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long-term loan to replace the construction loan upon completion of construction. Residential Mortgage Loans At December 31, 2016, the Company’s residential mortgage loan portfolio totaled $260,603,000, or 40.8% of the Company’s loan portfolio. All of the Company’s residential mortgage loans are secured by one to four family residential properties and are primarily located in the Bank’s market area. Commercial Real Estate Loans At December 31, 2016, the Company’s commercial real estate loan portfolio totaled $195,710,000, or 30.6% of the Company’s loan portfolio. All of the Company’s commercial real estate loans are secured by improved property such as office buildings, retail strip shopping centers, industrial condominium units and other small businesses, most of which are located in the Bank’s primary lending area. The largest commercial real estate loan outstanding at December 31, 2016 was a $14,100,000 loan secured by commercial property in Middle River, Maryland. This loan has consistently performed in accordance with the terms of the debt instrument. Loans secured by commercial real estate properties generally involve a greater degree of risk than residential mortgage loans. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to a greater extent to adverse conditions in the real estate market or the economy. 8 Table of Contents Construction and Land Acquisition and Development Loans The Bank originates loans to finance the construction of one-to-four family dwellings, and to a lesser extent, commercial real estate. It also originates loans for the acquisition and development of unimproved property to be used for residential and/or commercial purposes in cases where the Bank is to provide the construction funds to improve the properties. As of December 31, 2016, the Company had 91 construction loans outstanding in the gross aggregate amount of $57,166,000, representing 8.9% of its loan portfolio. Included in that total were commitments to advance an additional $15,728,000. Construction loan amounts are based on the appraised value of the property and, for builder loans, a feasibility study as to the potential marketability and profitability of the project. Construction loans generally have terms of up to one year, with reasonable extensions as needed, and typically have interest rates that float monthly at margins ranging from the prime rate to 2 percent above the prime rate. In addition to builders’ projects, the Bank finances the construction of single family, owner-occupied houses where qualified contractors are involved and on the basis of strict written underwriting and construction loan guidelines. Construction loans are structured either to be converted to permanent loans with the Bank upon the expiration of the construction phase or to be paid off by financing from another financial institution. Construction loans afford the Bank the opportunity to increase the interest rate sensitivity of its loan portfolio and to receive yields higher than those obtainable on loans secured by existing residential properties. These higher yields correspond to the higher risks associated with construction lending. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the project under construction that is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to value accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the ultimate success of the project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank is forced to foreclose on a project prior to or at completion, due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of the loan as well as related foreclosure and holding costs. In addition, the Bank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time. The Bank has attempted to address these risks through its underwriting procedures and its limited amount of construction lending on multi-family and commercial real estate properties. It is the policy of the Bank to conduct physical inspections of each property secured by a construction or rehabilitation loan for the purpose of reporting upon the progress of the construction of improvements. These inspections, referred to as “construction draw inspections,” are to be performed at the time of a request for an advance of construction funds. If no construction advance has been requested, a construction inspector or senior officer of the institution makes an inspection of the subject property at least quarterly. Land and Residential Building Lots Land loans include loans to developers for the development of residential subdivisions and loans on unimproved lots primarily to individuals. At December 31, 2016, the Company had outstanding land and residential building lot loans totaling $48,664,000, or 7.6% of the total loan portfolio. The largest of these loans is for $4,745,000, is secured by residential lots in Severn, Maryland, and has performed in accordance with the terms of the debt instrument. Land development loans typically are short-term loans; the duration of these loans is typically not greater than three years. The interest rate on land loans is generally at least 1% or 2% over the prime rate. The loan-to-value ratio generally does not exceed 75% at the time of loan origination. Land and residential building lot loans typically are made to customers of the Bank and developers and contractors with whom the Bank has had previous lending experience. In addition to the customary requirements for these types of loans, the Bank may also require a satisfactory Phase I environmental study and feasibility study to determine the profit potential of the development. 9 Table of Contents Lines of Credit and Commercial Non-Real Estate Loans The Bank also offers other business and commercial loans. These are loans to businesses are typically lines of credit or other loans that are not secured by real estate, although equipment, securities, or other collateral may secure them. They typically are offered to customers with long-standing relationships with the Bank. At December 31, 2016, $46,468,000, or 7.3%, of the loan portfolio consisted of lines of credit and other commercial loans. Home Equity and Other Consumer Loans The Bank also offers other loans to consumers, including home equity loans, home equity lines of credit and other consumer loans. At December 31, 2016, $20,339,000, or 3.2% of the loan portfolio consisted of these loans. Loan Portfolio Cash Flows The following table sets forth the estimated maturity of the Company’s loan portfolios by type of loan at December 31, 2016. The estimated maturity reflects contractual terms at December 31, 2016. Contractual principal repayments of loans do not necessarily reflect the actual life of the Bank’s loan portfolios. The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and because of enforcement of “due on sale” clauses. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans. Residential mortgage * Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial, non-real estate Home equity Consumer Total *Includes loans categorized as held for sale. Due Within one year or less Due after 1 through 5 years Due after 5 years Total (dollars in thousands) 18,627 $ 38,670 13,181 20,277 20,156 552 - 36 111,499 $ 19,505 $ 17,698 24,601 8,210 42,931 8,134 - 624 121,703 $ 232,778 $ 798 10,882 1,170 132,623 8,125 19,129 550 406,055 $ 270,910* 57,166 48,664 29,657 195,710 16,811 19,129 1,210 639,257 $ $ 10 Table of Contents The following table contains certain information as of December 31, 2016 relating to the loan portfolio of the Company with the dollar amounts of loans due after one year that have fixed and floating rates. All loans are shown maturing based upon contractual maturities and include scheduled payments but not possible prepayments. Residential mortgage* Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial, non-real estate Home equity Consumer Total *Includes loans categorized as held for sale. Loans to One Borrower Fixed Floating (dollars in thousands) $ $ 101,982 $ 5,941 17,808 731 81,620 11,312 - 1,174 220,568 $ 150,301 $ 12,555 17,675 8,649 93,934 4,947 19,129 - 307,190 $ Total 252,283* 18,496 35,483 9,380 175,554 16,259 19,129 1,174 527,758 Under regulatory guidelines, the aggregate amount of loans that the Bank may make to one borrower was $14,846,000 at December 31, 2016, which is 15% of the Bank’s unimpaired capital and unimpaired surplus. The Bank’s three largest loans at December 31, 2016 were a $14,100,000 loan secured by commercial property located in Middle River, Maryland, an $8,500,000 loan secured by commercial property in Landover, Maryland and a $7,431,000 loan secured by commercial property located in Edgewater, Maryland. At December 31, 2016, all three loans were performing as agreed. Origination and Sale of Loans The Bank originates residential loans in conformity with standard underwriting criteria per its loan investors to assure maximum eligibility for possible resale in the secondary market. Although the Bank has authority to lend anywhere in the United States, it has confined its loan origination activities primarily to the states of Maryland, Virginia and Delaware. Loan originations are developed from a number of sources, primarily from referrals from real estate brokers, internet leads, builders, and existing and walk‑in customers. The Bank’s mortgage loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan. Loans considered for the Bank’s portfolio with borrowers that have lending relationships less than $500,000 are approved by any of the Bank’s Officers, which includes the Chief Executive Officer, the Chief Operating Officer, the Chief Financial Officer, the Chief Credit Officer and the Chief Lending Officer. Loans considered for the Bank’s portfolio with borrowers that have lending relationships of $500,000 or greater are approved by the Bank’s Directors Loan Committee. Meetings of the Directors’ Loan Committee are open to attendance by any member of the Bank’s Board of Directors who wishes to attend. The loan committee reports to and consults with the Board of Directors in interpreting and applying the Bank’s lending policy. Single loans greater than $2,000,000, or loans to one borrower aggregating more than $4,000,000, up to $14,846,000 (the maximum amount of loans to one borrower as of December 31, 2016), must also have Board of Directors’ approval. The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate. The Bank requires borrowers to maintain fire and casualty insurance on its secured properties. 11 Table of Contents The procedure for approval of construction loans is the same as for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs. The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer. In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long- term loan to replace the construction loan upon completion of construction. Consumer loans are underwritten on the basis of the borrower's credit history and an analysis of the borrower's income and expenses, ability to repay the loan, and the value of the collateral, if any. Currently, it is the Bank’s policy to originate both fixed-rate and adjustable-rate loans. The Bank is currently active in the secondary market and sells a portion of its fixed-rate, and occasionally adjustable-rate, loans. Interest Rates, Points and Fees The Bank realizes interest, point, and fee income from its lending activities. The Bank also realizes income from commitment fees for making commitments to originate loans, and from prepayment and late charges, loan fees, application fees, and fees for other miscellaneous services. The Bank accounts for loan origination fees in accordance with standards set on the accounting for deferred costs and fees. These standards prohibit the immediate recognition of loan origination fees as revenues and require that such income (net of certain direct loan origination costs) for each loan be amortized, generally by the interest method, over the estimated life of the loan as an adjustment of yield. The Bank also realizes income from gains on sales of loans, and servicing released fees for loans sold with servicing released. Delinquencies, Allowance for Loan Losses and Classified Assets Delinquencies Management reviews delinquencies on all loans monthly. The Company’s collection procedures include sending a past due notice to the borrower on the 17th day of nonpayment, making telephone contact with the borrower between 20 and 30 days after nonpayment, and sending a letter after the 30th day of nonpayment. A notice of intent to foreclose is generally sent between 60 and 90 days after delinquency. When the borrower is contacted, the Company attempts to obtain full payment of the past due amount. However, the Company generally will seek to reach agreement with the borrower on a payment plan to avoid foreclosure. 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 generally accepted accounting principles. Actual results could differ significantly from those estimates. While management uses available information to estimate losses on loans, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the State of Maryland. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance consists of specific 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. 12 Table of Contents 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 and 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 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. 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 loans; Effects of any change in lending policies and procedures; Experience, ability and depth of management; · · · · · · National and local economic trends and conditions; and · Effect of any changes in concentration of credit. A loan is generally 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 as 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, sometimes referred to as a TDR, when the Bank, for economic or legal reasons relating to the borrower’s financial difficulties, 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 a TDR. 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. 13 Table of Contents The Bank discontinues the accrual of interest on loans 90 days or more past due, at which time all previously accrued but uncollected interest is deducted from income. $506,000 in interest income would have been recorded for the year ended December 31, 2016 if the loans had been current in accordance with their original terms and had been outstanding throughout the year ended December 31, 2016 or since their origination (if held for only part of the fiscal year). For the year ended December 31, 2016, $427,000 in interest income on such loans was actually included in net income. The following table sets forth information as to non-accrual loans and other non-performing assets. Loans accounted for on a non-accrual basis: Residential mortgage Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home Equity Consumer Total non-accrual loans Accruing loans greater than 90 days past due Foreclosed real-estate Total non-performing assets Nonaccrual troubled debt restructurings (included above) Accruing troubled debt restructurings Total non-accrual loans to net loans Allowance for loan losses to total non-performing loans, including loans contractually past due 90 days or more Total non-accrual and accruing loans greater than 90 days past due to total assets Total non-performing assets to total assets 2016 3,580 - 269 150 2,938 1 2,914 - 9,852 - 973 10,825 $ $ $ $ $ 2,392 $ 18,066 $ 1.6% $ $ $ $ $ $ $ At December 31, 2015 2014 (dollars in thousands) 2013 2012 3,191 244 277 483 2,681 - 2,098 - 8,974 - 1,744 10,718 $ $ $ $ $ 1,329 $ 24,386 $ 1.5% 6,052 115 847 388 652 1,775 3,016 - 12,845 - 1,947 14,792 $ $ $ $ $ 2,641 $ 27,724 $ 2.0% 6,802 814 183 304 1,155 - 1,777 - 11,035 - 8,972 20,007 $ $ $ $ $ 2,091 $ 34,827 $ 1.8% 14,436 8,564 4,688 1,877 5,793 111 2,000 26 37,495 - 11,441 48,936 5,635 56,448 5.8% 91.0% 97.6% 73.5% 106.4% 46.6% 1.3% 1.4% 1.2% 1.4% 1.7% 1.9% 1.4% 2.5% 4.4% 5.7% Included in non-accrual residential mortgage loans at December 31, 2016, were thirteen loans totaling $3,580,000 to consumers and no loans to builders. Included in non-accrual land loans at December 31, 2016 were three loans totaling $269,000. 14 Table of Contents Classified Assets Federal regulations provide for the classification of loans and other assets, such as debt and equity securities, considered by the OCC to be of lesser quality, as “substandard,” “doubtful” or “loss assets.” An asset is considered substandard if the paying capacity and net worth of the obligor or the collateral pledged, if any, inadequately protects it. Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions, and values. Assets classified as loss assets are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets that do not currently expose the insured institution to a sufficient degree of risk to warrant classification in one of these categories but possess credit deficiencies or potential weakness are required to be designated special mention by management. When an insured institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for losses in an amount deemed prudent by management. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as loss assets, it is to charge-off such amount. An institution’s determination as to the classification of its assets is subject to scrutiny by the OCC, which can require the establishment of additional general or specific loss allowances. The Bank reviews monthly the assets in its portfolio to determine whether any assets require classification in accordance with applicable regulations. Total classified loans decreased $2,247,000 to $11,626,000 at December 31, 2016 from $13,873,000 at December 31, 2015 primarily due to an improving economy. All of these loans were classified as substandard. The allowance for loan losses as of December 31, 2016 was $8,969,000, which was 1.4% of gross loans receivable and 91.0% of total non-performing loans. [see table on following page] 15 Table of Contents The following table summarizes the allocation of the allowance for loan losses by loan type and the percent of loans in each category compared to total loans (excluding loans held for sale) as of December 31, 2016 2015 2014 2013 2012 Percentage of Loans in each Category to Total Loans Allowance Amount Allowance Amount Percentage of Loans in each Category to Total Loans Percentage of Loans in each Category to Total Allowance Amount Loans (dollars in thousands) Percentage of Loans in each Category to Total Loans Percentage of Loans in each Category to Total Loans Allowance Amount Allowance Amount $ 3,833 41.44% $ 4,188 45.95% $ 4,664 45.38% $ 6,291 39.79% $ 8,418 39.22% Residential mortgage Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total $ 527 863 57 2,535 421 728 5 8,969 9.09% 7.74% 4.71% 31.12% 2.67% 3.04% 0.19% 100.00% $ 446 510 57 2,792 234 528 3 8,758 12.45% 4.61% 3.24% 28.11% 1.50% 3.94% 0.20% 100.00% $ 362 646 12 2,504 280 963 4 9,435 12.37% 4.46% 2.82% 29.11% 414 1,346 36 2,512 11.61% 5.29% 3.32% 33.83% 2,120 2,245 87 3,295 1.49% 4.22% 0.15% 100.00% $ 135 1,003 2 11,739 1.32% 4.66% 0.18% 100.00% $ 46 1,254 13 17,478 10.41% 7.41% 4.57% 32.33% 0.89% 5.04% 0.13% 100.00% 16 Table of Contents The following table contains information with respect to the Company’s allowance for loan losses for the years indicated: Average loans outstanding, net* Total gross loans outstanding at end of period* Total net loans outstanding at end of period* Allowance balance at beginning of period* Provision (credit) for loan losses Actual charge-offs Residential real estate Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home Equity Consumer Total charge-offs Recoveries Residential real estate Construction, land acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home Equity Consumer Total recoveries Net charge offs (recoveries) As of or For the Year Ended December 31, 2016 2015 2014 2013 2012 (dollars in thousands) $ $ $ $ 613,337 639,257 611,616 8,758 $ $ $ $ 618,309 $ 622,935 $ 648,959 $ 635,437 $ 689,124 $ 654,478 $ 602,859 $ 641,047 $ 606,539 $ 9,435 $ 11,739 $ 17,478 $ 692,831 697,997 662,825 25,938 (350) (280) 151 13 59 - 178 17 50 - 468 324 97 60 10 23 44 421 50 1,029 (561) 454 - - - 80 154 834 - 1,522 629 - 49 235 - 49 163 - 1,125 397 831 844 63 - 1,324 92 1,410 261 - 3,994 306 - 349 15 25 159 - 5 859 3,135 16,520 7,919 2,439 4,529 521 8,343 687 809 46 25,293 1,034 66 1,773 60 54 8 15 24 3,034 22,259 765 4,299 1,395 1,624 182 416 20 1,407 10 9,353 18 - - - - 110 - - 128 9,225 Allowance balance at end of year $ Net charge-offs (recoveries) as a percent of average loans* Allowance for loan losses to total gross loans at end of year* Allowance for loan losses to net loans at end of year* 8,969 $ (0.09%) 1.40% 1.47% 8,758 $ 9,435 $ 11,739 $ 17,478 0.06% 1.38% 1.45% 0.50% 1.37% 1.47% 3.43% 1.79% 1.94% 1.33% 2.50% 2.64% *Includes held for sale loans. 17 Table of Contents Investment Activities The Bank may invest in various types of liquid assets, including United States Treasury obliga-tions and securities of various federal agencies, including mortgage-backed securities, certificates of deposit at insured banks, bankers' acceptances and federal funds. As a member of the FHLB System, the Bank must maintain minimum levels of liquid assets specified by the OCC, which vary from time to time. Subject to various regulatory restrictions, banks may also invest a portion of their assets in certain commercial paper, corporate debt securities and mutual funds whose assets conform to the investments that a bank is authorized to make directly. The amortized cost of the Bank’s investment securities which are all held to maturity as of the dates indicated, are presented in the following table (excluding FHLB Stock) : US Treasury securities US Agency securities US Government sponsored mortgage-backed securities $ At December 31, 2016 2015 (dollars in thousands) 12,998 $ 20,027 29,732 21,057 $ 20,011 35,065 2014 27,140 17,044 15,432 Total Investment Securities Held to Maturity $ 62,757 $ 76,133 $ 59,616 18 Table of Contents Investment Scheduled Maturity Table As of December 31, 2016 One Year or Less Amortized Cost Weighted Average Yield More than One to Five Years More than Five to Ten Years More than Ten Years Amortized Cost Weighted Average Yield Amortized Cost Weighted Average Amortized Cost Weighted Average Yield Yield (dollars in thousands) Total Investment Securities Weighted Average Yield Fair Value Amortized Cost US Treasury securities US Agency securities US Government sponsored mortgage- backed securities* Total $ 7,999 1.45% $ 4,999 2.41% $ - - $ 1,004 1.03% 17,062 1.40% 1,961 3.15% - - 29,460 1.96% 272 5.20% securities $ 9,003 1.40% $ 51,521 1.82% $ 2,233 3.39% - - - - - $ 12,998 1.82% $ 13,165 - 20,027 1.55% 20,106 - 29,732 1.99% 29,556 - $ 62,757 1.80% $ 62,827 * The amortized cost of mortgage-backed securities as of December 31, 2016, by contractual maturity, is shown above. Expected maturities may differ from contractual maturities because the securities may be called or prepaid with or without prepayment penalties. 19 Table of Contents Deposits Deposits are attracted principally from within the Bank’s primary market areas through the offering of a variety of deposit instruments, including passbook and statement accounts and certificates of deposit ranging in terms from three months to five years. Deposit account terms vary, principally on the basis of the minimum balance required; the time periods the funds must remain on deposit and the interest rate. The Bank also offers individual retirement accounts. The Bank’s policies are designed primarily to attract deposits from local residents rather than to solicit deposits from areas outside the Bank’s primary markets. As of December 31, 2016, the Bank had $6,364,000 in brokered deposits. Interest rates paid maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations. Deposits in the Bank as of December 31, 2016, 2015 and 2014 consisted of the accounts described below: NOW accounts Money market accounts Passbooks Certificates of deposit Non-interest bearing accounts 2016 2015 (dollars in thousands) $ 63,137 $ 66,356 110,492 273,816 58,145 56,096 $ 47,690 111,992 277,778 30,215 2014 54,827 39,579 126,062 298,489 24,857 Total deposits $ 571,946 $ 523,771 $ 543,814 The following table contains information pertaining to the certificates of deposit held by the Bank with a minimum denomination of $100,000 as of December 31, 2016. Time Remaining Until Maturity Less than three months 3 months to 6 months Greater than 6 months to 12 months Greater than 12 months Total 20 Jumbo Certificates of Deposit (dollars in thousands) $ $ 23,472 29,508 36,790 55,818 145,588 Table of Contents Liquidity and Asset/Liability Management Two major objectives of asset and liability management are to maintain adequate liquidity and to control the interest sensitivity of the balance sheet. Liquidity is the measure of a company’s ability to maintain sufficient cash flow to fund operations and to meet financial obligations to depositors and borrowers. Liquidity is provided by the ability to attract and retain deposits and by principal and interest payments on loans and maturing securities in the investment portfolio. A strong core deposit base, supplemented by other deposits of varying maturities and rates, contributes to the Bank’s liquidity. Management believes that funds available through short-term borrowings and asset maturities are adequate to meet all anticipated needs for the next twelve months, and management is continually monitoring the Bank’s liquidity position to meet projected needs. Interest rate sensitivity is maintaining the ability to reprice interest earning assets and interest bearing liabilities in relationship to changes in the general level of interest rates. Management attributes interest rate sensitivity to a steady net interest margin through all phases of interest rate cycles. Management attempts to make the necessary adjustments to constrain adverse swings in net interest income resulting from interest rate movements through gap analysis and income simulation modeling techniques. Borrowings FHLB of Atlanta The Bank’s credit availability under the FHLB of Atlanta’s credit availability program was $232,193,000 at December 31, 2016. The Bank’s credit availability is based on the level of collateral pledged up to 30% of total assets. The Bank, from time to time, utilizes the line of credit when interest rates under the line are more favorable than obtaining deposits from the public. Subordinated Debentures As of December 31, 2016, the Company had outstanding approximately $20,619,000 in 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 the Company and Wells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.88% at December 31, 2016) 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 the Company, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by the Company 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 the Company. 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. The Company 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 Debenture, the Company 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 December 31, 2015, the Company had deferred the payment of fifteen quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,863,000. During the second quarter of 2016, the Company paid all of the deferred interest and as of December 31, 2016, the Company is current on all interest due on the 2035 Debenture. 21 Table of Contents Subordinated Notes and Series A Preferred Stock On November 15, 2008, the Company 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 $7,000,000. Each unit consists of 6,250 shares of the Company's Series A 8.0% Non-Cumulative Convertible Preferred Stock and the Company's Subordinated Notes (“Subordinated Notes”) in the original principal amount of $50,000. The Subordinated Notes earned 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 were redeemable in whole or in part at the option of the Company at any time beginning on December 31, 2009 until maturity, which was December 31, 2018. Dividends will not be paid on the Company’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 the Company’s board of directors declare any dividends on the Series A Preferred Stock and any unpaid dividends are not cumulative. Dividends on the Series A preferred stock have been declared and paid on June 30, 2016, September 30, 2016 and December 30, 2016 in the amount of $70,000 each quarter. Prior to that, the Company had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012. On September 30, 2016 the aggregate principal amount of Subordinated Notes outstanding of $3,500,000 was paid in full. The Subordinated Notes were redeemable in whole or in part at the option of the Company at any time beginning on December 31, 2009 until maturity, which was December 31, 2018. Debt issuance costs totaled $245,000 and were taken back into income upon the redemption. Notes Payable On September 30, 2016, the Company entered into a loan agreement with a commercial bank whereby the Company borrowed $3,500,000 for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Company, converts to either (1) floating rate of the Wall Street Journal Prime plus 0.50% or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing Federal Home Loan Bank rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If the Company elects the 5 year fixed rate of 275 basis points over the Federal Home Loan Bank rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth and fifth years of the FHLB Rate Period. The Company may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period. 22 Table of Contents A summary of all borrowings is presented below: Balance at end of year Average balance during year Maximum outstanding at any month end Weighted average interest rate at end of year Average interest rate during year Employees 2016 At or For the Years Ended December 31, 2014 2015 (Dollars in thousands) $ $ $ 124,119 137,036 149,119 $ $ $ 3.30% 3.35% 139,119 139,119 139,119 $ $ $ 3.55% 3.55% 139,119 139,119 139,119 3.38% 3.38% As of December 31, 2016, the Company and its subsidiaries had approximately 142 full-time equivalent employees. The Company’s employees are not represented by any collective bargaining group. Hyatt Commercial Hyatt Commercial is a subsidiary of the Bank and is a real estate brokerage company specializing in commercial real estate sales, leasing and property management. SBI Mortgage Company SBI Mortgage Company (“SBI”) is a subsidiary of the Company that has engaged in the origination of mortgages not suitable for the Bank. It owns subsidiary companies that purchase real estate for investment purposes. As of December 31, 2016, SBI had $1,407,000 in outstanding mortgage loans and it had $514,000 invested in subsidiaries, which funds were held in cash, pending potential acquisition of investment real estate. Crownsville Development Corporation Crownsville Development Corporation, which is doing business as Annapolis Equity Group, is a subsidiary of SBI and is engaged in the business of acquiring real estate for investment and syndication purposes. HS West, LLC HS West, LLC (“HS”) is a subsidiary of the Bank which constructed a building in Annapolis, Maryland that serves as the Company’s and the Bank’s administrative headquarters. A branch office of the Bank is also located in the building. In addition, HS leases space to four unrelated companies and to a law firm of which the President of the Company and the Bank is a partner. Severn Financial Services Corporation Severn Financial Services Corporation is a subsidiary of the Bank that is part of a joint venture with a local insurance agency to provide various insurance products to customers of the Company. Federal Banking Regulation The financial services industry in the Bank’s market area is highly competitive, including competition from commercial banks, savings banks, credit unions, finance companies and non-bank providers of financial services. Several of the Bank’s competitors have legal lending limits that exceed that of the Bank’s, as well as funding sources in the capital markets that exceeds the Bank’s availability. The increased competition has resulted from a changing legal and regulatory climate, as well as from the economic climate. 23 Table of Contents General. Banks and their holding companies are extensively regulated under both federal and state law. This regulation is intended primarily to protect depositors and the Deposit Insurance Fund (“DIF”), and not the stockholders of the Company. The summary below describes briefly the regulation that is applicable to the Company and the Bank, does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations. Federal Banking Regulation the Company General . Severn Bancorp is a unitary savings and loan holding company within the meaning of the Home Owners’ Loan Act. As such, Severn Bancorp is registered with the FRB and is subject to regulations, examinations, supervision and reporting requirements applicable to savings and loan holding companies. In addition, the FRB has enforcement authority over Severn Bancorp and any non-savings bank subsidiaries. Among other things, this authority permits the FRB to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. Permissible Activities. As a unitary savings and loan holding company, Severn Bancorp generally is not subject to activity restrictions, provided the Bank satisfies the Qualified Thrift Lender (“QTL”) test (see “ Qualified Thrift Lender Test” below). If the Bank failed to meet the QTL test, then Severn Bancorp would become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the Bank qualified as a QTL within one year thereafter, Severn Bancorp would be required to register as, and would become subject to the restrictions applicable to, a bank holding company. Additionally, if Severn Bancorp acquired control of another savings association, other than in a supervisory acquisition where the acquired association also met the QTL test, Severn Bancorp would thereupon become a multiple savings and loan holding company and thereafter be subject to further restrictions on its activities. The Company presently intends to continue to operate as a unitary savings and loan holding company. Regulatory Capital Requirements . Under capital regulations adopted pursuant to the Dodd-Frank Act, savings and loan holding companies became subject to the additional regulatory capital requirements. However, in May 2015, amendments to the FRB’s small bank holding company policy statement (the “SBHC Policy”) became effective. The amendments made the SBHC Policy applicable to savings and loan holding companies, such as Severn Bancorp, and increased the asset threshold to qualify to be subject to the provisions of the SBHC Policy from $500 million to $1.0 billion. Savings and loan holding companies that have total assets of $1.0 billion or less are subject to the SBHC Policy and are not required to comply with the regulatory capital requirements described below provided that such holding company (i) is not engaged in significant nonbanking activities either directly or through a nonbank subsidiary; (ii) does not conduct significant off- balance sheet activities (including securitization and asset management or administration) either directly or through a nonbank subsidiary; and (iii) does not have a material amount of debt or equity securities outstanding (other than trust preferred securities) that are registered with the Securities and Exchange Commission. The FRB may in its discretion exclude any savings and loan holding company, regardless of asset size, from the SBHB Policy if such action is warranted for supervisory purposes. The exemption continues until the Company’s total assets exceed $1.0 billion, does not meet the other requirements discussed above or the FRB deems it to be warranted for supervisory purposes. Certain of the savings and loan holding company capital requirements promulgated by the FRB in 2013 became effective as of January 1, 2015. Those requirements establish the following four minimum capital ratios that savings and loan holding companies not subject to the SBHC Policy must comply with as of that date: (i) a common equity tier 1 capital to total risk-weighted assets ratio of 4.5%; (ii) a tier 1 capital to total risk-weighted assets ratio of 6.0% (up from 4%); (iii) a total capital to total risk-weighted assets ratio of 8%; and (iv) a tier 1 capital to total assets leverage ratio of 4%. For more information, see “ Regulatory Capital Requirements ” under “ Regulation of the Bank ” below. 24 Table of Contents Restrictions on Acquisitions . Except under limited circumstances, savings and loan holding companies, such as the Company, are prohibited from (i) acquiring, without approval of the FRB, control of a savings association or a savings and loan holding company or all or substantially all of the assets of any such association or holding company (ii) acquiring, without prior approval of the FRB, more than 5% of the voting shares of a savings association or a holding company which is not a subsidiary thereof or (iii) acquiring control of an uninsured institution, or retaining, for more than one year after the date of any savings association becomes uninsured, control of such association. In evaluating proposed acquisitions of savings institutions by holding companies, the FRB considers the financial and managerial resources and future prospects of the holding company and the target institution, the effect of the acquisition on the risk to the DIF, the convenience and the needs of the community and competitive factors. N o director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company’s stock, may acquire control of any savings association, other than a subsidiary savings association, or of any other savings and loan holding company, without written approval of the FRB. Certain individuals, including Alan J. Hyatt, Louis Hyatt, and Melvin Hyatt, and their respective spouses (“Applicants”), filed an Application for Notice of Change In Control (“Notice”) in April 2001 pursuant to 12 CFR Section 574.3(b). The Notice permitted the Applicants to acquire up to 32.32% of the Company’s issued and outstanding shares of stock of the Company by April 16, 2002. Its then regulator, the Office of Thrift Supervision, approved requests by the Applicants to extend the time to consummate such acquisition of shares to December 16, 2011. The Applicants currently own approximately 29.86% of the total outstanding shares of the Company as of December 31, 2016. The FRB is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies; and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions. Federal Securities Law . The Company’s securities are registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. As such, the Company is subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Securities Exchange Act of 1934. Financial Services Modernization Legislation . In November 1999, the Gramm-Leach-Bliley Act of 1999 (“GLBA”) was enacted. The GLBA generally permits banks, other depository institutions, insurance companies and securities firms to enter into combinations that result in a single financial services organization to offer customers a wider array of financial services and products provided that they do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The GLBA resulted in increased competition for the Company and the Bank from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and the Bank. Maryland Corporation Law . The Company is incorporated under the laws of the State of Maryland, and is therefore subject to regulation by the state of Maryland. The rights of the Company’s stockholders are governed by the Maryland General Corporation Law. Regulation of the Bank General . As a federally chartered, DIF-insured savings association, the Bank is subject to extensive regulation, primarily by the OCC and secondarily the FDIC. Lending activities and other investments of the Bank must comply with various statutory and regulatory requirements. The Bank is also subject to certain reserve requirements promulgated by the FRB. The OCC regularly examines the Bank and prepares reports for the consideration of the Bank’s Board of Directors on the operations of the Bank. The relationship between the Bank and depositors and borrowers is also regulated by federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents utilized by the Bank. 25 Table of Contents The Bank must file reports with the OCC and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. Regulatory Capital Requirements. Federal regulations require all FDIC-insured depository institutions to meet several minimum capital standards: a common equity tier 1 capital to total risk-based assets ratio of 4.5%; a tier 1 capital to total risk-based assets ratio of 6.0%, a total capital to total risk-based assets ratio of 8%, a tier 1 capital to total assets leverage ratio of 4%, and a tangible capital, measured as core capital (tier 1 capital), to average total assets ratio of 1.5%. Common equity tier 1 capital generally consists of common stock and related surplus, retained earnings, accumulated other comprehensive income and, subject to certain adjustments, minority common equity interests in subsidiaries, reduced by goodwill and other intangible assets (other than certain mortgage servicing assets), net of associated deferred tax liabilities. Tier 1 Capital means the sum of common equity tier 1 capital and additional tier 1 capital. Additional tier 1 capital generally includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries. Under the amendments, cumulative preferred stock (other than cumulative preferred stock issued to the U.S. Treasury Department under the TARP Capital Purchase Program or the Small Business Lending Fund) no longer qualifies as additional tier 1 capital. Trust preferred securities and other non-qualifying capital instruments issued prior to May 19, 2010 by bank and savings and loan holding companies with less than $15 billion in assets as of December 31, 2009 or by mutual holding companies may continue to be included in tier 1 capital but will be phased out over 10 years beginning in 2016 for all other banking organizations. Total Capital includes tier 1 capital and tier 2 capital. Tier 2 capital is comprised of capital instruments and related surplus meeting specified requirements, and may include cumulative preferred stock and long-term perpetual preferred stock, mandatory convertible securities, intermediate preferred stock, and subordinated debt. Tangible Capital means the amount of core capital (tier 1 capital), plus the amount of outstanding perpetual preferred stock (including related surplus) not included in tier 1 capital. Calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations. In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, assets, including certain off-balance sheet assets (e.g., recourse obligations, direct credit substitutes, and residual interests) are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset. Higher levels of capital are required for asset categories believed to present greater risk. For example, a risk weight of 0% is assigned to cash and U.S. government securities, a risk weight of 50% is generally assigned to prudently underwritten first lien residential mortgages, a risk weight of 100% is assigned to first lien residential mortgages not qualifying under the prudently underwritten standards as well as commercial and consumer loans, a risk weight of 150% is assigned to certain past due loans, a risk weight of 250% is assigned to certain mortgage serving rights, and a risk weight of between 0% to 600% is assigned to permissible equity interests, depending on certain specified factors. In addition to higher capital requirements, the amended regulations provide that depository institutions and their holding companies are required to maintain a common equity tier 1 Capital conservation buffer of at least 2.5% of risk-weighted assets over and above the minimum risk-based capital requirements. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases or for the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning on January 1, 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented at 2.5% on January 1, 2019. For 2017, the capital conservation buffer will be 1.25% of risk-weighted assets. The capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% common equity tier 1 capital, 8.5% tier 1 capital and 10.5% total capital on a fully phased-in basis. 26 Table of Contents In addition to requiring institutions to meet the applicable capital standards for savings institutions, the OCC may require institutions to meet capital standards in excess of the prescribed standards as the OCC determines necessary or appropriate for such institution in light of the particular circumstances of the institution. Such circumstances would include a high degree of exposure to interest rate risk, concentration of credit risk and certain risks arising from non-traditional activity. The OCC may treat the failure of any savings institution to maintain capital at or above such level as an unsafe or unsound practice and may issue a directive requiring any savings institution which fails to maintain capital at or above the minimum level required by the OCC to submit and adhere to a plan for increasing capital. As shown below, the Bank’s regulatory capital exceeded all minimum regulatory capital requirements applicable to it as of December 31, 2016 and 2015. Actual Required For Capital Adequacy Purposes Amount % Amount % Minimum Capital Adequacy with Capital Buffer Amount (dollars in thousands) % Required To Be Well Capitalized Under Prompt Corrective Action Provisions Amount % $ $ 98,970 98,970 98,970 98,970 106,517 112,959 112,959 112,959 112,959 120,193 12.9% $ 16.5% 16.5% 12.9% 17.8% 14.8% $ 19.6% 19.6% 14.8% 20.8% 11,488 35,977 26,983 30,634 47,969 11,423 34,626 25,970 30,461 46,168 1.5% 6.0% $ 4.5% 4.0% 8.0% 1.5% 6.0% 4.5% 4.0% 8.0% N/A 39,725 30,730 35,420 51,717 N/A N/A N/A N/A N/A N/A 6.6% $ 5.1% 4.6% 8.6% $ N/A N/A N/A N/A N/A N/A 47,969 38,975 38,292 59,962 N/A 46,168 37,512 38,076 57,710 N/A 8.0% 6.5% 5.0% 10.0% N/A 8.0% 6.5% 5.0% 10.0% December 31, 2016 Tangible (1) Tier 1 capital (2) Common Equity Tier 1(2) ) Leverage (1) Total (2) December 31, 2015 Tangible (1) Tier 1 capital (2) Common Equity Tier 1(2) ) Leverage (1) Total (2) (1) To adjusted total assets. (2) To risk-weighted assets. Enforcement. The OCC has primary enforcement responsibility over federal savings associations and has the authority to bring enforcement action against the institution and all “institution-affiliated parties,” including stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement actions by the OCC may range from issuance of a capital directive or a cease and desist order, to removal of officers or directors of the institution and the appointment of a receiver or conservator. The FDIC also has the authority to terminate deposit insurance or recommend to the director of the OCC that enforcement action be taken with respect to a particular savings institution. If action is not taken by the director of the OCC, the FDIC has authority to take action under specific circumstances. Safety and Soundness Standards . Federal law requires each federal banking agency, including the OCC, to prescribe to certain standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines further provide that savings institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions. If the OCC determines that a savings institution is not in compliance with the safety and soundness guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines. A savings institution must submit an acceptable compliance plan to the OCC within 30 days of receipt of a request for such a plan. If the institution fails to submit an acceptable plan, the OCC must issue an order directing the institution to correct the deficiency. Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions. 27 Table of Contents Prompt Corrective Action . Under the prompt corrective action regulations, the OCC is required and authorized to take supervisory actions against undercapitalized savings associations. For this purpose, a savings association is placed into one of the following five categories dependent on their respective capital ratios: · An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a tier 1 risk-based capital ratio of 8.0% or greater, a common equity tier 1 risk-based capital ratio of 6.5% or greater and a leverage ratio of 5.0% or greater. · An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a tier 1 risk-based capital ratio of 6.0% or greater, a common equity tier 1 risk-based capital ratio of 4.5% or greater and a leverage ratio of 4.0% or greater. · An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a tier 1 risk-based capital ratio of less than 6.0%, a common equity tier 1 risk-based capital ratio of less than 4.5% or a leverage ratio of less than 4.0%. · An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a tier 1 risk-based capital ratio of less than 4.0%, a common equity tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%. · An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%. Generally, the Federal Deposit Insurance Act requires the OCC to appoint a receiver or conservator for an institution within 90 days of that institution becoming “critically undercapitalized”. The regulation also provides that a capital restoration plan must be filed with the OCC within 45 days after an institution receives notice that it is “undercapitalized”, “significantly undercapitalized” or “critically undercapitalized”. In addition, numerous mandatory supervisory actions become immediately applicable to the institution, including, but not limited to, restrictions on growth, investment activities, payment of dividends and other capital distributions, and affiliate transactions. The OCC may also take any one of a number of discretionary supervisory actions against the undercapitalized institutions, including the issuance of a capital directive and, in the case of an institution that fails to file a required capital restoration plan, the replacement of senior executive officers and directors. As of December 31, 2016, the Bank met the capital requirements of a “well capitalized” institution under applicable OCC regulations. Premiums for Deposit Insurance . The Bank’s deposits are insured up to applicable limits by the DIF of the FDIC and are backed by the full faith and credit of the United States government. The FDIC regulations assess insurance premiums based on an institution’s risk. Under this assessment system, the FDIC evaluates the risk of each financial institution based on its supervisory rating, financial ratios, and long-term debt issuer rating. The assessments are based on an institution’s total assets less tangible capital. The base assessment rates range from 2.5 to 9 basis points for the least risky institutions to 30 to 45 basis points for the riskiest. The rate schedules will automatically adjust in the future as the DIF reaches certain milestones. Effective July 1, 2016, the FDIC adopted changes that eliminated the risk categories. Assessments for most institutions are now based on financial measures and supervisory ratings derived from statistical modeling estimating the probability of failure within three years. In conjunction with the Deposit Insurance Fund reserve ratio achieving 1.5%, the assessment range (inclusive of possible adjustments) was reduced for most banks and savings associations to 1.5 basis points to 30 basis points. The maximum deposit insurance amount is $250,000 per depositor. 28 Table of Contents The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for the Bank could have a material adverse effect on the Company’s earnings. All FDIC-insured depository institutions pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as Financing Corporation (“FICO”) bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The FICO assessment is based on total assets less tangible capital. The payment made in the fourth quarter of 2016 was based on a FICO assessment rate of 0.58 of a basis point and the first quarter of 2017 FICO assessment rate payment was 0.56 of a basis point. FICO assessments will continue until the bonds mature in 2017 through 2019. The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operation of the Bank. Privacy . The Bank is subject to the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records. Additionally, the Gramm-Leach-Bliley Act (“GLBA”) places limitations on the sharing of consumer financial information by financial institutions with unaffiliated third parties. Pursuant to the GLBA and rules adopted thereunder, financial institutions must provide: · · initial and annual notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; and a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties. Since the GLBA’s enactment, a number of states have implemented their own versions of privacy laws. The Bank has implemented its privacy policies in accordance with applicable law. Loans-to-One Borrower Limitations . With certain limited exceptions, the maximum amount that a savings association or a national bank may lend to any borrower (including certain related entities of the borrower) may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. At December 31, 2016, the Bank’s loans-to-one-borrower limit was $14,846,000 based upon the 15% of unimpaired capital and surplus measurement. Qualified Thrift Lender Test . Savings associations must meet a QTL test, which may be met either by maintaining, on average, at least 65% of its portfolio assets in qualified thrift investments in at least nine of the most recent twelve month period, or meeting the definition of a “domestic building and loan association” as defined in the Code. “Portfolio Assets” generally means total assets of a savings institution, less the sum of (i) specified liquid assets up to 20% of total assets, (ii) goodwill and other intangible assets, and (iii) the value of property used in the conduct of the savings association’s business. Qualified thrift investments are primarily residential mortgages and related investments, including certain mortgage‑related securities. Associations that fail to meet the QTL test must either convert to a bank charter or operate under specified restrictions. As of December 31, 2016, the Bank was in compliance with its QTL requirement and met the definition of a domestic building and loan association. 29 Table of Contents Affiliate Transactions . Transactions between savings associations and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act as made applicable to savings associations by Section 11 of the Home Owners’ Loan Act (HOLA). A savings association affiliate includes any company or entity which controls the savings institution or that is controlled by a company that controls the savings association. For example, the holding company of a savings association and any companies which are controlled by such holding company, are affiliates of the savings association. Generally, Section 23A limits the extent to which the savings association or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such association’s capital stock and surplus, as well as contains an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus. Section 23B applies to “covered transactions,” as well as certain other transactions and requires that all transactions be on terms substantially the same, or at least as favorable, to the savings association as those provided to a non-affiliate. “Covered transaction” include the making of loans to, purchase of assets from and issuance of a guarantee to an affiliate and similar transactions. Section 23B transactions also include the provision of services and the sale of assets by a savings association to an affiliate. In addition to the restrictions imposed by Sections 23A and 23B, Section 11 of the Home Owners’ Loan Act prohibits a savings association from (i) making a loan or other extension of credit to an affiliate, except for any affiliate which engages only in certain activities which are permissible for bank holding companies, or (ii) purchasing or investing in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which are subsidiaries of the savings association. The Bank’s authority to extend credit to executive officers, directors, trustees and 10% stockholders, as well as entities under such person’s control, is currently governed by Section 22(g) and 22(h) of the Federal Reserve Act and Regulation O promulgated by the FRB. Among other things, these regulations generally require such loans to be made on terms substantially similar to those offered to unaffiliated individuals, place limits on the amounts of the loans the Bank may make to such persons based, in part, on the Bank’s capital position, and require certain board of directors’ approval procedures to be followed. Capital Distribution Limitations . OCC regulations impose limitations upon all capital distributions by savings associations, such as cash dividends, payments to repurchase or otherwise acquire its shares, payments to shareholders of another institution in a cash-out merger and other distributions charged against capital. The OCC regulations require a savings association to file an application for approval of a capital distribution if: · · · · the association is not eligible for expedited treatment of its filings with the OCC; the total amount of all of capital distributions, including the proposed capital distribution, for the applicable calendar year exceeds its net income for that year to date plus retained net income for the preceding two years; the association would not be at least adequately capitalized, as determined under the capital requirements described above under “ Prompt Corrective Action ,” following the distribution; or the proposed capital distribution would violate any applicable statute, regulation, or regulatory agreement or condition. In addition, a savings association must give the OCC notice of a capital distribution if the savings association is not required to file an application, but: · would not be well capitalized, as determined under the capital requirements described above under “ Prompt Corrective Action ,” following the · · distribution; the proposed capital distribution would reduce the amount of or retire any part of the savings association's common or preferred stock or retire any part of debt instruments such as notes or debentures included in capital, other than regular payments required under a debt instrument; or the savings association is a subsidiary of a savings and loan holding company, is filing a notice of the distribution with the FRB and is not otherwise required to file an application or notice regarding the proposed distribution with the OCC, in which case an information copy of the notice filed by the holding company with the FRB needs to be simultaneously provided to the OCC. Further, any savings association subsidiary of a savings and loan holding company, such as the Bank, also must file a notice with the FRB of any proposed dividend or distribution. The application or notice, as applicable, must be filed with the regulators at least 30 days before the proposed declaration of dividend or approval of the proposed capital distribution by its board of directors. 30 Table of Contents The OCC or FRB may prohibit a proposed dividend or capital distribution that would otherwise be permitted if it determines that: · · · following the distribution, the savings association will be undercapitalized, significantly undercapitalized, or critically undercapitalized, as determined under the capital requirements described above under “ Prompt Corrective Action; the proposed distribution raises safety or soundness concerns; or the proposed capital distribution would violate any applicable statute, regulation or regulatory agreement or condition. In addition, as noted above, beginning in 2016, if the Bank does not have the required capital conservation buffer under the amended capital rules, its ability to pay dividends to the Company will be limited. Branching . Under OCC branching regulations, the Bank is generally authorized to open branches in any state of the United States (i) if the Bank qualifies as a “domestic building and loan association” under the Code, which qualification requirements are similar to those for a Qualified Thrift Lender under the Home Owners’ Loan Act, or (ii) if the law of the state in which the branch is located, or is to be located, would permit establishment of the branch if the savings association were a state savings association chartered by such state. The OCC authority preempts any state law purporting to regulate branching by federal savings banks. Community Reinvestment Act and the Fair Lending Laws . Federal savings banks have a responsibility under the Community Reinvestment Act and related regulations of the OCC to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities and the denial of applications. In addition, an institution's failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in the OCC, other federal regulatory agencies as well as the Department of Justice taking enforcement actions. Based on an examination conducted June 30, 2015, the Bank received a satisfactory rating. Federal Home Loan Bank System . The Bank is a member of the FHLB-Atlanta. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. Under the capital plan of the FHLB-Atlanta as of December 31, 2016, the Bank was required to own at least $4,933,000 of the capital stock of the FHLB- Atlanta. As of such date, the Bank owned $4,933,000 of the capital stock of the FHLB-Atlanta and was in compliance with the capital plan requirements. Federal Reserve System . The FRB requires all depository institutions to maintain non‑interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non‑personal time deposits. For transaction accounts in 2017, the first $15.5 million, up from $15.2 million in 2016, will be exempt from reserve requirements. A 3 percent reserve ratio will be assessed on transaction accounts over $15.5 million up to and including $115.1 million, up from $110.2 million in 2016. A 10 percent reserve ratio will be assessed on transaction accounts in excess of $115.1 million. At December 31, 2016, the Bank was in compliance with the reserve requirements. Activities of Subsidiaries . A federal savings bank seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through an existing subsidiary must provide 30 days prior notice to the OCC and conduct any activities of the subsidiary in compliance with regulations and orders of the OCC. The OCC has the power to require a savings association to divest any subsidiary or terminate any activity conducted by a subsidiary that the OCC determines to pose a serious threat to the financial safety, soundness or stability of the savings association or to be otherwise inconsistent with sound banking practices. 31 Table of Contents Tying Arrangements . Federal savings banks are prohibited, subject to some exceptions, from extending credit to or offering any other services, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution. Other Regulations. Interest and other charges collected or contracted for by the Bank are subject to state usury laws and federal laws concerning interest rates. The Bank’s operations are also subject to federal laws applicable to credit transactions, such as the: · · Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers; Real Estate Settlement Procedures Act, requiring that borrowers for mortgage loans for one-to four family residential real estate receive various disclosures, including good faith estimates of settlement costs, lender servicing and escrow account practices, and prohibiting certain practices that increase the cost of settlement services; · Home Mortgage Disclosure Act, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves; Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit; Fair Credit Reporting Act, governing the use and provision of information to credit reporting agencies; Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; Truth in Savings Act; and rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws. · · · · · In addition, the Consumer Financial Protection Bureau issues regulations and standards under these federal consumer protection laws that affect our consumer businesses. These include regulations setting “ability to repay” and “qualified mortgage” standards for residential mortgage loans and mortgage loan servicing and originator compensation standards. The Bank is evaluating recent regulations and proposals, and devotes significant compliance, legal and operational resources to compliance with consumer protection regulations and standards. The operations of the Bank also are subject to the: · · · Electronic Funds Transfer Act and Regulation E promulgated thereunder, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; Check Clearing for the 21st Century Act (also known as “Check 21”), which gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check; and The USA PATRIOT Act, which requires savings associations to, among other things, establish broadened anti-money laundering compliance programs, and due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements that also apply to financial institutions under the Bank Secrecy Act and the Office of Foreign Assets Control regulations. 32 Table of Contents Item 1A. Risk Factors Unless the context indicates otherwise, all references to “we,” “us,” “our” in this subsection “Risk Factors” refer to the Company and its subsidiaries. You should carefully consider the risks and uncertainties described below as well as elsewhere in this Annual Report on Form 10-K. If any of the risks or uncertainties actually occurs, our business, financial condition or results of future operations could be materially adversely affected. The risks and uncertainties described in this Form 10-K are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us. This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of many factors, including the risks faced by us described below and elsewhere in this Annual Report on Form 10-K. Changes in interest rates could adversely affect our financial condition and results of operations. The operations of financial institutions, such as ours, are dependent to a large degree on net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings. Our net interest income is significantly affected by market rates of interest that in turn are affected by prevailing economic conditions, fiscal and monetary policies of the federal government and the policies of various regulatory agencies. Like all financial institutions, our balance sheet is affected by fluctuations in interest rates. Volatility in interest rates can also result in disintermediation, which is the flow of funds away from financial institutions into direct investments, such as U.S. Government bonds, corporate securities and other investment vehicles, including mutual funds, which, because of the absence of federal insurance premiums and reserve requirements, generally pay higher rates of return than those offered by financial institutions such as ours. In December 2015, the FRB raised the target range for the federal funds rate for the first time since 2006 and indicated that further interest rate hikes may be undertaken. A second rate increase occurred in December 2016 and the Federal Reserve indicated that three more hikes may occur in 2017. Sharply rising interest rates could disrupt domestic and world markets and could adversely affect the value of our investment portfolio or our liquidity and results of operations. We expect to experience continual competition for deposit accounts which may make it difficult to reduce the interest paid on some deposits. We believe that, in the current market environment, we have adequate policies and procedures for maintaining a conservative interest rate sensitive position. However, there is no assurance that this condition will continue. A sharp movement up or down in deposit rates, loan rates, investment fund rates and other interest-sensitive instruments on our balance sheet could have a significant, adverse impact on our net interest income and operating results. Most of our loans are secured by real estate located in our market area. If there is a downturn in the real estate market, additional borrowers may default on their loans and we may not be able to fully recover our loans. Although the real estate market has recovered from the financial crisis of 2008-2009, a subsequent downturn in the real estate market could adversely affect our business because most of our loans are secured by real estate. Substantially all of our real estate collateral is located in the states of Maryland, Virginia and Delaware. Real estate values and real estate markets are generally affected by changes in national, regional or local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies and acts of nature. In addition to the risks generally present with respect to mortgage lending activities, our operations are affected by other factors affecting our borrowers, including: · the ability of our mortgagors to make mortgage payments, 33 Table of Contents · · · the ability of our borrowers to attract and retain buyers or tenants, which may in turn be affected by local conditions such as an oversupply of space or a reduction in demand for rental space in the area, the attractiveness of properties to buyers and tenants, and competition from other available space, or by the ability of the owner to pay leasing commissions, provide adequate maintenance and insurance, pay tenant improvements costs and make other tenant concessions, interest rate levels and the availability of credit to refinance loans at or prior to maturity, and increased operating costs, including energy costs, real estate taxes and costs of compliance with environmental controls and regulations. As of December 31, 2016, approximately 96% of the book value of our loan portfolio consisted of loans collateralized by various types of real estate. If real estate prices decline, the value of real estate collateral securing our loans will be reduced. Our ability to recover defaulted loans by foreclosing and selling the real estate collateral would then be diminished, and we would be more likely to incur financial losses on defaulted loans. In addition, approximately 47% of the book value of our loans consisted of construction, land acquisition and development loans, commercial real estate loans and land loans, which present additional risks described in “Item 1. Business - Construction Loans” of this Form 10-K. Our loan portfolio exhibits a high degree of risk. We have a significant amount of nonresidential loans, as well as construction and land loans granted on a speculative basis. Although permanent single-family, owner-occupied loans currently represent the largest single component of assets and impaired loans, we have a significant level of nonresidential loans, construction loans, and land loans that have an above-average risk exposure. At December 31, 2016 and December 31, 2015, our non-accrual loans (those loans 90 or more days in arrears) equaled $9,852,000 and $8,974,000, respectively. There were twenty-three residential loans (including construction, land acquisition and development, land loans and home equity lines of credit) in non-accrual status totaling $6,763,000 and eight commercial loans in non-accrual status totaling $2,939,000 at December 31, 2016, compared to thirty-eight residential loans in non-accrual status totaling $5,810,000, and seven commercial loans in non-accrual status totaling $2,681,000 at December 31, 2015. For the years ended December 31, 2016 and December 31, 2015, there were $(561,000) and $397,000 of net loan (recoveries) charge-offs, respectively. At December 31, 2016, the total allowance for loan losses was $8,969,000, which was 1.47% of total net loans, compared with $8,758,000, which was 1.45% of total net loans, as of December 31, 2015. We are exposed to risk of environmental liabilities with respect to properties to which we take title. In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we become subject to significant environmental liabilities, our business, financial condition, results of operations and cash flows could be materially and adversely affected. Our operations are located in Anne Arundel County, Maryland, which makes our business highly susceptible to local economic conditions. An economic downturn or recession in this area may adversely affect our ability to operate profitably. Unlike larger banking organizations that are geographically diversified, our operations are concentrated in Anne Arundel County, Maryland. In addition, nearly all of our loans have been made to borrowers in the states of Maryland, Virginia and Delaware. As a result of this geographic concentration, our financial results depend largely upon economic conditions in our market area. A deterioration or recession in economic conditions in this market could result in one or more of the following: 34 Table of Contents · · · · · a decrease in deposits; an increase in loan delinquencies; an increase in problem assets and foreclosures; a decrease in the demand for our products and services; and a decrease in the value of collateral for loans, especially real estate, and reduction in customers’ borrowing capacities. Any of the foregoing factors may adversely affect our ability to operate profitably. We are subject to federal and state regulation and the monetary policies of the FRB. Such regulation and policies can have a material adverse effect on our earnings and prospects. Our operations are heavily regulated and will be affected by present and future legislation and by the policies established from time to time by various federal and state regulatory authorities. In particular, the monetary policies of the FRB have had a significant effect on the operating results of banks in the past, and are expected to continue to do so in the future. Among the instruments of monetary policy used by the FRB to implement its objectives are changes in the discount rate charged on bank borrowings and changes in the reserve requirements on bank deposits. In December 2015, the FRB raised the target range for the federal funds rate for the first time since 2006. A second rate increase occurred in December 2016 and the Federal Reserve indicated that three more hikes may occur in 2017. It is not possible to predict what changes, if any, will be made to the monetary policies of the FRB or to existing federal and state legislation or the effect that such changes may have on our future business and earnings prospects. The Dodd-Frank Act has significantly changed the bank regulatory structure and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies have been given significant discretion in drafting the implementing rules and regulations, many of which are not in final form. Consequently, the full impact of the Dodd-Frank Act may not be known for years. If the Bank becomes “undercapitalized” as determined under the “prompt corrective action” initiatives of the federal bank regulators, such regulatory authorities will have the authority to require the Bank to, among other things, alter, reduce or terminate any activity that the regulator determines poses an excessive risk to the Bank. The Bank could further be directed to take any other action that the regulatory agency determines will better carry out the purpose of prompt corrective action. The Bank could be subject to these prompt corrective action restrictions if federal regulators determine that the Bank is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. The Company has become subject to more stringent capital requirements, which may adversely impact its return on equity, require it to raise additional capital, or constrain it from paying dividends or repurchasing shares. Effective January 1, 2015, the OCC implemented a new rule that substantially amended the regulatory risk-based capital rules applicable to the Bank. The new rule implemented the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act. The rule includes new minimum risk-based capital and leverage ratios, and revised the definition of what constitutes “capital” for purposes of calculating these ratios. The new minimum capital requirements are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from prior rules); and (iv) a Tier 1 leverage ratio of 4%. The new rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios, and results in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 to risk-based assets capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new capital conservation buffer requirement will be phased in beginning in January 2016 and in 2017 is 1.25% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such actions. 35 Table of Contents The application of more stringent capital requirements for the Bank could, among other things, result in lower returns on equity, require the raising of additional capital, and result in regulatory actions such as the inability to pay dividends or repurchase shares if we were to be unable to comply with such requirements. The Bank’s reliance on brokered deposits could adversely affect its liquidity and operating results. Among other sources of funds, we rely on brokered deposits to provide funds with which to make loans and provide for other liquidity needs. On December 31, 2016, brokered deposits totaled $6.4 million, or approximately 1.1% of total deposits. The Bank’s utilizes a variety of sources for brokered certificates of deposit. Generally brokered deposits may not be as stable as other types of deposits. In the future, those depositors may not replace their brokered deposits with us as they mature, or we may have to pay a higher rate of interest to keep those deposits or to replace them with other deposits or other sources of funds. Not being able to maintain or replace those deposits as they mature would adversely affect our liquidity. Paying higher deposit rates to maintain or replace brokered deposits would adversely affect our net interest margin and operating results. Income from secondary mortgage market operations is volatile, and we may incur losses with respect to our secondary mortgage market operations that could negatively affect our earnings. A key component of our strategy is to sell in the secondary market the longer term, conforming fixed-rate residential mortgage loans that we originate, earning non-interest income in the form of gains on sale. When interest rates rise, the demand for mortgage loans tend to fall and may reduce the number of loans we can originate for sale. Weak or deteriorating economic conditions also tend to reduce loan demand. Although we sell, and intend to continue selling, most loans in the secondary market with limited or no recourse, we are required, and will continue to be required, to give customary representations and warranties to the buyers relating to compliance with applicable law. If we breach those representations and warranties, the buyers will be able to require us to repurchase the loans and we may incur a loss on the repurchase. We may be adversely affected by changes in economic and political conditions and by governmental monetary and fiscal policies. The banking industry is affected, directly and indirectly, by local, domestic, and international economic and political conditions, and by governmental monetary and fiscal policies. Conditions such as inflation, recession, unemployment, volatile interest rates, tight money supply, real estate values, international conflicts and other factors beyond our control may adversely affect our potential profitability. Any future rises in interest rates, while increasing the income yield on our earning assets, may adversely affect loan demand and the cost of funds and, consequently, our profitability. Any future decreases in interest rates may adversely affect our profitability because such decreases may reduce the amounts that we may earn on our assets. Economic downturns have resulted and may continue to result in the delinquency of outstanding loans. We do not expect any one particular factor to materially affect our results of operations. However, downtrends in several areas, including real estate, construction and consumer spending, have had and may continue to have a material adverse impact on our ability to remain profitable. Further, there can be no assurance that the asset values of the loans included in our loan portfolio, the value of properties and other collateral securing such loans, or the value of foreclosed real estate will remain at current levels. Our stock price may be volatile due to limited trading volume. Our common stock is traded on the NASDAQ Capital Market. However, the average daily trading volume in the Company’s common stock has been relatively small, averaging less than 6,000 shares per day during 2016. As a result, trades involving a relatively small number of shares may have a significant effect on the market price of the common stock, and it may be difficult for investors to acquire or dispose of large blocks of stock without significantly affecting the market price. 36 Table of Contents We have established an allowance for loan losses based on our management's estimates. Actual losses could differ significantly from those estimates. If the allowance is not adequate, it could have a material adverse effect on our earnings and the price of our common stock. We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management's best estimate of probable incurred losses within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; industry concentrations and other unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. If charge-offs in future periods exceed the allowance for loan losses, we may need additional provisions to increase the allowance for loan losses. Furthermore, growth in the loan portfolio would generally lead to an increase in the provision for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and capital, and may have a material adverse effect on our financial condition, results of operations and cash flows. We compete with a number of local, regional and national financial institutions for customers. We face strong competition from savings and loan associations, banks, and other financial institutions that have branch offices or otherwise operate in our market area, as well as many other companies now offering a range of financial services. Many of these competitors have substantially greater financial resources and larger branch systems than us. In addition, many of our competitors have higher legal lending limits than us. Particularly intense competition exists for sources of funds including savings and retail time deposits as well as for loans and other services offered by us. In addition, over the last several years, the banking industry has undergone substantial consolidation, and this trend is expected to continue. Significant ongoing consolidation in the banking industry may result in one or more large competitors emerging in our primary target market. The financial resources, human capital and expertise of one or more large institutions could threaten our ability to maintain our competitiveness. We face intense competitive pressure on customer pricing, which may materially and adversely affect revenues and profitability. We generate net interest income, and charge our customers fees, based on prevailing market conditions for deposits, loans and other financial services. In order to increase deposit, loan and other service volumes, enter new market segments and expand our base of customers and the size of individual relationships, we must provide competitive pricing for such products and services. In order to stay competitive, we have had to intensify our efforts around attractively pricing our products and services. To the extent that we must continue to adjust our pricing to stay competitive, we will need to grow our volumes and balances in order to offset the effects of declining net interest income and fee-based margins. Increased pricing pressure also enhances the importance of cost containment and productivity initiatives, and we may not succeed in these efforts. 37 Table of Contents Our brand, reputation and relationship with our customers are key assets of our business and may be affected by how we are perceived in the marketplace. Our brand and its attributes are key assets of our business. The ability to attract and retain customers to the Company’s products and services is highly dependent upon the external perceptions of us and the industry in which we operate. Our business may be affected by actions taken by competitors, customers, third party providers, employees, regulators, suppliers or others that impact the perception of the brand, such as creditor practices that may be viewed as “predatory,” customer service quality issues, and employee relations issues. Adverse developments with respect to our industry may also, by association, impair our reputation, or result in greater regulatory or legislative scrutiny. The operations of our business, including our interaction with customers, are increasingly done via electronic means, and this has increased our risks related to cyber-attacks. We are exposed to the risk of cyber-attacks in the normal course of business. In general, cyber incidents can result from deliberate attacks or unintentional events. There has been an increased level of attention focused recently on cyber-attacks against large corporations that include, but are not limited to, gaining unauthorized access to digital systems for purposes of misappropriating cash, other assets or sensitive information, corrupting data, or causing operational disruption. Cyber-attacks may also be carried out in a manner that does not require gaining unauthorized access, such as by causing denial-of-service attacks on websites. Cyber-attacks may be carried out by third parties or insiders using techniques that range from highly sophisticated efforts to electronically circumvent network security or overwhelm websites to more traditional intelligence gathering and social engineering aimed at obtaining information necessary to gain access. The objectives of cyber-attacks vary widely and can include theft of financial assets, intellectual property, or other sensitive information, including the information belonging to our banking customers. Cyber-attacks may also be directed at disrupting our operations. While we have not incurred any losses related to cyber-attacks, nor are we aware of any specific or threatened cyber-incidents as of the date of this report, we may incur substantial costs and suffer other negative consequences if we fall victim to successful cyber-attacks. Such negative consequences could include remediation costs that may include liability for stolen assets or information and repairing system damage that may have been caused; increased cybersecurity protection costs that may include organizational changes, deploying additional personnel and protection technologies, training employees, and engaging third party experts and consultants; lost revenues resulting from unauthorized use of proprietary information or the failure to retain or attract customers following an attack; litigation; and reputational damage adversely affecting customer or investor confidence. Our business is highly reliant on technology and our ability to manage the operational risks associated with technology. We rely heavily on communications and information systems to conduct our business. Our business involves storing and processing sensitive customer data. Any failure, interruption or breach in security of these systems could result in theft of customer data or failures or disruptions in our customer relationship management, general ledger, deposit, loan, data storage, processing and other systems. Our inability to access these information systems at critical points in time could unfavorably impact the timeliness and efficiency of our business operations. In addition, we operate a number of money transfer and related electronic, check and other payment connections that are vulnerable to individuals engaging in fraudulent activities that seek to compromise payments and related financial systems illegally. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, result in increased expense to contain the event and/or require that we provide credit monitoring services for affected customers or expose us to civil litigation and regulatory fines and sanctions, any of which could have a material adverse effect on our financial condition and results of operations. 38 Table of Contents Our business is highly reliant on third party vendors and our ability to manage the operational risks associated with outsourcing those services. We rely on third parties to provide services that are integral to our operations. These vendors provide services that support our operations, including storage and processing of sensitive consumer date. A cyber security breach of a vendor’s system may result in theft of our data or disruption of business processes. A material breach of customer data at a service provider’s site may negatively impact our business reputation and cause a loss of customer business; result in increased expense to contain the event and/or require that we provide credit monitoring services for affected customers, result in regulatory fines and sanctions and may result in litigation. In most cases, we will remain primarily liable to our customers for losses arising from a breach of a vendor’s data security system. We rely on our outsourced service providers to implement and maintain prudent cyber security controls. We have procedures in place to assess a vendor’s cyber security controls prior to establishing a contractual relationship and to periodically review assessments of those control systems; however, these procedures are not infallible and a vendor’s system can be breached despite the procedures we employ. If our third party providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we would be able to negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. We continually encounter technological change, and, if we are unable to develop and implement efficient and customer friendly technology, we could lose business. The financial services industry is continually undergoing rapid technological change, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to achieve additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations. Our success depends on our senior management team, and if we are not able to retain our senior management team, it could have a material adverse effect on us. We are highly dependent upon the continued services and experience of our senior management team, including Alan J. Hyatt, our Chairman, President and Chief Executive Officer. We depend on the services of Mr. Hyatt and the other members of our senior management team to, among other things, continue the development and implementation of our strategies, and maintain and develop our customer relationships. We do not have an employment agreement with members of our senior management, nor do we maintain “key-man” life insurance on our senior management. If we are unable to retain Mr. Hyatt and other members of our senior management team, our business could be materially and adversely affected. If we fail to maintain an effective system of internal control over financial reporting and disclosure controls and procedures, we may be unable to accurately report our financial results and comply with the reporting requirements under the Securities Exchange Act of 1934. As a result, current and potential stockholders may lose confidence in our financial reporting and disclosure required under the Securities Exchange Act of 1934, which could adversely affect our business and stock price and could subject us to regulatory scrutiny. 39 Table of Contents Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, referred to as Section 404, we are required to include in our Annual Reports on Form 10-K, our management’s report on internal control over financial reporting. We are currently not required to include an opinion of our independent registered public accounting firm as to our internal controls because we are a “smaller reporting company” under SEC rules and, therefore, stockholders do not have the benefit of such an independent review of our internal controls. Compliance with the requirements of Section 404 is expensive and time-consuming. If, in the future, we fail to complete this evaluation in a timely manner, or, if required, our independent registered public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting. In addition, any failure to maintain an effective system of disclosure controls and procedures could cause our current and potential stockholders and customers to lose confidence in our financial reporting and disclosure required under the Securities Exchange Act of 1934, which could adversely affect our business and stock price. Terrorist attacks and threats or actual war may impact all aspects of our operations, revenues, costs and stock price in unpredictable ways. Terrorist attacks in the United States and abroad, as well as future events occurring in response to or in connection with them, including, without limitation, future terrorist attacks against U.S. targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions, may impact our operations. Any of these events could cause consumer confidence and savings to decrease or could result in increased volatility in the United States and worldwide financial markets and economy. Any of these occurrences could have an adverse impact on our operating results, revenues and costs and may result in the volatility of the market price for our common stock and on the future price of our common stock. There can be no assurance that we will pay dividends in the future. Bank regulations govern and limit the payment of dividends and capital distributions to stockholders and purchases or redemption by the Company of its stock. In addition, the Company suspended its common stock dividend in the fourth quarter of 2009 to preserve its capital. Although we expect to be able to resume our policy of quarterly dividend payments sometime in the future, this dividend policy will be reviewed in light of future earnings, bank regulations and other considerations. No assurance can be given, therefore, that cash dividends on our common stock will be paid in the future. Our Series A preferred stock and 2035 Debentures contain restrictions on our ability to declare and pay dividends on, or repurchase our common stock. Our ability to declare dividends on our common stock are limited by the terms of our 8.0% Non-Cumulative Convertible Preferred Stock, referred to as Series A preferred stock. We 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 our 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. Dividends on the Series A preferred stock have been declared and paid on June 20, 2016, September 30, 2016 and December 30, 2016 in the amount of $70,000 each quarter. Prior to that, the Company had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012. Further, under the terms of our Junior Subordinated Debt Securities due 2035, referred to as the 2035 Debentures, if (i) there has occurred and is continuing an event of default, (ii) we are in default with respect to payment of any obligations under the related guarantee or (iii) we have given notice of our election to defer payments of interest on the 2035 Debentures by extending the interest distribution period as provided in the indenture governing the 2035 Debentures and such period, or any extension thereof, has commenced and is continuing, then we 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 our capital stock, including our common stock. As permitted under the terms of the 2035 Debenture, as of December 31, 2015, the Company had deferred the payment of fifteen quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,863,000. During the second quarter of 2016, the Company paid all of the deferred interest and as of December 31, 2016, the Company was current on all interest due on the 2035 Debenture. 40 Table of Contents An investment in our securities is not insured against loss. Investments in our common stock are not deposits insured against loss by the FDIC or any other entity. As a result, an investor may lose some or all of his, her or its investment. Conversion of our Series A preferred stock or exercise of the warrant issued to the Treasury Department will dilute the ownership interest of existing stockholders. In two private placements conducted in November 2008, we issued Series A preferred stock convertible into 437,500 shares of our common stock, subject to adjustment. A warrant to purchase 556,976 shares of our common stock, subject to adjustment, was issued in relation to the placement of the Series B Preferred Stock. The conversion of some or all of the Series A preferred stock or the exercise of the warrant will dilute the ownership interest of existing stockholders. Any sales in the public market of the common stock issuable upon such conversion or exercise could adversely affect prevailing market prices of our common stock. In addition, the existence of the Series A preferred stock or warrant may encourage short selling by market participants because the conversion of the Series A preferred stock or exercise of the warrant could depress the price of our common stock. “Anti-takeover” provisions will make it more difficult for a third party to acquire control of us, even if the change in control would be beneficial to our equity holders. Our charter presently contains certain provisions that may be deemed to be “anti-takeover” and “anti-greenmail” in nature in that such provisions may deter, discourage or make more difficult the assumption of control of us by another corporation or person through a tender offer, merger, proxy contest or similar transaction or series of transactions. For example, currently, our charter provides that our Board of Directors may amend the charter, without stockholder approval, to increase or decrease the aggregate number of shares of our stock or the number of shares of any class that we have authority to issue. In addition, our charter provides for a classified Board, with each Board member serving a staggered three-year term. Directors may be removed only for cause and only with the approval of the holders of at least 75 percent of our common stock. The overall effects of the “anti-takeover” and “anti-greenmail” provisions may be to discourage, make more costly or more difficult, or prevent a future takeover offer, prevent stockholders from receiving a premium for their securities in a takeover offer, and enhance the possibility that a future bidder for control of us will be required to act through arms-length negotiation with our Board of Directors. These provisions may also have the effect of perpetuating incumbent management. Item 1B. Unresolved Staff Comments Not applicable. Item 2. Properties HS constructed a building in Annapolis, Maryland that serves as the Company’s and the Bank’s administrative headquarters. A branch office of the Bank is also included in the building. The Company and the Bank lease their executive and administrative offices from HS. In addition, HS leases space to four unrelated companies and to a law firm in which the President of the Company and the Bank is a partner. The Company has five retail branch locations in Anne Arundel County, Maryland, of which it owns three and leases two from third parties. The current terms of the leases expire in July 2020 and February 2026. There is no option to renew the lease for any additional terms on the first lease and an option to renew every three to five years on the second lease for twenty-five years. In addition, the Bank leases office space in Annapolis, Maryland from a third party. The lease expires January 2017, and the option to renew the lease for one additional five year term was exercised. 41 Table of Contents Item 3. Legal Proceedings At December 31, 2016, t here are no material pending legal proceedings to which the Company, the Bank or any subsidiary is a party or to which any of their property is subject. Item 4. Mine Safety Disclosures Not applicable. PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The common stock of the Company is traded on the Nasdaq Stock Market, LLC under the symbol “SVBI”. As of March 8, 2017, there were 156 stockholders of record of the Company’s common stock. Computershare, 211 Quality Circle, Suite 210, College Station, Texas 77845-4470, serves as the Transfer Agent and Registrar for the Company. The following table sets forth the high and low sales prices per share of the Company’s common stock for the years indicated, as reported on the Nasdaq Stock Market, LLC: Quarter 1 st $ 2 nd 3 rd 4 th Dividend Policy Quarterly Stock Information 2016 Stock Price Range Low 4.99 $ 5.05 5.93 6.25 High 5.78 $ 6.15 6.85 8.07 Per Share Dividend - - - - 2015 Stock Price Range Low 4.25 $ 4.61 4.66 4.66 High 4.95 $ 5.12 5.09 5.88 Quarter 1 st $ 2 nd 3 rd 4 th Per Share Dividend - - - - Federal banking regulations limit the amount of dividends that banking institutions may pay and may require prior approval or non-objection from federal banking regulators before any dividends, capital distributions or share redemptions can be made. The Company’s main source of income is dividends from the Bank. As a result, any dividends ever paid by the Company to its common shareholders depends primarily upon regulatory approval and receipt of dividends from the Bank. The Company suspended its common stock dividend in the fourth quarter of 2009 to preserve its capital. The Company’s ability to declare a dividend on its common stock is also limited by the terms of the Company’s Series A preferred stock. The Company 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. Dividends on the Series A preferred stock have been declared and paid on June 20, 2016, September 30, 2016 and December 30, 2016 in the amount of $70,000 each quarter. Prior to that, the Company had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012. As of December 31, 2016, the Company declared and paid dividends on its Series A preferred stock for the final 3 quarters of 2016. 42 Table of Contents Previously, the Series B Preferred Stock had limitations on the payments of dividends on common stock. On May 11, 2016, the Company redeemed 10,000 shares of the Series B Preferred Stock for $10,000,000. On September 8, 2016, the Company redeemed the remaining 13,393 shares of stock for $13,393,000, thereby removing the common dividend restriction related to the Series B Preferred Stock. Additionally, under the terms of the Company's 2035 Debentures, if (i) there has occurred and is continuing an event of default, (ii) the Company is in default with respect to payment of any obligations under the related guarantee or (iii) the Company has given notice of its election to defer payments of interest on the 2035 Debentures by extending the interest distribution period as provided in the indenture governing the 2035 Debentures and such period, or any extension thereof, has commenced and is continuing, then the Company 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. As permitted under the terms of the 2035 Debenture, as of December 31, 2015, the Company had deferred the payment of fifteen quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,863,000. During the second quarter of 2016, the Company paid all of the deferred interest and as of December 31, 2016, the Company is current on all interest due on the 2035 Debenture. The Company did not repurchase any shares of common stock during the fourth quarter of 2016. Item 6. Selected Financial Data The following summary financial information is derived from the audited consolidated financial statements of the Company, except as noted below. The information is a summary and should be read in conjunction with the Company’s audited consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations. Balance Sheet Data Total assets Total loans, net Investment securities held to maturity Non-performing loans Total non-performing assets Deposits Long-term debt Total liabilities Stockholders’ equity Book value per common share Common shares outstanding Other Data: Number of: Full service retail banking facilities Full-time equivalent employees Summary Financial and Other Data At December 31, 2016 2015 2014 2013 2012 (dollars in thousands, except per share information) $ $ 787,485 $ 601,309 62,757 9,852 10,825 571,946 103,500 699,555 87,930 6.98 $ 12,123,179 762,079 $ 589,656 76,133 8,974 10,718 523,771 115,000 675,623 86,456 5.93 $ 10,088,879 776,328 $ 633,882 59,616 12,845 14,792 543,814 115,000 692,518 83,810 5.68 $ 10,067,379 799,603 $ 602,813 44,661 11,035 20,007 571,249 115,000 716,834 82,769 5.57 $ 10,066,679 852,118 651,709 34,066 37,495 48,936 599,394 115,000 743,122 108,996 8.18 10,066,679 4 152 4 150 4 160 4 142 5 142 43 Table of Contents Summary of Operations Interest income Interest expense Net interest income Provision (credit) for loan losses Net interest income after provision for loan losses Non-interest income Non-interest expense Income (loss) before income tax (benefit) provision (Benefit) provision for income taxes Net income (loss) Per Common Share Data: Basic earnings (loss) per common share Diluted earnings (loss) per common share Weighted number of common shares outstanding basic Weighted number of common shares outstanding diluted $ $ $ $ 2016 30,750 $ 8,561 22,189 (350) 22,539 6,361 23,374 5,526 (10,014) 15,540 $ For the Year Ended December 31, 2015 2014 2013 2012 (dollars in thousands, except per share information) 31,153 $ 8,992 22,161 (280) 22,441 6,110 23,926 4,625 90 4,535 $ 31,816 $ 8,634 23,182 831 22,351 4,325 23,736 2,940 31 2,909 $ 33,792 $ 9,184 24,608 16,520 8,088 5,529 30,072 (16,455) 8,710 (25,165) $ 39,057 12,502 26,555 765 25,790 4,123 23,527 6,386 2,658 3,728 1.20 $ 1.19 $ 11,522,333 11,547,892 0.21 $ 0.21 $ 10,083,942 10,112,653 0.06 $ 0.06 $ 10,067,379 10,096,387 (2.64) $ (2.64) $ 10,066,679 10,066,679 0.22 0.22 10,066,679 10,066,679 44 Table of Contents Performance Ratios: Return on average assets Return on average equity Net interest margin Interest rate spread Non-interest expense to average assets Efficiency ratio* Asset Quality Ratios: Average equity to average assets Nonperforming assets to total assets at end of year Nonperforming loans to total gross loans at end of year** Allowance for loan losses to net loans at end of year** Allowance for loan losses to nonperforming loans at end of year** Key Operating Ratios At or For the Year Ended December 31, 2016 2015 2014 2013 2012 1.99% 17.08% 3.19% 3.17% 3.01% 81.19% 0.59% 5.45% 3.18% 3.14% 3.09% 83.82% 0.37% 3.55% 3.26% 3.24% 3.07% 86.25% (3.00%) (24.45%) 3.28% 3.24% 3.64% 79.73% 0.42% 3.50% 3.33% 3.27% 2.69% 66.00% 11.70% 10.75% 10.42% 12.28% 12.11% 1.37% 1.41% 1.91% 2.50% 1.54% 1.41% 1.86% 1.69% 1.47% 1.45% 1.47% 1.95% 5.74% 5.37% 2.68% 91.03% 97.59% 73.45% 106.38% 46.61% * The efficiency ratio is non-interest expenses less foreclosure costs as a percentage of net interest income plus non-interest income. **Includes held for sale loans. 45 Table of Contents Average Balance Sheet The following table contains for the periods indicated information regarding the total dollar amounts of interest income from interest-earning assets and the resulting average yields, the total dollar amount of interest expense on interest-bearing liabilities and the resulting average costs, net interest income, and the net yield on interest-earning assets. 2016 Year Ended December 31, 2015 2014 Average Volume Interest Rate Average Volume Interest Rate Average Volume Interest Rate (dollars in thousands) $ 613,337 $ 29,262 634 515 339 30,750 38,822 32,484 9,989 694,632 82,213 $ 776,845 $ 618,309 $ 29,734 709 1.63% 43,254 395 1.59% 25,227 3.40% 10,806 315 4.43% 697,596 31,153 4.81% $ 622,935 $ 30,574 746 1.64% 44,468 205 9,518 1.57% 2.92% 33,560 291 4.47% 710,481 31,816 4.91% 1.68% 2.15% 0.87% 4.48% 75,505 $ 773,101 75,125 $ 785,606 655 3,378 4,528 8,561 $ 259,212 281,538 137,036 677,786 8,165 90,894 $ 776,845 635 3,415 4,942 8,992 0.25% $ 244,810 1.20% 293,174 3.30% 139,124 1.26% 677,108 12,857 83,136 $ 773,101 0.26% $ 261,513 1.16% 293,682 3.55% 139,122 1.33% 694,317 9,457 81,832 $ 785,606 417 3,511 4,706 8,634 0.16% 1.20% 3.38% 1.24% ASSETS Loans (1) Investments (2) Mortgage-backed securities Other interest-earning assets (3) Total interest-earning assets Non-interest earning assets Total Assets LIABILITIES AND STOCKHOLDERS' EQUITY Savings and checking deposits Certificates of deposits Borrowings Total interest-bearing liabilities Non-interest bearing liabilities Stockholders' equity Total liabilities and stockholders' equity Net interest income and Interest rate spread $ 22,189 3.17% $ 22,161 3.14% $ 23,182 3.19% 3.18% 3.24% 3.26% Net interest margin Average interest-earning assets to average interest-bearing liabilities 102.49% 103.03% 102.33% (1) Held for sale and non-accrual loans are included in the average balances and in the computation of yields. (2) The Company does not have any tax-exempt investment securities. (3) Other interest earning assets include interest earning deposits in other banks, federal funds, and FHLB stock investments. 46 Table of Contents Interest-earning assets Loans Investments Mortgage-backed securities Other interest-earning assets Total interest income Interest-bearing liabilities Savings and checking deposits Certificates of deposits Borrowings Total interest expense Rate Volume Table Year ended December 31, 2016 vs. Year ended December 31, 2015 Year ended December 31, 2015 vs. Year ended December 31, 2014 Total Change Changes Due to Volume (1) Rate (1) Total Change Changes Due to Volume (1) Rate (1) (dollars in thousands) $ (472) $ (75) 120 24 (403) 20 (37) (414) (431) (237) $ (72) 115 (28) (222) 36 (140) (125) (229) (235) $ (3) 5 52 (181) (16) 103 (289) (202) (840) $ (37) 190 24 (663) 218 (96) 236 358 (223) $ (20) 246 (663) (660) (43) (6) - (49) (617) (17) (56) 687 (3) 261 (90) 236 407 Net change in net interest income $ 28 $ 7 $ 21 $ (1,021) $ (611) $ (410) (1) Changes in interest income/expense not arising from volume or rate variances are allocated proportionately to rate and volume. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview The Company provides a wide range of personal and commercial banking services. Personal services include mortgage lending and various other lending services as well as deposit products such as personal internet banking and online bill pay, checking accounts, individual retirement accounts, money market accounts, and 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. The Company also provides ATMs, credit cards, debit cards, mortgage lending, safe deposit boxes, and telephone banking, among other products and services. The Company has experienced an improved level of profitability in 2016, as well as increased loan originations and expanded local economic activity. The significant increase in net income was largely due to the reversal of the valuation allowance that the Company had placed on its deferred tax assets during the second quarter of 2016. This resulted in a gain of $11,837,000 being recorded. Management believes that, while conditions continue to improve, and real estate values in the Company’s market area continue to stabilize and, in some cases improve, including job losses and other factors, still exist for some customers. The interest rate spread between the Company’s cost of funds and what it earns on loans has increased from 2015 levels and competition for new loans and deposits remains strong. The Company expects to experience similar market conditions in 2017 as 2016, as the national and local economies continue to improve and as the employment environment in its market improves. If interest rates increase, demand for borrowing may decrease and the Company’s interest rate spread could decrease. The Company 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 the Company, 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. 47 Table of Contents The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to the Company’s ability to originate and grow its mortgage loans and deposits, as will the Company’s continued focus on maintaining a low overhead. If the volatility in the market and the economy continues or worsens, the Company’s business, financial condition, results of operations, access to funds and the price of its stock could be materially and adversely impacted. Critical Accounting Policies The Company’s significant accounting policies and recent accounting pronouncements are set forth in Note 1 of the consolidated financial statements which are included under Part IV, Item 5 in this Form 10-K. Of these significant accounting policies, the Company considers the policies regarding the allowance for loan losses, the valuation of foreclosed real estate, the evaluation of other than temporary impairment of investment securities and the valuation of the deferred tax asset to be its most critical accounting policies, given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio and the material effect that such judgments can have on the results of operations and future taxable income. In addition, changes in economic conditions can have a significant impact on real estate values of underlying collateral affecting the allowance for loan losses and therefore the provision for loan losses and results of operations as well as the valuation of foreclosed real estate. The Company has developed policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers that is not known to management at the time of the issuance of the consolidated financial statements. Comparison of Statement of Financial Condition for December 31, 2016 versus 2015. Financial Condition Total assets increased by $25,406,000, or 3.3% to $787,485,000 at December 31, 2016, compared to the $762,079,000 at December 31, 2015. Increases in loans, cash, and deferred income taxes were the reasons for the increase. Cash Cash and cash equivalents increased by $23,523,000, or 54.0%, to $67,114,000 at December 31, 2016, compared to $43,591,000 at December 31, 2015. This increase was primarily due to proceeds received in 2016 from matured securities and mortgage backed securities pay downs and deposit growth. Investments Investment securities held to maturity decreased by $13,376,000, or 17.6%, to $62,757,000 at December 31, 2016, compared to $76,133,000 at December 31, 2015. This decrease was primarily due to management’s decision to use matured securities funds and pay downs from mortgage backed securities to fund an increase in loan demand. Loans Loans Held For Sale. Loans held for sale decreased by $2,896,000, or 21.9%, to $10,307,000 at December 31, 2016, compared to $13,203,000 at December 31, 2015. This decrease was primarily due to the timing of loans pending sale on the secondary market as of December 31, 2016 compared to December 31, 2015. Loans Receivable. Total loans receivable, net increased by $11,653,000, or 2.0%, to $601,309,000 at December 31, 2016, compared to $589,656,000 at December 31, 2015. This increase was primarily due to an increase in the commercial portfolio loan demand. 48 Table of Contents Allowance for Loan Losses The allowance for loan losses increased by $211,000, or 2.4%, at December 31, 2016 to $8,969,000, compared to $8,758,000 at December 31, 2015. This increase in the allowance was primarily due to an increased loan portfolio, and management’s assessment of the collectability of the loans in the Company’s portfolio. The Bank continued to receive recoveries in 2016 and experienced a lower number of charge-offs in 2016 versus 2015. Foreclosed Real Estate Foreclosed real estate decreased by $771,000, or 44.2%, to $973,000 at December 31, 2016, compared to $1,744,000 at December 31, 2015. This decrease was primarily due to the sales of foreclosed properties in 2016 that were included in the balance as of December 31, 2015, and the lower level of loans foreclosed on in 2016 compared to 2015. Premises and Equipment Premises and equipment decreased by $260,000, or 1.1%, to $24,030,000 at December 31, 2016, compared to $24,290,000 at December 31, 2015. This decrease was primarily due to the annual depreciation taken on premises and equipment in 2016 partially offset by new fixed assets acquired in 2016. Deferred Income Taxes During the second quarter of 2016, the Company was able to remove the valuation allowance that it once had placed against its deferred tax assets. As a result, the full value of the deferred tax asset was recorded as an asset. As of December 31, 2016, the deferred tax asset was $10,081,000. As of December 31, 2015, the net deferred tax asset was $0. Accrued Interest Receivable and Other Assets Accrued interest receivable and other assets decreased by $1,855,000, or 23.7%, to $5,981,000 at December 31, 2016, compared to $7,836,000 at December 31, 2015. This decrease was primarily due to a decrease in income tax receivable, mortgage servicing rights and prepaid expenses, partially offset by an increase in derivative assets. Liabilities Deposits. Total deposits increased by $48,175,000, or 9.2%, to $571,946,000 at December 31, 2016, compared to $523,771,000 at December 31, 2015. This increase was primarily the result of opening a new branch in Severna Park and an increase in core deposits and brokered CDs. FHLB-Atlanta Advances. The Bank’s credit availability under the FHLB-Atlanta’s credit availability program was $232,193,000 at December 31, 2016. The Bank’s credit availability is based on the level of collateral pledged up to 30% of total assets. FHLB-Atlanta advances decreased by $15,000,000, or 13.0%, at December 31, 2016 to $100,000,000, compared to $115,000,000 at December 31, 2015. The Bank had sufficient liquidity to pay off the maturing advances in 2016 and did not have the need for additional advances. Subordinated Debentures. As of December 31, 2016, the Company had outstanding approximately $20,619,000 in 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 the Company and Wells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.88% at December 31, 2016) 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 the Company, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by the Company on January 7, 2010. 49 Table of Contents The 2035 Debentures were issued and sold to Severn Capital Trust I (the “Trust”), of which 100% of the common equity is owned by the Company. 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. The Company 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 Debenture, the Company 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 December 31, 2015, the Company had deferred the payment of fifteen quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,863,000. During the second quarter of 2016, the Company paid all of the deferred interest and as of December 31, 2016, the Company is current on all interest due on the 2035 Debenture. Accrued Interest Payable and Other Liabilities. Accrued interest payable and other liabilities decreased $9,243,000, or 72.5%, from $12,733,000 as of December 31, 2015 to $3,490,000 as of December 31, 2015. The decrease was due to the repayment of the deferred interest on the Subordinated Debentures and the repayment of all accrued and unpaid dividends and interest on its Series B Preferred Stock in 2016. The total amount of deferred interest paid on the Subordinated Debentures was $1,863,000 and the amount of dividends and interest paid on the Series B Preferred Stock was $7,590,000. Subordinated Notes and Series A Preferred Stock. On November 15, 2008, the Company 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 $7,000,000. Each unit consists of 6,250 shares of the Company's Series A 8.0% Non- Cumulative Convertible Preferred Stock and the Company's Subordinated Notes (“Subordinated Notes”) in the original principal amount of $50,000. The Subordinated Notes earned 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 were redeemable in whole or in part at the option of the Company at any time beginning on December 31, 2009 until maturity, which was December 31, 2018. Dividends will not be paid on the Company’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 the Company’s board of directors declare any dividends on the Series A Preferred Stock and any unpaid dividends are not cumulative. Dividends on the Series A preferred stock have been declared and paid on June 30, 2016, September 30, 2016 and December 30, 2016 in the amount of $70,000 each quarter. Prior to that, the Company had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012. On September 30, 2016 the aggregate principal amount of Subordinated Notes outstanding of $3,500,000 was paid in full. The Subordinated Notes were redeemable in whole or in part at the option of the Company at any time beginning on December 31, 2009 until maturity, which was December 31, 2018. Series B Preferred Stock. On November 21, 2008, the Company entered into an agreement with the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued and sold (i) 23,393 shares of its Series B Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share with a liquidation preference of $1,000 per share, (the “Series B Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 556,976 shares of the Company’s common stock, par value $0.01 per share, for an aggregate purchase price of $23,393,000. 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 the Warrant. On April 15, 2016, the Company paid all unpaid cumulative dividends of $6,550,000 and unpaid cumulative interest of $1,040,000 on the Series B Preferred Stock totaling $7,590,000. On May 11, 2016, the Company declared and paid a dividend of $326,000 on the Series B Preferred Stock, and redeemed 10,000 shares of such stock for $10,000,000. On August 11, 2016 the Company declared and paid a dividend of $301,000 and on September 8, 2016 a final dividend of $77,000 was paid along with the redemption of the 13,393 remaining shares of the Series B Preferred stock for $13,393,000. As of December 31, 2016, the Company has paid the dividend arrearages on its Series B preferred stock and redeemed all outstanding shares. 50 Table of Contents 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. The warrant expires November 11, 2018. Notes Payable . On September 30, 2016, the Company entered into a loan agreement with a commercial bank whereby the Company borrowed $3,500,000 for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Company, converts to either (1) floating rate of the Wall Street Journal Prime plus 0.50% or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing Federal Home Loan Bank rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If the Company elects the 5 year fixed rate of 275 basis points over the Federal Home Loan Bank rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth and fifth years of the FHLB Rate Period. The Company may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period. Stockholders’ Equity. Stockholders' equity increased $1,474,000, or 1.7%, to $87,930,000 at December 31, 2016 from $86,456,000 at December 31, 2015. Stockholders' equity increased primarily as a result of net income of $15,540,000 for the year ended December 31, 2016 and net proceeds of $10,510,000 from a private placement of common stock completed in April 2016, partially offset by the redemption of $23,393,000 in Series B Preferred Stock during 2016 and $1,231,000 in dividends paid on such shares. Comparison of Results of Operations for the Years Ended December 31, 2016 and 2015. General. Net income increased $11,005,000, or 242.7%, to $15,540,000 for the year ended December 31, 2016 compared to $4,535,000 for the year ended December 31, 2015. Earnings per common share, after the effect of dividends declared on preferred stock and amortization of discount on preferred stock, increased to $1.20 per basic common share and $1.19 per diluted common share for the year ended December 31, 2016 compared to $0.21 per basic common share and $0.21 per diluted common share for the year ended December 31, 2015. This increase in net income was primarily due to a non-recurring income tax benefit of $11,837,000, resulting from a reversal of a net deferred tax asset valuation allowance which was recorded in the second quarter of 2016. Net Interest Income. Net interest income (interest earned net of interest charges) increased $28,000, or 0.1%, to $22,189,000 for the year ended December 31, 2016, compared to $22,161,000 for the year ended December 31, 2015. This increase was primarily due to lower interest expense on borrowings offset by a decrease in the Company’s loan interest. The Company’s interest rate spread increased 3 basis points to 3.17% for the year ended December 31, 2016, compared to 3.14% for the year ended December 31, 2015. Provision for Loan Losses. The Company’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 the Bank determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio loan delinquencies at least as often as monthly. All loans that are delinquent and all loans within the various categories of the Bank’s portfolio as a group are evaluated. The Bank’s Board, with the advice and recommendation of the Bank’s loss mitigation committee, 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. 51 Table of Contents During the year ended December 31, 2016, the credit to the provision for loan losses was ($350,000) compared to ($280,000) for the year ended December 31, 2015. This increase of $70,000 was primarily due to increased recoveries during the year ended December 31, 2016 compared to December 31, 2015 and lower net charge-offs taken in 2016 compared to 2015. The total allowance for loan losses increased $211,000, or 2.4% to $8,969,000 as of December 31, 2016, compared to $8,758,000 as of December 31, 2015. This increase in the allowance was primarily due to growth in loan portfolio, a decrease in net charge offs at December 31, 2016 compared to the level at December 31, 2015 and management’s assessment of the collectability of the loans in the Company’s portfolio. Non-Interest Income. Total non-interest income increased $125,000, or 1.8%, to $7,071,000 for the year ended December 31, 2016 compared to $6,946,000 for the year ended December 31, 2015. Revenues from mortgage banking activities decreased $110,000, or 2.9%, to $3,654,000 for the year ended December 31, 2016, compared to $3,746,000 for the year ended December 31, 2015. This increase was primarily a result of the number of residential loan originations sold on the secondary market in 2016, compared to 2015. Real estate commissions increased $210,000, or 15.9%, to $1,529,000 for the year ended December 31, 2016, compared to $1,319,000 for the year ended December 31, 2015. This increase was primarily the result of an improvement in general business conditions in the Company’s market and a resulting increase in commercial sales and leasing in 2016 compared to 2015. Real estate management fees increased $80,000, or 12.2%, to $738,000 for the year ended December 31, 2016, compared to $658,000 for the year ended December 31, 2015. This increase was primarily due to an increase in properties managed in 2016 compared to 2015. Other non-interest income decreased $55,000, or 4.6%, to $1,150,000 for the year ended December 31, 2016, compared to $1,205,000 for the year ended December 31, 2015. This decrease was primarily due to an approximate $88,000 gain recorded for the sale of collateral from a subsidiary investment in 2015. Non-Interest Expenses. Total non-interest expense decreased $678,000, or 2.7%, to $24,084,000 for the year ended December 31, 2016 compared to $24,762,000 for the year ended December 31, 2015. Compensation and related expenses decreased $205,000, or 1.3%, to $15,425,000 for the year ended December 31, 2016, compared to $15,630,000 for the year ended December 31, 2015. This decrease was due to the departure of certain employees in 2016 and a decrease in commissions on real estate loan originations. As of December 31, 2016, the Company had 142 full-time equivalent employees compared to 152 at December 31, 2015. Occupancy expense increased $182,000, or 10.9%, to $1,858,000 for the year ended December 31, 2016, compared to $1,676,000 for the year ended December 31, 2015. This increase was primarily due to the costs of opening a new branch in Severna Park during the fall of 2016. Foreclosed real estate expenses, net decreased $36,000, or 15.7%, to $194,000 for the year ended December 31, 2016, compared to $230,000 for the year ended December 31, 2015. This decrease was primarily due to $145,000 of recoveries on write-downs and other expenses on REO properties sold in prior years. Included in expenses for 2016 were write-downs of approximately $218,000 and other expenses of approximately $162,000, partially offset by net gains on sale of REO of approximately $42,000. Legal fees decreased $90,000, or 25.4%, to $264,000 for the year ended December 31, 2016, compared to $354,000 the year ended December 31, 2015. This decrease was primarily due to reduced use of attorneys in 2016 compared to 2015. The FDIC and regulatory assessment decreased $652,000, or 52.8%, to $582,000 for the year ended December 31, 2016, compared to $1,234,000 for the year ended December 31, 2015. This decrease was primarily the result of a lower FDIC calculation assessment in 2016 due to the termination of the Supervisory Agreements with the OCC and Federal Reserve Bank. 52 Table of Contents Professional fees increased $18,000, or 2.0%, to $905,000 for the year ended December 31, 2016, compared to $887,000 for the year ended December 31, 2015. This increase was primarily the result of an increase in accounting fees, partially offset by a decrease in consulting fees for loan reviews, marketing and loan workouts in 2016 compared to 2015. Advertising expenses decreased $57,000, or 7.5%, to $703,000 for the year ended December 31, 2016, compared to $760,000 for the year ended December 31, 2015. This decrease was primarily due to the decrease in promoting, printing, and the advertising of products offered by the Company. Data processing charges decreased $117,000, or 13.5%, to $747,000 for the year ended December 31, 2016, compared to $864,000 for the year ended December 31, 2015. This decrease was due to cost savings realized by a renegotiated contract for core processing in late 2014. Mortgage leads acquired decreased by $126,000, or 15.1% to $710,000 as of December 31, 2016, compared to $836,000 as of December 31, 2015. The decrease is due to the Bank relying less on purchasing leads and focusing more on direct mortgage loan originations. Credit report and appraisal fees decreased $122,000, or 15.8%, to $651,000 for the year ended December 31, 2016, compared to $773,000 for the year ended December 31, 2015. This decrease was due to a lower level of appraisals ordered in 2016. Other non-interest expense increased $527,000, or 34.7%, to $2,045,000 for the year ended December 31, 2016, compared to $1,518,000 for the year ended December 31, 2015. This increase was primarily the result of a decrease in fair value of interest rate lock commitments and mandatory forward contracts in 2016, compared to 2015, a reduction of the reserves required on the standby letters of credit in 2016, an increase in bank service charge, savings account losses, office expense, stock expense and other loan fee expense. Income Taxes. Income taxes provision decreased $10,104,000, to a benefit of $(10,014,000) for the year ended December 31, 2016, compared to a provision of $90,000 for the year ended December 31, 2015. This decrease in income taxes was primarily due to a non-recurring income tax benefit of $11,837,000, resulting from a reversal of a net deferred tax asset valuation allowance which was recorded in the second quarter of 2016. Liquidity and Capital Resources In 2016, the Company’s sources of liquidity were loan repayments, maturing investments, deposits, borrowed funds, and proceeds from loans sold on the secondary market. The Company considers core deposits stable funding sources and includes all deposits, except time deposits of $100,000 or more. The Bank’s experience has been that a substantial portion of certificates of deposit renew at time of maturity and remain on deposit with the Bank. Additionally, loan payments, maturities, deposit growth and earnings contributed to the Company’s flow of funds. In addition to its ability to generate deposits, the Company has external sources of funds, which may be drawn upon when desired. The primary source of external liquidity is an available line of credit with the FHLB-Atlanta. The Bank’s credit availability under the FHLB of Atlanta’s credit availability program was $232,193,000 at December 31, 2016, of which $100,000,000 was outstanding. The Bank’s credit availability is based on the level of collateral pledged up to 30% of total assets. The maturities of these long-term advances at December 31, 2016 were as follows (dollars in thousands): Rate 2.43% to 4.05% $ 2.58% to 3.43% 4.00% $ Amount 70,000 15,000 15,000 100,000 Maturity 2017 2018 2019 As of December 31, 2016, the Company had outstanding $20,619,000 in principal amount of subordinated debt, consisting of the 2035 Debentures. The 2035 Debentures total $20,619,000 in principal amount which pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.88% at December 31, 2016) plus 200 basis points, and matures on January 7, 2035. 53 Table of Contents The Subordinated Notes that totaled $3,500,000 and paid interest at an annual rate of 8.0%, were paid off on September 30, 2016 and replaced with a loan from a commercial bank whereby the Company borrowed $3,500,000 for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Company, converts to either (1) floating rate of the Wall Street Journal Prime plus .50% or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing Federal Home Loan Bank rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If the Bancorp elects the 5 year fixed rate of 275 basis points over the Federal Home Loan Bank rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth and fifth years of the FHLB Rate Period. The Company may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period. As of December 31, 2016, the Company had $574,000 outstanding in mortgage loan commitments, and unadvanced construction commitments of $15,728,000 which the Company expects to fund from the sources of liquidity described above. These amounts do not include undisbursed lines of credit, home equity lines of credit and standby letters of credit, in the aggregate amount of $45,883,000 at December 31, 2016, which the Company anticipates it will be able to fund, if required, from these liquidity sources in the regular course of business. In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on liquidity. As of December 31, 2016, the Company had no material commitments for capital expenditures. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. As of December 31, 2016, that the Bank exceeded all capital adequacy requirements to which it is subject and is considered well-capitalized as shown in the table on Page 26. We anticipate that our primary sources of liquidity in fiscal 2017 will be from loan repayments, maturing investments, deposit growth and borrowed funds. We believe that these sources of liquidity will be sufficient for the Company to meet its liquidity needs over the next twelve months. Cash generated from these liquidity sources may be affected by a number of factors. See “Risk Factors” for a discussion of the factors that can negatively impact the amount of cash we could receive. Off-Balance Sheet Arrangements . The Company has certain outstanding commitments and obligations that could impact the Company’s financial condition, liquidity, revenues or expenses. These commitments and obligations include standby letters of credit, home equity lines of credit, loan commitments, lines of credit, and loans sold and serviced with limited repurchase provisions. Standby letters of credit, which are conditional commitments of the Company to guarantee performance of customers to various municipalities, decreased $1,915,000, or 32.3%, as of December 31, 2016 to $4,022,000, compared to $5,937,000 as of December 31, 2015. The Company continues to experience a decrease in demand from its customers for letter of credit requirements. The Company requires collateral supporting these letters of credit as deemed necessary, and 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 for guarantees under standby letters of credit issued as of December 31, 2016 and 2015 was $94,000 and $115,000, respectively. 54 Table of Contents Unadvanced construction commitments decreased $5,373,000, or 25.5%, as of December 31, 2016 to $15,728,000, compared to $21,101,000 as of December 31, 2015. This decrease was primarily the result of decreased construction activity in 2016 and the resulting lower level of new construction loan originations. Home equity lines of credit increased $269,000, or 3.6%, as of December 31, 2016 to $7,736,000, compared to $7,467,000 as of December 31, 2015. Home equity lines of credit allow the borrowers to draw funds up to a specified loan amount, from time to time. The Company’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans. Mortgage loan commitments decreased $2,659,000, or 82.2%, as of December 31, 2016 to $574,000, compared to $3,233,000 as of December 31, 2015. This decrease was primarily due to the timing of loan commitments at year end. Loan commitments are obligations of the Company to provide loans, and such commitments are made in the usual course of business, however, these obligations can and do fluctuate based on the timing of when new loans are entered into. Lines of credit, which are obligations of the Company to fund loans made to certain borrowers, increased $6,936,000, or 25.5%, to $34,125,000 as of December 31, 2016, compared to $27,189,000 as of December 31, 2015. The increase was a result of a higher demand for this type of loan product during 2016. The Company’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans. Loans sold and serviced with limited repurchase provisions increased $5,666,000, or 8.7%, to $70,773,000 as of December 31, 2016, compared to $65,107,000 as of December 31, 2015. This increase was primarily due to an increase in demand for new residential loans originated for sale on the secondary market in 2016 and management’s decision to sell a larger portion of the new loan originations with servicing retained by the Company. Generally, loans are sold with servicing released, however loans sold to FHLMC or FNMA servicing has been retained. The Company uses the same credit policies in making commitments and conditional obligations as it does for its on-balance sheet instruments. Except for the liability recorded for standby letters of credit at December 31, 2016, liabilities for credit losses associated with these commitments were not material at December 31, 2016 and 2015. Contractual Obligations The following table contains, for the periods indicated, information regarding the financial obligations owing by the Company under contractual obligations. Long-term borrowings Subordinated debentures Operating lease obligations Certificates of Deposit Payments due by period (dollars in thousands) Total Less than 1 year 1 to 3 years More than 3 to 5 years More than 5 years $ 100,000 $ 70,000 $ 30,000 $ 20,619 - - - $ - 1,545 242 450 320 273,816 169,331 56,508 46,982 - 20,619 533 995 Total $ 395,980 $ 239,573 $ 86,958 $ 47,302 $ 22,147 55 Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk The principal objective of the Company’s interest rate risk management is to evaluate the interest rate risk included in balance sheet accounts, determine the level of risks appropriate given the Company’s business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the Company’s interest rate risk management policy. Through this management, the Company seeks to reduce the vulnerability of its operations to changes in interest rates. The Board of Directors of the Company is responsible for reviewing assets/liability policies and interest rate risk position. The Board of Directors reviews the interest rate risk position on a quarterly basis and, in connection with this review, evaluates the Company’s business activities and strategies, the effect of those strategies on the Company’s net interest margin and the effect that changes in interest rates will have on the Company’s loan portfolio. While continuous movement of interest rates is certain, the extent and timing of these movements is not always predictable. Any movement in interest rates has an effect on the Company’s profitability. The Company faces the risk that rising interest rates could cause the cost of interest bearing liabilities, such as deposits and borrowings, to rise faster than the yield on interest earning assets, such as loans and investments. The Company’s interest rate spread and interest rate margin also may be negatively impacted in a declining interest rate environment even though the Company generally borrows at short-term interest rates and lends at longer-term interest rates. This is because loans and other interest earning assets may be prepaid and replaced with lower yielding assets before the supporting interest bearing liabilities reprice downward. The Company’s interest rate margin may also be negatively impacted in a flat or inverse-yield curve environment. Mortgage origination activity tends to increase when interest rates trend lower and decrease when interest rates rise. The Company’s primary strategy to control interest rate risk is to sell substantially all long-term fixed-rate loans in the secondary market. The Company did retain a higher amount of certain loans, including residential mortgages with floating rates, but these loans typically have interest rates that reset after a period of three to seven years. To further control interest rate risk related to its loan portfolio, the Company originates construction loans that typically have terms of one year or less. The turnover in construction loan portfolio assists the Company in maintaining a reasonable level of interest rate risk. The primary market risk facing the Company is interest rate risk. From an enterprise prospective, the Company manages this risk by striving to balance its loan origination activities with the interest rate market. The Company attempts to maintain a substantial portion of its loan portfolio in short-term loans such as construction loans. This has proven to be an effective hedge against rapid increases in interest rates as the construction loan portfolio reprices rapidly. The matching of maturity or repricing of interest earning assets and interest bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring the Bank’s interest rate sensitivity gap. An interest earning asset or interest bearing liability is interest rate sensitive within a specific time period if it will mature or reprice within that time period. The difference between rate sensitive assets and rate sensitive liabilities represents the Bank’s interest sensitivity gap. Exposure to interest rate risk is actively monitored by the Company’s management. Its objective is to maintain a consistent level of profitability within acceptable risk tolerances across a broad range of potential interest rate environments . The Company uses the BankersGPS model to monitor its exposure to interest rate risk, which calculates changes in the economic value of equity (“EVE”). The following table represents the Company’s EVE at December 31, 2016. 56 Table of Contents ECONOMIC VALUE OF EQUITY (EVE) Change In Rates Economic Value of Equity $ Amount (dollars in thousands) $ Change % Change +400bp +300bp +200bp +100bp 0bp -100bp -200bp -300bp -400bp 94,969 97,482 100,764 104,973 110,058 116,076 123,169 131,635 141,638 (15,089) (12,576) (9,294) (5,085) 6,018 13,111 21,577 31,580 (13.7)% (11.4)% (8.4)% (4.6)% 5.5% 11.9% 19.6% 28.7% The above table suggests that if interest rates rise 100 basis points, the Company’s value of equity would decrease by $5,085,000. The preceding income simulation analysis does not represent a forecast of actual results and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, which are subject to change, including: the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. Also, as market conditions vary, prepayment/refinancing levels, the varying impact of interest rate changes on caps and floors embedded in adjustable-rate loans, early withdrawal of deposits, changes in product preferences, and other internal/external variables will likely deviate from those assumed. Item 8. Financial Statements and Supplementary Data Financial statements and supplementary data are included herein at pages F-1 through F-58, and incorporated herein by reference. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Disclosure Controls and Procedures, Under the supervision and with the participation of the Company's management, including its Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its disclosure controls and procedures as of December 31, 2016. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the period covered by this report, the Company’s disclosure controls and procedures were effective in reaching a reasonable level of assurance that (i) information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) information required to be disclosed by the Company in its reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to its management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. The Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company’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 December 31, 2016, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Based on that evaluation, there was no such change during the quarter ended December 31, 2016. 57 Table of Contents 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 the Company 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. Management’s Report on Internal Control over Financial Reporting The Company is responsible for the preparation, integrity, and fair presentation of the consolidated financial statements included in this annual report. The consolidated financial statements and notes included in this annual report have been prepared in conformity with accounting principles generally accepted in the United States of America, and as such, include some amounts that are based on management’s best estimates and judgments. The Company’s management is responsible for establishing and maintaining effective internal control over financial reporting. The system of internal control over financial reporting, as it relates to the consolidated financial statements, is evaluated for effectiveness by management and tested for reliability through a program of internal audits and management testing and review. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework 2013 . Based on its assessment, management concluded that as of December 31, 2016, the Company’s internal control over financial reporting is effective and meets the criteria of the Internal Control – Integrated Framework . This Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to a provision of the Dodd-Frank Act which eliminates such requirement for “smaller reporting companies”, as defined in SEC regulations. Item 9B. Other Information None. PART III Item 10. Directors, Executive Officers and Corporate Governance Paul B. Susie, age 50, joined the Company in July 2016 and currently serves as Executive Vice President and Chief Financial Officer. Mr. Susie brings to Severn a strong background and many years of experience in financial management and banking in particular. He previously held the position of Chief Financial Officer at Hopkins Federal Savings Bank and 1st Mariner Bank. He has also held financial executive positions in biopharmaceutical, manufacturing and marine companies. Mr. Susie has passed the CPA Exam, is a member of the American Institute of Certified Public Accountants and is a Chartered Global Management Accountant. He received his Bachelor of Science in Accounting from the University of Baltimore. Christopher A. Chick, age 49, joined the Company in 2015 as Executive Vice President and Chief Lending Officer. Mr. Chick has over 26 years in the banking industry. Prior to joining the Company, Mr. Chick held various management positions at Susquehanna Bank and was a Bank Examiner with the Office of Thrift Supervision. Mr. Chick is a graduate of the University of Baltimore where he received his Master of Finance. He is also a graduate of the Maryland Bankers Association, Executive School of Bank Management. Mr. Chick has been recognized within the industry with various awards including Next Leader in Banking, Maryland Bankers Association and Top Banker Award, Smart CEO. 58 Table of Contents Information concerning Alan J. Hyatt will be contained in the proxy statement for the 2017 Annual Meeting of Shareholders. The additional information required by this item will be included in the Company’s definitive Proxy Statement relating to the 2017 Annual Stockholders Meeting (“Proxy Statement”), which the Company intends to file with the Securities and Exchange Commission within 120 days after December 31, 2016, and is incorporated herein by reference. The Company has adopted a code of ethics that applies to its employees, including its chief executive officer, chief financial officer, and persons performing similar functions and directors. A copy of the code of ethics is filed as an exhibit to the Company’s Form 10-K for the year ended December 31, 2003, which was filed with the Securities and Exchange Commission on March 25, 2004. The Company intends to satisfy the disclosure requirement under Item 10 of Form 8-K regarding any future amendments to a provision of its code of ethics by posting such information on the Company’s website: www.severnbank.com. Item 11. Executive Compensation The information required by this item will be included in the Company’s Proxy Statement, which the Company intends to file with the Securities and Exchange Commission within 120 days after December 31, 2016, and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The following table provides certain information as of December 31, 2016 with respect to the Company’s equity based compensation plans. Plan Category Equity compensation plan approved by security holders Equity compensation plans not approved by security holders Total Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted-average exercise price of outstanding options, warrants and rights Number of securities remaining available for future issuance under equity compensation plans 339,500 $ - 339,500 $ 5.31 - 5.31 242,001 - 242,001 The additional information required by this item will be included in the Company’s Proxy Statement, which the Company intends to file with the Securities and Exchange Commission within 120 days after December 31, 2016, and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this item will be included in the Company’s Proxy Statement, which the Company intends to file with the Securities and Exchange Commission with 120 days after December 31, 2016, and is incorporated herein by reference. 59 Table of Contents Item 14. Principal Accounting Fees and Services The information required by this item will be included in the Company’s Proxy Statement, which the Company intends to file with the Securities and Exchange Commission with 120 days after December 31, 2016, and is incorporated herein by reference. Item 15. Exhibits, Financial Statement Schedules PART IV (a) The following consolidated financial statements of the Company and its wholly owned sub-sidiaries are filed as part of this report: 1. Financial Statements · · · · · · Report of BDO USA, LLP, independent registered public accounting firm. Consolidated statements of financial condition at December 31, 2016 and December 31, 2015 Consolidated statements of income for the years ended December 31, 2016 and 2015, Consolidated statements of stockholders’ equity for the years ended December 31, 2016 and 2015 Consolidated statements of cash flows for the years ended December 31, 2016 and 2015 Notes to consolidated financial statements 2. 3. Exhibit No. 3.1 3.2 4.1 4.2 10.1+ 10.2+ 10.3+ 10.4+ 10.5+ 10.6 10.7 10.8 10.9 10.10+ 10.11+ 10.12 14.1 21.1* 23.1* 31.1* 31.2* 32 * 101* Financial Statement Schedules All financial statement schedules have been omitted, as required information is either inapplicable or included in the consolidated financial statements or related notes. Exhibits The following exhibits are filed as part of this report: Description of Exhibit Articles of Incorporation of Severn Bancorp, Inc., as amended (1) Bylaws of Severn Bancorp, Inc., as amended (2) Warrant for Purchase of Shares of Common Stock (3) Form of Common Stock Certificate Stock Option Plan (4) Employee Stock Ownership Plan (5) Form of Common Stock Option Agreement (6) 2008 Equity Incentive Plan (7) Form of Subscription Agreement (8) Form of Subordinated Note (8) Purchase Agreement, dated November 21, 2008, between the Company and the United States Department of the Treasury (3) Supervisory Agreement dated November 23, 2009 between Severn Savings Bank, FSB and the OTS (9) Supervisory Agreement dated November 23, 2009 between Severn Bancorp, Inc. and the OTS (9) Form of Director Option Award (10) Form of Employee Option Award (10) Formal Agreement between Severn Savings Bank, FSB and the Office of the Comptroller of the Currency, dated April 23, 2013. (11) Code of Ethics (12) Subsidiaries of Severn Bancorp, Inc. Consent of BDO USA, LLP Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002 Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002 Certification of CEO and CFO pursuant to Section 906 of Sarbanes-Oxley Act of 2002 The following financial statements from Severn Bancorp, Inc. Annual Report on Form 10-K as of December 31, 2016, 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; (iv) the Consolidated Statements of Cash Flows; and (v) the Notes to Consolidated Financial Statements. 60 Table of Contents + Denotes management contract, compensatory plan or arrangement. * Filed herewith. (1) Incorporated by reference from the Company’s Annual Report on Form 10-K for fiscal year ended December 31, 2008 and filed with the Securities and Exchange Commission on March 11, 2009. (2) Incorporated by reference from the Company’s Annual Report on Form 10-K for fiscal year ended December 31, 2007 and filed with Securities and Exchange Commission on March 12, 2008. (3) Incorporated by reference from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on November 24, 2008. (4) Incorporated by reference from the Company's Annual Report on Form 10-K for fiscal year ended December 31, 2004 and filed with the Securities and Exchange Commission on March 21, 2005. (5) Incorporated by reference from the Company's Registration Statement on Form 10 filed with the Securities and Exchange Commission on June 7, 2002. (6) Incorporated by reference from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on March 20, 2006. (7) Incorporated by reference from the Company’s 2008 Proxy Statement filed with Securities and Exchange Commission on March 12, 2008. (8) Incorporated by reference from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on November 18, 2008. (9) Incorporated by reference from the Company's Annual Report on Form 10-K for fiscal year ended December 31, 2009 and filed with the Securities and Exchange Commission on March 15, 2010. (10) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 and filed with the Securities and Exchange Commission on August 13, 2010. (11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2013 and filed with the Securities and Exchange Commission on May 8, 2013. (12) Incorporated by reference from the Company's Annual Report on Form 10-K for fiscal year ended December 31, 2003 and filed with the Securities and Exchange Commission on March 25, 2004. Item 16. Form 10-K Summary None . 61 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 22, 2017 SEVERN BANCORP, INC. /s/ Alan J. Hyatt Alan J. Hyatt Chairman of the Board, President, Chief Executive Officer and Director 62 Table of Contents Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 March 22, 2017 /s / Alan J. Hyatt Alan J. Hyatt Chairman of the Board, President, Chief Executive Officer and Director /s/ Paul B. Susie Paul B. Susie, Executive Vice President, and Chief Financial Officer /s/ Konrad M. Wayson Konrad M. Wayson, Director Vice Chairman of the Board /s/ Raymond S. Crosby Raymond S. Crosby, Director / s / James H. Johnson, Jr. James H. Johnson, Jr., Director /s/ David S. Jones David S. Jones, Director / s / Eric M. Keitz Eric M. Keitz, Director /s/ John A. Lamon III John A. Lamon III, Director /s/ Albert W. Shields Albert W. Shields, Director /s/ Mary Kathleen Sulick Mary Kathleen Sulick, Director 63 Table of Contents Board of Directors and Stockholders Severn Bancorp, Inc. Report of Independent Registered Public Accounting Firm We have audited the accompanying consolidated statements of financial condition of Severn Bancorp, Inc. and Subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of income, stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Severn Bancorp, Inc. and Subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. /s/BDO USA, LLP Harrisburg, Pennsylvania March 22, 2017 F-1 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (dollars in thousands, except per share data) Cash and due from banks Interest bearing deposits in other banks Federal Funds Sold Cash and cash equivalents ASSETS $ Investment securities held to maturity (fair value: $62,827 at December 31, 2016; $76,310 at December 31, 2015) Loans held for sale Loans receivable, net of allowance for loan losses of $8,969 and $8,758 in 2016 and 2015, respectively Premises and equipment, net Foreclosed real estate Federal Home Loan Bank stock, at cost Net deferred income taxes Accrued interest receivable and other assets December 31, 2016 2015 39,396 $ 22,192 5,526 67,114 62,757 10,307 601,309 24,030 973 4,933 10,081 5,981 28,366 15,225 - 43,591 76,133 13,203 589,656 24,290 1,744 5,626 - 7,836 Total assets $ 787,485 $ 762,079 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Deposits Long-term borrowings Subordinated debentures Accrued interest payable and other liabilities Total Liabilities 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 December 31, 2016 and December 31, 2015 Preferred stock series “B”, 0 and 23,393 shares issued and outstanding; and $0 and $23,393 liquidation preference, respectively Common stock, $0.01 par value, 20,000,000 shares authorized; 12,123,179 and 10,088,879 shares issued and outstanding, respectively Additional paid-in capital Retained earnings Total stockholders' equity $ 571,946 $ 103,500 20,619 3,490 523,771 115,000 24,119 12,733 699,555 675,623 4 - 4 - 121 63,960 23,845 101 76,335 10,016 87,930 86,456 Total liabilities and stockholders' equity $ 787,485 $ 762,079 The accompanying notes to consolidated financial statements are an integral part of these statements. F-2 SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland CONSOLIDATED STATEMENTS OF INCOME (dollars in thousands, except per share data) Table of Contents Interest Income Loans, including fees Securities, taxable Other Total interest income Interest Expense Deposits Borrowings and subordinated debentures Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Non-Interest Income Mortgage banking activities Real estate commissions Real estate management fees Other Total non-interest income Non-Interest Expenses Compensation and related expenses Occupancy Foreclosed real estate expenses, net Legal FDIC assessments and regulatory expense Professional fees Advertising Data processing Mortgage leads purchased Credit reports and appraisal fees Other Total non-interest expenses Income before income tax (benefit) provision Income tax (benefit) provision Net income Amortization of discount on preferred stock Dividends on preferred stock Net income available to common stockholders Basic income per common share Diluted income per common share Years Ended December 31, 2016 2015 $ $ $ $ 29,262 $ 1,149 339 30,750 4,033 4,528 8,561 22,189 (350) 22,539 3,654 1,529 738 1,150 7,071 15,425 1,858 194 264 582 905 703 747 710 651 2,045 24,084 5,526 (10,014) 15,540 270 1,441 13,829 $ 1.20 $ 1.19 $ 29,734 1,104 315 31,153 4,050 4,942 8,992 22,161 (280) 22,441 3,764 1,319 658 1,205 6,946 15,630 1,676 230 354 1,234 887 760 864 836 773 1,518 24,762 4,625 90 4,535 271 2,105 2,159 0.21 0.21 The accompanying notes to consolidated financial statements are an integral part of these statement s. F-3 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 2016 and 2015 (dollars in thousands, except per share data) Preferred Stock Common Stock Additional Paid-In Capital Retained Earnings Total Stockholders’ Equity Balance - December 31, 2014 $ 4 $ 101 $ 75,848 $ 7,857 $ 83,810 Net Income Stock-based compensation Dividend declared on Series B preferred stock Amortization of discount on Series B preferred stock Exercised Options (21,500 shares) Balance - December 31, 2015 Net Income Stock issuance (2,015,500 shares) net of expenses of $575 Stock-based compensation Dividend declared on Series A preferred stock Stock redemption on Series B preferred stock (23,393 shares) Dividend declared on Series B preferred stock Amortization of discount on Series B preferred stock Exercised Options (18,800 shares) - - - - - 4 - - - - - - - - - - - - 101 - 20 - - - - - - 120 - 271 96 76,335 - 10,490 184 - (23,393) - 270 74 4,535 - (2,105) (271) - 10,016 15,540 - - (210) - (1,231) (270) - 4,535 120 (2,105) - 96 86,456 15,540 10,510 184 (210) (23,393) (1,231) - 74 Balance - December 31, 2016 $ 4 $ 121 $ 63,960 $ 23,845 $ 87,930 The accompanying notes to consolidated financial statements are an integral part of these statements. F-4 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland CONSOLIDATED STATEMENTS OF CASH FLOWS (dollars in thousands) Cash Flows from Operating Activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deferred loan fees Net amortization of premiums and Discounts Provision for loan losses Provision for depreciation Provision for foreclosed real estate Gain on sale of loans Gain on sale of foreclosed real estate Proceeds from loans sold to others Loans originated for sale Stock-based compensation expense Deferred income tax benefit Decrease in accrued interest receivable and other assets (Decrease) increase in accrued interest payable and other liabilities Net cash provided by operating activities Cash Flows from Investing Activities Purchase of investment securities held to maturity Proceeds from maturing investment securities held to Maturity Principal collected on mortgage-backed securities held to Maturity Net (increase) decrease in loans Proceeds from sale of foreclosed real estate Investment in premises and equipment Redemption of FHLB stock Net cash provided by investing activities F-5 Years Ended December 31, 2016 2015 $ 15,540 $ 4,535 (1,330) 412 (350) 1,164 218 (3,654) (42) 153,644 (147,094) 184 (10,081) 1 ,854 (2,844) (1,283) 458 (280) 1,137 58 (2,927) (49) 160,236 (163,347) 120 - 1,452 1,043 7,621 1,153 (3,562) 10,000 6,526 (11,548) 2,170 (903) 693 (27,830) 7,000 3,855 43,555 2,428 (268) 310 3,376 29,050 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (dollars in thousands) Cash Flows from Financing Activities Net increase (decrease) in deposits Additional borrowed funds, long term Repayment of borrowed funds, long term Series A preferred stock dividends Series B preferred stock dividends Stock redemption of Series B preferred stock Net proceeds from common stock issuance Proceeds from exercise of options Net cash provided by (used in) financing activities Increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosure of cash flows information: Cash (received) paid during year for: Interest Income taxes Transfer of net loans to foreclosed real estate Years Ended December 31, 2016 2015 $ 48,175 $ 3,500 (18,500) (210) (7,630) (23,393) 10,510 74 (20,043) - - - - - 96 12,526 (19,947) 23,523 43,591 10,256 33,335 $ 67,114 $ 43,591 $ $ $ 11,160 $ 7,991 (1,457) $ (273) 1,575 $ 2,234 The accompanying notes to consolidated financial statements are an integral part of these statements. F-6 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies A. B. C. D. Principles of Consolidation - The consolidated financial statements include the accounts of Severn Bancorp, Inc. (the "Company"), and its wholly-owned subsidiaries, SBI Mortgage Company and SBI Mortgage Company's subsidiary, Crownsville Development Corporation, and its subsidiary, Crownsville Holdings I, LLC, Severn Mortgage Company, 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. Business - The Bank's primary business activity is the acceptance of deposits from the general public and the use of the proceeds for investments and loan originations. The Bank is subject to competition from other financial institutions. In addition, the Bank is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities. The Company has no reportable segments. Management does not separately allocate expenses, including the cost of funding loan demand, between the retail and real estate operations of the Company. As such, discrete financial information is not available and segment reporting would not be meaningful. Estimates - The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the fair value of foreclosed real estate, the evaluation of other than temporary impairment of investment securities and the valuation allowance of deferred tax assets. Investment Securities Held to Maturity – Investment securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Declines in the fair value of held to maturity securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer and (3) determines if the Bank does not intend to sell the security before recovery of its amortized cost. F-7 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies - Continued E. F. G. H. Federal Home Loan Bank Stock – Federal Home Loan Bank of Atlanta (the “FHLB”) stock is an equity interest in the FHLB, which does not have a readily determinable fair value for purposes of generally accepted accounting principles, because its ownership is restricted and it lacks a market. FHLB stock can be sold back only at par value of $100 per share and only to the FHLB or another member institution. As of December 31, 2016 and 2015, the Bank owned shares totaling $4,933,000 and $5,626,000, respectively. The Bank evaluated the FHLB stock for impairment in accordance with generally accepted accounting principles. The Bank’s determination of whether this investment is impaired is based on an assessment of the ultimate recoverability of its cost rather than by recognizing temporary declines in value. The determination of whether a decline in value affects the ultimate recoverability of its cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, (3) the impact of legislative and regulatory changes on institutions and accordingly on the customer base of the FHLB, and (4) the liquidity position of the FHLB. Management has evaluated the FHLB stock for impairment and believes that no impairment charge is necessary as of December 31, 2016. Loans Held for Sale - Loans held for sale are carried at cost. Derivative Financial Instruments – The Bank enters into commitments to fund residential loans with intentions of selling them in the secondary market. The Bank also enters into forward sales agreements for certain funded loans and loan commitments. The Bank records unfunded commitments intended for loans held for sale and forward sale agreements at fair value with changes in fair value recorded as a component of other income. Loans originated and intended for sale in the secondary market are carried at cost. Loan Servicing - Loans serviced for others and not included in the accompanying consolidated statements of financial condition totaled $75,227,000 and $76,460,000 at December 31, 2016 and 2015, respectively. As of December 31, 2016, the Bank was servicing $18,288,000 in loans for Federal Home Loan Mortgage Corporation (“FHLMC”), $39,095,000 in loans for Federal National Mortgage Association (“FNMA”) and $17,844,000 in loans for other investors. The value of the related mortgage servicing rights totaled $557,000 and $623,000 at December 31, 2016 and 2015, respectively, and are included in other assets Mortgage loans held for sale are sold either with the mortgage servicing rights released or retained by the Bank. Gains and losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying values of the loan servicing rights, if retained, and related mortgage loans sold. F-8 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies - Continued I. Loans - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs related to originating the loans. The Bank categorizes the loans into eight classifications: residential mortgage; construction; land acquisition and development; land; lines of credit; commercial real estate; commercial non-real estate; home equity; and consumer. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. Residential lending is generally considered to involve less risk than other forms of lending, although payment experience on these loans is dependent to some extent on economic and market conditions in the Bank's lending area. Multifamily residential, commercial, construction and other loan repayments are generally dependent on the operations of the related properties or the financial condition of its borrower or guarantor. Accordingly, repayment of such loans can be more susceptible to adverse conditions in the real estate market and the regional economy. A substantial portion of the Bank's loans receivable is mortgage loans secured by residential and commercial real estate properties located in the State of Maryland. Loans are extended only after evaluation by management of customers' creditworthiness and other relevant factors on a case-by-case basis. The Bank generally does not lend more than 80% of the appraised value of a property and requires private mortgage insurance on residential mortgages with loan-to-value ratios in excess of 80%. In addition, the Bank generally obtains personal guarantees of repayment from borrowers and/or others for construction, commercial and multifamily residential loans and disburses the proceeds of construction and similar loans only as work progresses on the related projects. The 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 in the current year, but not collected for loans that are placed on non-accrual or charged-off, is reversed against interest income. Any interest accrued in prior years for loans that are placed on non-accrual or charged-off is charged against the allowance for loan losses. If a loan meets a certain criteria, it may be 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 all doubt related to the collection of the full amount due has been removed. F-9 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued J. Allowance for Loan Losses - The allowance for loan losses is maintained at 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 generally accepted accounting principles. Actual results could differ significantly from those estimates. Future additions or reduction in the allowance may be necessary based on changes in economic conditions, particularly in the State of Maryland. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance consists of specific 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. 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 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. 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; F-10 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued · · · Experience, ability and depth of management; National and local economic trends and conditions; and Effect of any changes in concentration of credit. A loan is generally considered impaired if it meets any of the following 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; or Loans that are troubled debt restructurings. The Bank assigns risk ratings to the loans in its portfolio, These 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. 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. K . Foreclosed Real Estate - Real estate acquired through or in the process of foreclosure is recorded at fair value less estimated disposal costs. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using estimates as described under the caption "Allowance for Loan Losses". In the event of a subsequent change in fair value, the carrying amount is adjusted to the new fair value, less disposal costs. The amount of the change is charged or credited to other expense. Expenses on foreclosed real estate incurred prior to the disposition of the property, such as maintenance, insurance and taxes, and physical security, are charged to expense. Material expenses that improve the property to its best use are capitalized to the property. If a foreclosed property is sold for more or less than the carrying value, a gain or losses is recognized upon the sale of the property. F-11 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued L. M. N. O. Transfers of Financial Assets – Transfers of financial assets, including loan and loan participation sales, are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from The Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) The Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return the specific assets. Premises and Equipment - Premises and equipment are carried at cost less accumulated depreciation. Depreciation and amortization of premises and equipment is accumulated by the use of the straight-line method over the estimated useful lives of the assets. Additions and improvements are capitalized, and charges for repairs and maintenance are expensed when incurred. The related cost and accumulated depreciation are eliminated from the accounts when an asset is sold or retired and the resultant gain or loss is credited or charged to income. Statement of Cash Flows - In the statement of cash flows, cash and cash equivalents include cash on hand, amounts due from banks, Federal Home Loan Bank of Atlanta overnight deposits, and federal funds sold. Generally, federal funds are sold for one day periods. Income Taxes - Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities based on enacted tax rates expected to be in effect when such amounts are realized or settled. Deferred tax assets are recognized only to the extent that it is more likely than not that such amount will be realized based on consideration of available evidence. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. To the extent that current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. The Company recognizes a tax position as a benefit only if it “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination presumed to occur. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The judgment about the level of future taxable income is inherently subjective and is reviewed on a continual basis as regulatory and business factors change. The Company recognizes interest and penalties on income taxes as a component of income tax expense. F-12 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued P. Q. R. Earnings Per Common Share - Basic earnings per share of common stock for the years ended December 31, 2016 and 2015 is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for each year. 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 the Company 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 years ended December 31, 2016 and 2015, because they were anti- dilutive, were shares of common stock issuable upon exercise of outstanding stock options totaling 94,000 and 151,500, respectively, 556,976 shares of common stock issuable upon the exercise of a warrant and 437,500 shares of common stock issuable upon conversion of the Company’s Series A preferred stock. Common shares – weighted average (basic) Common share equivalents – weighted average Common shares – weighted average (diluted) Year Ended December 31, 2016 11,522,333 52,559 11,547,892 2015 10,083,942 28,711 10,112,653 Advertising Cost - Advertising cost is expensed as incurred and totaled $703,000, and $760,000 for the years ended December 31, 2016, and 2015, respectively. Troubled Debt Restructuring – Loans are classified as troubled debt restructurings if the Bank grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a troubled debt restructuring may include extending the maturity date of the loan, reducing the interest rate on the loan to a rate below market, a combination of rate adjustments and maturity extensions, or by other means including covenant modifications, forbearances or other concessions. Loans that are classified as troubled debt restructurings, or TDRs, are considered impaired. F-13 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued S . T. U. Significant Group Concentrations of Credit Risk – Most of the Company’s activities are with customers located in Anne Arundel County, Maryland and nearby areas. Note 2, of the Notes to Consolidated Financial Statements discusses the types of securities that the Company currently invests in. Note 3 discusses the types of lending that the Company engages in. Although the Company intends to have a diversified loan portfolio, its debtors’ ability to honor their contracts will be influenced by the region’s economy. The Company does not have any significant concentrations to any one customer. The Company’s investment portfolio consists principally of obligations of the United States and its agencies. In the opinion of management, there is no concentration of credit risk in its investment portfolio. The Company places deposits in correspondent accounts and, on occasion, sells Federal funds to qualified financial institutions. Management believes credit risk associated with correspondent accounts is not significant. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk. Off-Balance Sheet Financial Instruments – In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit. Such financial instruments are recorded in the consolidated balance sheet at fair value with changes in fair value recorded as a component of other income. Recent Accounting Pronouncements – 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 principle 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, 2017. Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim periods within that year. The Company is still in the process of evaluating the effect that ASU 2014-09, as augmented by subsequent modifying pronouncements, will have on the Consolidated Financial Statements. Under ASU 2016-01, Amendment to the Recognition and Measurement Guidance for Financial Instruments, an entity is required to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in Other Comprehensive Income the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of Available For Sale debt securities in combination with other deferred tax assets. The Amendment provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes. The Amendment also requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements. The new standard takes effect in 2018 for public companies. Early adoption is only permitted for the provision related to instrument-specific credit risk and the fair value disclosure exemption provided to nonpublic entities. The Company has evaluated the effect of ASU 2016-01 and believes adoption will not have a material effect on the Consolidated Financial Statements. F-14 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued Under ASU 2016-09 Stock Compensation, introduces targeted amendments intended to simplify the accounting for stock compensation. Specifically, the ASU requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity also should recognize excess tax benefits, and assess the need for a valuation allowance, regardless of whether the benefit reduces taxes payable in the current period. That is, off balance sheet accounting for net operating losses stemming from excess tax benefits would no longer be required and instead such net operating losses would be recognized when they arise. Existing net operating losses that are currently tracked off balance sheet would be recognized, net of a valuation allowance if required, through an adjustment to opening retained earnings in the period of adoption. Entities will no longer need to maintain and track an “APIC pool.” The ASU also requires excess tax benefits to be classified along with other income tax cash flows as an operating activity in the statement of cash flows. In addition, the ASU elevates the statutory tax withholding threshold to qualify for equity classification up to the maximum statutory tax rates in the applicable jurisdiction(s). The ASU also clarifies that cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. The ASU provides an optional accounting policy election (with limited exceptions), to be applied on an entity-wide basis, to either estimate the number of awards that are expected to vest (consistent with existing U.S. GAAP) or account for forfeitures when they occur. The ASU was effective on January 1, 2017. There has been no material impact on the Company’s Consolidated Financial Statements upon its implementation. In February 2016, the FASB issued ASU 2016-02, “Leases.” The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company has determined that the provisions of ASU No. 2016-02 may result in an increase in assets to recognize the present value of the lease obligations with a corresponding increase in liabilities, however, the Company does not expect this to have a material impact on the Company’s financial position, results of operations or cash flows. F-15 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued Under ASU 2016-13, Financial Instruments – Credit Losses the ASU sets forth a “current expected credit loss” (CECL) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. While the Company is currently in the process of evaluating the impact of the amended guidance on its Consolidated Financial Statements, it currently expects the ALLL to increase upon adoption given that the allowance will be required to cover the full remaining expected life of the portfolio upon adoption, rather than the incurred loss model under current U.S. GAAP. The extent of this increase is still being evaluated and will depend on economic conditions and the composition of the Company’s loan and lease portfolio at the time of adoption. Under ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments clarifications of how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are intended to reduce diversity in practice. · Cash payments for debt prepayment or extinguishment costs will be classified in financing activities. · Upon settlement of zero-coupon bonds and bonds with insignificant cash coupons, the portion of the payment attributable to imputed interest will be classified as an operating activity, while the portion of the payment attributable to principal will be classified as a financing activity. · Cash paid by an acquirer that isn’t soon after a business combination for the settlement of a contingent consideration liability will be separated between financing activities and operating activities. Cash payments up to the amount of the contingent consideration liability recognized at the acquisition date will be classified in financing activities; any excess will be classified in operating activities. Cash paid soon after the business combination will be classified in investing activities. · Cash proceeds received from the settlement of insurance claims will be classified on the basis of the related insurance coverage (that is, the nature of the loss). Cash proceeds from lump-sum settlements will be classified based on the nature of each loss included in the settlement. · Cash proceeds received from the settlement of corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) policies will be classified as cash inflows from investing activities. Cash payments for premiums on COLI and BOLI may be classified as cash outflows for investing, operating, or a combination of both. · A transferor’s beneficial interest obtained in a securitization of financial assets will be disclosed as a noncash activity, and cash received from beneficial interests will be classified in investing activities. · Distributions received from equity method investees will be classified using either a cumulative earnings approach or a look- through approach as an accounting policy election. F-16 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies – Continued The ASU, which becomes effective after December 15, 2017, contains additional guidance clarifying when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) versus when an entity should classify the aggregate amount into one class of cash flows on the basis of predominance. The Company is continuing to evaluate the impact of the ASU on its Consolidated Financial Statements, but the effects of classifying cash receipts and cash payments on the Consolidated Balance Sheets is not expected to be material. Subsequent Events – The Company has evaluated events and transactions occurring subsequent to December 31, 2016, the date of the consolidated statements of financial condition, for items that should potentially be recognized or disclosed in the consolidated financial statements. The evaluation was conducted through the date these consolidated financial statements were issued and the Company believes that there were no material subsequent events requiring disclosure. Concentration of Credit Risk – From time to time, the Bank will maintain balances with its correspondent bank that exceed the $250,000 federally insured deposit limit. Management routinely evaluates the credit worthiness of the correspondent bank and does not feel they pose a significant risk to the Company . 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 . V. W. X. F-17 Table of Contents Note 2 - Investment Securities SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The amortized cost and fair value of investment securities held to maturity are as follows: December 31, 2016: US Treasury securities US Agency securities US Government sponsored mortgage-backed securities Total December 31, 2015: US Treasury securities US Agency securities US Government sponsored mortgage-backed securities Total Amortized Gross Unrealized Gross Unrealized Cost Gains Losses Fair Value (dollars in thousands) $ $ $ $ 12,998 $ 20,027 29,732 62,757 $ 21,057 $ 20,011 35,065 76,133 $ 167 $ 133 52 352 $ 276 $ 139 41 456 $ - $ 54 228 282 $ 8 $ 76 195 279 $ 13,165 20,106 29,556 62,827 21,325 20,074 34,911 76,310 There were no investment securities pledged as collateral for the years ended December 31, 2016 and 2015. The following table shows fair value and unrealized losses, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position as of December 31, 2016. Included in the table are five Agency securities and eleven Mortgage-backed securities in a gross unrealized loss position at December 31, 2016. There were four US Treasury securities, thirteen Agency securities and twelve Mortgage-backed securities in a gross unrealized loss position at December 31, 2015. Management believes that the unrealized losses in 2016 and 2015 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 December 31, 2016 or December 31, 2015, 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. F-18 Table of Contents Note 2 - Investment Securities – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2016: (dollars in thousands) Less than 12 months 12 Months or More Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses US Treasury securities US Agency securities US Government sponsored mortgage- backed securities Total December 31, 2015: US Treasury securities US Agency securities US Government sponsored mortgage- backed securities Total $ $ $ $ - $ 5,002 23,457 28,459 $ 3,992 $ 12,958 31,091 48,041 $ - $ 54 228 282 $ 8 $ 76 195 279 $ - $ - - - $ - $ - - - $ - $ - - - $ - $ - - - $ - $ 5,002 23,457 28,459 $ 3,992 $ 12,958 31,091 48,041 $ - 54 228 282 8 76 195 279 The amortized cost and estimated fair value of debt securities as of December 31, 2016, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Due in one year or less Due from one year to five years Due from five years to ten years US Government sponsored mortgage-backed securities F-19 Held to Maturity (dollars in thousands) Amortized Cost Estimated Fair Value $ $ 9,003 $ 22,061 1,961 29,732 62,757 $ 9,031 22,194 2,046 29,556 62,827 Table of Contents Note 3 - Loans Receivable SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loans receivable, including unfunded commitments consist of the following: Residential mortgage, total Individually evaluated for impairment Collectively evaluated for impairment Construction, land acquisition and development, total Individually evaluated for impairment Collectively evaluated for impairment Land, total Individually evaluated for impairment Collectively evaluated for impairment Lines of credit, total Individually evaluated for impairment Collectively evaluated for impairment Commercial real estate, total Individually evaluated for impairment Collectively evaluated for impairment Commercial non-real estate, total Individually evaluated for impairment Collectively evaluated for impairment Home equity, total Individually evaluated for impairment Collectively evaluated for impairment Consumer, total Individually evaluated for impairment Collectively evaluated for impairment Total Loans Less Unfunded commitments included above Individually evaluated for impairment Collectively evaluated for impairment Allowance for loan losses Deferred loan origination fees and costs, net Net Loans December 31 2016 2015 (dollars in thousands) $ 260,603 $ 20,403 240,200 285,930 26,087 259,843 57,166 - 57,166 48,664 858 47,806 29,657 148 29,509 77,478 309 77,169 28,677 1,608 27,069 20,188 299 19,889 195,710 5,656 190,054 174,912 6,321 168,591 16,811 - 16,811 19,129 3,137 15,992 1,210 96 1,114 9,296 122 9,174 24,529 2,285 22,244 1,224 10 1,214 628,950 622,234 (15,728) 613,222 30,298 582,924 613,222 (8,969) (2,944) 601,309 $ (21,101) 601,133 37,041 564,092 601,133 (8,758) (2,719) 589,656 $ F-20 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 3 – 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 in accordance with our underwriting policies which include 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. 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. 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. Land loans are underwritten according to our policies which include 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. F-21 Table of Contents Note 3 – Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Commercial non-real estate loans are underwritten in accordance with our policies and include 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. 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 lower value of the underlying collateral, if any. 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. 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 upon. Once the loan has been transferred from Loans Receivable to Foreclosed Real Estate, a charge off is recorded for the difference between the recorded amount of the loan and the net fair 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 fair value of the underlying collateral. · The loan is considered to be impaired and either the fair value of the loan, the expected future cash flow from the loan, or the underlying collateral of the loan is insufficient to repay the carrying amount of the loan. The loan is written down by the amount of the difference between the recorded balance and fair value described above. F-22 Table of Contents Note 3 – Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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. The Company has experienced 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. The Company 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). The Company’s evaluation is primarily focused on various key financial metrics, including net worth, leverage ratios, and liquidity. It is the Company's policy to update such information annually, or more frequently as warranted, over the life of the loan. While the Company 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 the Company has found it necessary to seek performance under a guarantee, it has been able to effectively mitigate its losses. As stated above, the Company’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 the Company'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. F-23 Table of Contents Note 3 – Loans Receivable – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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, the Company'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. The Company has not advanced additional interest reserves to keep a loan from becoming nonperforming. F-24 Table of Contents Note 3 - Loans Receivable – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following is a summary of the allowance for loan losses for the years ended December 31, 2016 and December 31, 2015 (dollars in thousands): 2016 Total Residential Mortgage Acquisition and Development Land Lines of Credit Commercial Real Estate Commercial Non-Real Estate Home Equity Consumer Beginning Balance Provision Charge-offs Recoveries Ending Balance $ 8,758 $ (350) (468) 1,029 $ 8,969 $ 4,188 $ (528) (151) 324 3,833 $ 446 $ (3) (13) 97 527 $ 510 $ 352 (59) 60 863 $ 57 $ (10) - 10 57 $ 2,792 $ (102) (178) 23 2,535 $ 234 $ 160 (17) 44 421 $ 528 $ (171) (50) 421 728 $ Allowance on loans individually evaluated for impairment $ 2,373 $ 1,703 $ - $ 53 $ 15 $ 196 $ - $ 402 $ Allowance on loans collectively evaluated for impairment $ 6,596 $ 2,130 $ 527 $ 810 $ 42 $ 2,339 $ 421 $ 326 $ 3 (48) - 50 5 4 1 2015 Total Residential Mortgage Acquisition and Development Land Lines of Credit Commercial Real Estate Commercial Non-Real Estate Home Equity Consumer Beginning Balance Provision Charge-offs Recoveries Ending Balance $ 9,435 $ (280) (1,522) 1,125 $ 8,758 $ 4,664 $ (651) (454) 629 4,188 $ 362 $ 84 - - 446 $ 646 $ (185) - 49 510 $ 12 $ (190) - 235 57 $ 2,504 $ 368 (80) - 2,792 $ 280 $ 59 (154) 49 234 $ 963 $ 236 (834) 163 528 $ Allowance on loans individually evaluated for impairment $ 2,282 $ 1,838 $ - $ 78 $ 30 $ 328 $ 5 $ 2 $ Allowance on loans collectively evaluated for impairment $ 6,476 $ 2,350 $ 446 $ 432 $ 27 $ 2,464 $ 229 $ 526 $ 4 (1) - - 3 1 2 F-25 Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The allowance for loan losses is based on management’s judgment and evaluation of the loan portfolio. Management assesses the adequacy of the allowance for loan losses and the need for any addition thereto, by considering the nature and size of the loan portfolio, overall portfolio quality, review of specific problem loans, economic conditions that may affect the borrowers’ ability to pay or the value of property securing loans, and other relevant factors. While management believes the allowance was adequate at December 31, 2016, changing economic and market conditions may require future adjustments to the allowance for loan losses. 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. F-26 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 3 - Loans Receivable - Continued The following tables summarize impaired loans at December 31, 2016 and 2015 (dollars in thousands): December 31, 2016 Residential mortgage Construction, acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total Impaired loans December 31, 2015 Residential mortgage Construction, acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total Impaired loans Impaired Loans with Specific Allowance Impaired Loans with No Specific Allowance Total Impaired Loans Recorded Investment Related Allowance Recorded Investment Recorded Investment 11,065 $ - 417 148 1,958 - 1,608 96 15,292 $ 1,703 $ - 53 15 196 - 402 4 2,373 $ 9,338 $ - 441 - 3,698 - 1,529 - 15,006 $ 20,403 $ - 858 148 5,656 - 3,137 96 30,298 $ Unpaid Principal Balance 21,030 - 858 148 5,858 - 3,747 96 31,737 Impaired Loans with Specific Allowance Impaired Loans with No Specific Allowance Total Impaired Loans Recorded Investment Related Allowance Recorded Investment Recorded Investment 1,838 $ - 78 30 328 5 2 1 2,282 $ 14,202 $ 309 969 - 3,107 19 2,269 - 20,875 $ 26,087 $ 309 1,608 299 6,321 122 2,285 10 37,041 $ 11,885 $ - 639 299 3,214 103 16 10 16,166 $ F-27 Unpaid Principal Balance 26,656 309 1,723 299 6,469 123 3,251 10 38,840 $ $ $ $ Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following tables summarize average impaired loans for the years ended December 31, 2016 and 2015 (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 December 31, 2016 Residential mortgage $ Construction, acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total Impaired loans $ 10,785 $ - 489 149 2,020 25 679 79 14,226 $ 463 $ - 26 7 100 1 7 2 606 $ 12,747 $ 208 1,026 141 4,021 4 1,889 17 20,053 $ 521 $ 9 27 2 187 - 75 - 821 $ 23,532 $ 208 1,515 290 6,041 29 2,568 96 34,279 $ 984 9 53 9 287 1 82 2 1,427 Impaired Loans with Specific Allowance Impaired Loans with No Specific Allowance Average Recorded Investment Interest Income Recognized Average Recorded Investment Interest Income Recognized Total Impaired Loans Average Recorded Investment Interest Income Recognized December 31, 2015 Residential mortgage $ Construction, acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total Impaired loans $ 12,645 $ 114 822 25 2,933 213 337 11 17,100 $ 13,886 $ 573 1,035 321 2,179 10 2,520 414 20,938 $ 564 $ 29 72 18 166 13 115 3 980 $ 26,531 $ 687 1,857 346 5,112 223 2,857 425 38,038 $ 1,104 30 93 19 300 18 123 3 1,690 540 $ 1 21 1 134 5 8 - 710 $ F-28 Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Included in the above impaired loans amount at December 31, 2016 is $20,446,000 of loans that are not in non-accrual status. In addition, there was a total of $20,403,000 of residential real estate loans included in impaired loans at December 31, 2016, of which $17,075,000 were to consumers and $3,328,000 to builders. The following tables present the classes of the loan portfolio, including unfunded commitments summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk rating system as of December 31, 2016 and 2015 (dollars in thousands): December 31, 2016 Residential mortgage Construction acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans December 31, 2015 Residential mortgage Construction acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans Pass Special Mention Substandard Doubtful Total 251,763 $ 57,166 47,886 29,289 184,820 16,722 16,056 1,210 604,912 $ 4,316 $ - - 116 7,420 88 472 - 12,412 $ 4,524 $ - 778 252 3,470 1 2,601 - 11,626 $ - $ - - - - - - - - $ 260,603 57,166 48,664 29,657 195,710 16,811 19,129 1,210 628,950 Pass Special Mention Substandard Doubtful Total 268,583 $ 77,168 26,845 19,521 155,766 9,151 22,018 1,224 580,276 $ 12,457 $ 71 1,268 368 13,208 125 588 - 28,085 $ 4,890 $ 239 564 299 5,938 20 1,923 - 13,873 $ - $ - - - - - - - - $ 285,930 77,478 28,677 20,188 174,912 9,296 24,529 1,224 622,234 $ $ $ $ Included in the Pass column were $15,728,000 and $21,101,000 in unfunded commitments at December 31, 2016 and 2015, respectively. F-29 Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Management further monitors the performance and credit quality of the loan portfolio by analyzing the payment histories and delinquencies of the loans within the portfolio. There were no loans past due greater than 90 days and still accruing as of December 31, 2016 and 2015. Included in the Current column were $15,728,000 and $21,101,000 in unfunded commitments at December 31, 2016 and 2015, respectively. The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans as of December 31, 2016 and 2015 (dollars in thousands): December 31, 2016 Residential mortgage Construction $ acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans $ December 31, 2015 Residential mortgage Construction $ acquisition and development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans $ 30-59 Days Past Due 60-89 Days Past Due 90+ Days Past Due Total Past Due Current Total Loans Non-Accrual 1,472 $ 2,074 $ 964 $ 4,510 $ 256,093 $ 260,603 $ 3,580 - 106 - - - 34 4 1,616 $ - - - 171 - - - 2,245 $ - 6 - 515 - 2,174 - 3,659 $ - 112 - 686 - 2,208 4 7,520 $ 57,166 48,552 29,657 195,024 16,811 16,921 1,206 621,430 $ 57,166 48,664 29,657 195,710 16,811 19,129 1,210 628,950 $ - 269 150 2,938 1 2,914 - 9,852 30-59 Days Past Due 60-89 Days Past Due 90+ Days Past Due Total Past Due Current Total Loans Non-Accrual 1,593 $ 65 $ 2,461 $ 4,119 $ 281,811 $ 285,930 $ 3,191 - 137 149 253 - - 3 2,135 $ - - - - - - - 65 $ - 156 - 292 - 625 - 3,534 $ F-30 - 293 149 545 - 625 3 5,734 $ 77,478 28,384 20,039 174,367 9,296 23,904 1,221 616,500 $ 77,478 28,677 20,188 174,912 9,296 24,529 1,224 622,234 $ 244 277 483 2,681 - 2,098 - 8,974 Table of Contents Note 3 - Loans Receivable – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated statements of financial condition. The contract amounts of these instruments express the extent of involvement the Bank has in each class of financial instruments. The Bank's exposure to credit loss from non-performance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk. Financial Instruments Whose Contract Amounts Represent Credit Risk Standby letters of credit Home equity lines of credit Unadvanced construction commitments Mortgage loan commitments Lines of credit Loans sold and serviced with limited repurchase provisions $ Contract Amount At December 31, 2016 2015 (dollars in thousands) 4,022 $ 7,736 15,728 574 34,125 70,773 5,937 7,467 21,101 3,233 27,189 65,107 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 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, except for certain standby letters of credit, that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of December 31, 2016 and 2015 for guarantees under standby letters of credit issued was $94,000 and $115,000, 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. F-31 Table of Contents Note 3 - Loans Receivable – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Mortgage loan commitments not reflected in the accompanying statements of financial condition at December 31, 2016 included two loans at a fixed interest of 4.25% totaling $574,000 and at December 31, 2015 included seven loans at a fixed interest rate range of 3.75% to 8.00% totaling $3,233,000. 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 years ended December 31, 2016 and 2015 were $149,990,000 and $157,420,000, respectively. The reserve recorded for these loans at December 31, 2016 and 2015 was $48,000 and $0, respectively. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within a period ranging generally from 120 to 180 days after the sale date depending on the investor’s agreement. The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. The Bank repurchased one loan in 2016 in the amount of $343,000 and no loans in 2015. Only loans originated specifically for sale are recorded as held for sale at the period ended December 31, 2016 and December 31, 2015. Except for the liability recorded for standby letters of credit of $94,000 and $115,000 at December 31, 2016 and 2015, respectively, liabilities for credit losses associated with these commitments were not material at December 31, 2016 and 2015. Bancorp considers a modification of a loan term a Troubled Debt Restructure 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. F-32 Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following tables present newly restructured loans that occurred during the years ended December 31, 2016 and 2015 by the type of concession (dollars in thousands): Rate Term Modification Contracts Modifications Contracts Combination Modifications Contracts Total Total Contracts Year ended December 31, 2016 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 $ - - - - - - - - - - $ - - - - - - - - $ - $ - - - - - - - - $ - $ - - - - - - - - $ - $ - - - - - - - - $ 624 - - - - - - - 624 624 - - - - - - - 624 3 $ 624 - - - - - - - 3 $ - - - - - - - 624 3 $ 624 - - - - - - - 3 $ - - - - - - - 624 3 - - - - - - - 3 3 - - - - - - - 3 - - - - - - - - - - - - - - - - - - F-33 Table of Contents Note 3 - Loans Receivable - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Rate Term Modification Contracts Modifications Contracts Combination Modifications Contracts Total Total Contracts Year ended December 31, 2015 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 $ - - - - - - - - - - $ - - - - - - - - $ - $ - - - - - - - - $ 91 - - - - - - - 91 91 - - - - - - - 91 1 $ - - - - - - - 1 $ 1 $ - - - - - - - 1 $ - - 61 - - - - - 61 109 - 31 - - - - - 140 1 $ 91 - 1 - - - - - 2 $ - 61 - - - - - 152 1 $ 200 - 1 - - - - - 2 $ - 31 - - - - - 231 2 - 1 - - - - - 3 2 - 1 - - - - - 3 All troubled debt restructurings are considered impaired loans. Impaired loans are evaluated for a potential loss following the criteria set forth earlier in this footnote. F-34 Table of Contents Note 3 - Loans Receivable – Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Interest on TDRs was accounted for under the following methods as of December 31, 2016 and December 31, 2015 (dollars in thousands): Number of Contracts Accrual Status Number of Contracts Non- Accrual Status Total Number of Contracts Total Modifications December 31, 2016 Residential mortgage Construction, acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans December 31, 2015 Residential mortgage Construction, acquisition and Development Land Lines of credit Commercial real estate Commercial non-real estate Home equity Consumer Total loans 48 $ - 2 - 3 - - 5 58 $ 55 $ 1 6 - 4 4 - 1 71 $ 15,886 - 170 - 1,914 - - 96 18,066 20,831 71 907 - 2,464 103 - 10 24,386 4 $ - 1 - 2 - - - 7 $ 3 $ - 1 - 2 - - - 6 $ 2,137 - 6 - 249 - - - 2,392 1,071 - 6 - 252 - - - 1,329 52 $ - 3 - 5 - - 5 65 $ 58 $ 1 7 - 6 4 - 1 77 $ 18,023 - 176 - 2,163 - - 96 20,458 21,902 71 913 - 2,716 103 - 10 25,715 There were three TDRs totaling $2,030,000 that were in a non-accrual status at December 31, 2016 because they failed to perform in accordance with the terms of their restructuring agreements. F-35 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4 - Premises and Equipment Premises and equipment are summarized by major classification as follows: Land Building Leasehold improvements Furniture, fixtures and equipment Construction in process Total at cost Accumulated depreciation December 31, 2016 2015 (dollars in thousands) $ $ 1,537 $ 29,464 2,202 2,718 81 36,002 (11,972) 24,030 $ 1,537 29,464 1,676 2,385 37 35,099 (10,809) 24,290 Estimated Useful Lives - 39 Years 15-27.5 Years 3-10 Years Depreciation expense was $1,164,000 and $1,137,000 for the years ended December 31, 2016 and 2015, respectively. The Company has five retail branch locations in Anne Arundel County, Maryland, of which it owns three and leases two from third parties. The current terms of the leases expire in July 2020 and February 2026. There is no option to renew the lease for any additional terms on the first lease and an option to renew every three to five years on the second lease for twenty-five years. In addition, the Bank leases office space in Annapolis, Maryland from a third party. The lease expired January 2017, and was renewed for an additional five year term. F-36 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4 - Premises and Equipment - Continued The minimum future annual rental payments on leases are as follows: Years Ended December 31, (in thousands) 2017 2018 2019 2020 2021 Thereafter $ Total rent expense was $175,000 and $131,000 for the years ended December 31, 2016 and 2015, respectively. The minimum future annual rental income on leases is as follows: Years Ended December 31, (in thousands) 2017 2018 2019 2020 2021 Thereafter $ 242 225 225 185 135 533 994 945 945 716 515 488 H.S. West, LLC, a subsidiary of the Bank, leases space to three unrelated companies and to a law firm of which the President of the Company and the Bank is a partner. Total gross rental income included in occupancy expense on the Consolidated Statements of Operations was $1,004,000 and $970,000 for the years ended December 31, 2016 and 2015, respectively. F-37 Table of Contents Note 5 – Foreclosed Real Estate SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2016, the Company had foreclosed real estate consisting of one residential property with a carrying value of $206,000 and six land parcels with a carrying value of $767,000. During the year ended December 31, 2016, the Company sold a total of twelve properties previously included in foreclosed real estate. The properties sold during 2016 had a combined net book value of $2,128,000 after total write-downs taken subsequent to their transfer from loans to foreclosed real estate of $246,000, and were sold at a combined net gain of $42,000. The following table summarizes the changes in foreclosed real estate for the years ended December 31, 2016 and 2015 (dollars in thousands): Foreclosed real estate at December 31, 2014 Transferred from impaired loans, net of specific reserves of $0 Property improvements Additional write downs Property sold Foreclosed real estate at December 31, 2015 Transferred from impaired loans, net of specific reserves of $0 Property improvements Additional write downs Property sold Foreclosed real estate at December 31, 2016 $ $ $ 1,947 2,234 - (58) (2,379) 1,744 1,575 - (218) (2,128) 973 Total foreclosed real estate expense for 2016 was $194,000. Net gain on the property sales was $42,000, property write downs totaled $218,000,operating expense was $162,000 and net recoveries from properties sold in prior years was $145,000. Total foreclosed real estate expense for 2015 was $230,000. Net gain on the property sales was $49,000, property write downs totaled $58,000 and operating expense was $221,000. Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process according to local requirements of the applicable jurisdiction totaled $5,022,000 as of December 31, 2016. Note 6 - Investment in Federal Home Loan Bank of Atlanta Stock The Bank is required to maintain an investment in the stock of the FHLB in an amount equal to at least 1% of the unpaid principal balances of the Bank's residential mortgage loans or 1/20 of its outstanding advances from the FHLB, whichever is greater. Purchases and sales of stock are made directly with the FHLB at par value. F-38 Table of Contents Note 7 – Deposits SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deposits in the Bank as of December 31, 2016 and 2015 consisted of the following: Category Checking accounts Money market accounts Passbooks Certificates of deposit Non-interest bearing accounts Total deposits December 31, 2016 Amount December 31, 2015 Amount Percent Percent (dollars in thousands) $ $ 63,137 66,356 110,492 273,816 58,145 571,946 11.04% $ 11.60% 19.32% 47.87% 10.17% 100.00% $ 56,096 47,690 111,992 277,778 30,215 523,771 10.71% 9.11% 21.38% 53.03% 5.77% 100.00% At December 31, 2016 scheduled maturities of certificates of deposit are as follows: One year or less More than 1 year to 2 years More than 2 years to 3 years More than 3 years to 4 years More than 4 years to 5 years More than 5 years Amount (dollars in thousands) 169,331 40,388 16,120 25,861 21,121 995 273,816 $ $ The aggregate amount of jumbo certificates of deposit with a minimum denomination of $250,000 was $39,131,000 and $25,713,000 at December 31, 2016 and 2015, respectively. Note 8 – Borrowings Federal Home Loan Bank Borrowings The Bank's total credit availability under the FHLB’s credit availability program was $232,193,000 and $192,672,000 at December 31, 2016 and 2015, respectively. The Bank’s credit availability is based on the level of collateral pledged up to 30% of total assets. There were no short-term borrowings with the FHLB at December 31, 2016 and 2015. Advances outstanding were $100,000,000 at December 31, 2016 and $115,000,000 at December 31, 2015. The maturities of these long-term advances at December 31, 2016 are as follows (dollars in thousands): Rate 2.43% to 4.05% 2.58% to 3.43% $ 4.00% Amount Maturity 70,000 15,000 15,000 2017 2018 2019 $ 100,000 F-39 Table of Contents Note 8 – Borrowings - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Bank's stock in the FHLB is pledged as security for the advances and under a blanket floating lien security agreement with the FHLB. The Bank is required to maintain as collateral for its advances, qualified loans in varying amounts depending on the loan type. Loans with an approximate fair value of $338,060,000 are pledged as collateral at December 31, 2016. Other Borrowings On September 30, 2016, the Company entered into a loan agreement with a commercial bank whereby the Company borrowed $3,500,000 for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Company, converts to either (1) floating rate of the Wall Street Journal Prime plus .50% or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing Federal Home Loan Bank rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If the Bancorp elects the 5 year fixed rate of 275 basis points over the Federal Home Loan Bank rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth and fifth years of the FHLB Rate Period. The Company may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period. Note 9 - Subordinated Debentures The 2035 Debentures As of December 31, 2016, the Company had outstanding approximately $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 the Company and Wells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.88% December 31, 2016) 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 the Company, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by the Company 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 the Company. 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. The Company has entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee. $17,000,000 of the proceeds from the Company’s issuance of the debentures was contributed to the Bank, and qualifies as Tier 1 capital for the Bank under Federal Reserve Board guidelines. Under the terms of the 2035 Indenture, the Company 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. During the second quarter of 2016, the Company paid all of the deferred interest and as of December 31, 2016, the Company is current on all interest due on the 2035 Debenture. F-40 Table of Contents Note 9 - Subordinated Debentures - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Under the terms of the Company’s 2035 Debenture, the Company could 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 during any interest any interest deferral period. As of December 31, 2016, the Company was current with all interest payments due under the 2035 debenture. The Series A Subordinated Notes On November 15, 2008, the Company 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 consisted of 6,250 shares of the Company's Series A preferred stock and the Company's Subordinated Note in the original principal amount of $50,000. In the aggregate, the Series A Preferred Stock totaled $3.5 million and the Subordinated Note totaled $3.5 million. On September 30, 2016 the $3,500,000 aggregate principal amount of Subordinated Notes outstanding was paid in full. Previously, the Subordinated Notes earned interest at an annual rate of 8.0%, payable quarterly in arrears on the last day of March, June, September and December which commenced December 31, 2008. The Subordinated Notes were redeemable in whole or in part at the option of The Company at any time beginning on December 31, 2009 until maturity. Note 10 – Employee Benefit Plans The Bank has a 401(k) Retirement Savings Plan. Employees may contribute a percentage of their salary up to the maximum amount allowed by law. The Bank matches 50% of the first 6% of an employee's contribution.. All employees who have completed one year of service with the Bank are eligible to participate in the company match. The Bank's contributions to this plan were $215,000, and $217,000 for the years ended December 31, 2016 and 2015, respectively. The Bank has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of participating employees. The Bank recognized ESOP expense of $140,000 for each of the years ended December 31, 2016 and 2015. The plan and had allocated shares totaling 549,428 and 519,025, and had unallocated shares to participants in the plan totaling 30,000 shares and 10,000 shares as of December 31, 2016 and 2015, respectively. The fair value of the unallocated shares at December 31, 2016 was approximately $237,000. Note 11 - Stockholders’ Equity Series A Preferred Stock As part of the private placement offering discussed in Note 9, the Company issued a total of 437,500 shares of its Series A 8.0% Non-Cumulative Convertible preferred stock (“Series A preferred stock”). The liquidation preference is $8.00 per share. Holders of Series A preferred stock will not be entitled to any further liquidation distribution on the Series A preferred stock. Each share of Series A preferred stock is convertible at the option of the holder into one share of the Company 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 the Company common stock. At the option of the Company, on and after December 31, 2015, at any time and from time to time, some or all of the Series A preferred stock may be converted into shares of the Company 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. F-41 Table of Contents Note 11 - Stockholders’ Equity - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS If declared by the Company'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 the Company’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 the Company's board of directors declare any dividends on the Series A Preferred Stock and any unpaid dividends shall not be cumulative. On June 30, 2016 and September 30, 2016 and December 31, 2016, the Company declared and paid dividends on the Series A Preferred Stock in the amount of $70,000 each. Prior to that, the Company had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012. Series B Preferred Stock On November 21, 2008, the Company entered into an agreement with the United States Department of the Treasury (“Treasury”), pursuant to which the Company 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 the Company’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 23,393,000 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 remained the same. The Treasury continues to hold the Warrant. The Series B preferred stock qualified as Tier 1 capital and paid cumulative compounding dividends at a rate of 9% per annum. The Series B preferred stock was redeemable by the Company. On May 11, 2016, the Company redeemed 10,000 shares of the Series B Preferred Stock for a payment of $10,000,000 and on September 8, 2016, the Company redeemed the remaining 13,393 shares for $13,393,000. On April 15, 2016, the Company paid all unpaid cumulative dividends and interest in arrears on the Series B Preferred Stock totaling $7,590,000. On May 11, 2016, the Company declared and paid a dividend of $326,000 on the Series B Preferred Stock, on August 11, 2016 it declared and paid a dividend of $301,000 and on September 8, 2016 a final dividend of $77,000 was paid. The Series B Warrant 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. The warrant expires November 21, 2018 F-42 Table of Contents Note 11 - Stockholders’ Equity - Continued Dividend Restrictions SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company’s ability to declare dividends on its common stock is limited by the terms of the Company’s Series A Preferred Stock and previously Series B Preferred Stock. The Company 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. Note 12- Stock-Based Compensation The Company has a stock-based compensation plan for directors, officers, and other key employees of the Company. 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 the Company’s old stock-based compensation plan. Under the terms of the plan, the Company has the ability to grant various stock compensation incentives, including stock options, stock appreciation rights, and restricted stock. The number of shares available to grant under the plan was 260,501 at December 31, 2016. 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 the Company 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. The Company follows FASB ASC 718, Compensation – Stock Compensation (FASB ASC 718) 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. Stock-based compensation expense included in the consolidated statements of operations for the years ended December 31, 2016 and 2015 totaled $184,000 and $120,000, respectively. There was no income tax benefit recognized in the consolidated statements of operations for stock-based compensation for the years ended December 31, 2016 and 2015. There were 74,000 options granted in 2016 and 111,500 options granted in 2015. F-43 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12- Stock-Based Compensation – Continued Information regarding the Company’s stock option plan as of and for the years ended December 31, 2016 and 2015 is as follows: Options outstanding, December 31, 2014 Options granted Options exercised Options forfeited Options outstanding, December 31, 2015 Options granted Options exercised Options forfeited Options outstanding, December 31, 2016 Options exercisable, December 31, 2016 Option price range at December 31, 2016 Weighted Average Exercise Weighted Average Remaining Aggregate Intrinsic Shares 328,200 111,500 (21,500) (78,400) 339,800 74,000 (18,800) (55,500) 339,500 138,066 Price 4.33 5.85 4.48 4.29 4.83 6.98 3.96 5.08 5.31 4.48 $ 3.37 to $7.48 Life Value 4.89 $ 1.89 $ 878,385 472,635 The aggregate intrinsic value of the options outstanding as of December 31, 2016 and December 31, 2015 was $878,000 and $323,000, respectively. The aggregate intrinsic value of the options exercisable as of December 31, 2016 and December 31, 2015 was $473,000 and $165,000, respectively. The aggregate intrinsic value of options exercised during the years ended December 31, 2016 and 2015 were $74,000 and $27,000, respectively. 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 in current and prior periods presented. Expected life of options Risk-free interest rate Expected volatility Expected dividend yield Weighted average fair value of options granted 2016 2015 5.5 years 5.5 years 1.77% 58.32% 0.00% $ 3.55 1.71% 61.84% 0.00% 3.16 $ The expected life of options amount is based on the vesting period and the expiration date 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 the Company over a five year period. The expected dividend yield is based on the Company’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. F-44 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12- Stock-Based Compensation – Continued The following table summarizes the nonvested options in the Company’s stock option plan as of December 31, 2016. Shares Nonvested options outstanding, December 31, 2015 Nonvested options granted Nonvested options vested Nonvested options forfeited Nonvested options outstanding, December 31, 2016 $ 235,570 74,000 (52,636) (55,500) 201,434 $ Weighted Average Exercise Price 5.13 6.98 4.87 5.08 5.89 As of December 31, 2016, there was approximately $640,200 of total unrecognized stock-based compensation cost related to non-vested stock options, which is expected to be recognized over a period of sixty months. Note 13- Regulatory Matters As of December 31, 2016, the Company’s reservable liability was below the threshold established by the Federal Reserve Bank and therefore, the Company was not required to maintain reserves (in the form of deposits with the Federal Reserve Bank or a correspondent bank on behalf of the Federal Reserve Bank.) Federal banking agencies have adopted proposals that have substantially amended the regulatory capital rules applicable to the Company 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 were effective with respect to the Company and the Bank in January 2015, with certain requirements to be phased in during 2016. 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. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). As of December 31, 2016, the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, Common Equity Tier 1 and Tier 1 leverage ratios as set forth in the table. The Bank’s actual capital amounts and ratios are also presented in the table. F-45 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 13- Regulatory Matters – Continued The following table presents the Bank's actual capital amounts and ratios at December 31, 2016 and 2015: Required For Capital Adequacy Purposes % Amount % Minimum Capital Adequacy with Capital Buffer Amount (dollars in thousands) % Required To Be Well Capitalized Under Prompt Corrective Action Provisions Amount % 12.9% $ 16.5% 16.5% 12.9% 17.8% 14.8% $ 19.6% 19.6% 14.8% 20.8% 11,488 35,977 26,983 30,634 47,969 11,423 34,626 25,970 30,461 46,168 1.50% 6.00% $ 4.50% 4.00% 8.00% N/A 39,725 30,730 35,420 51,717 1.50% 6.00% 4.50% 4.00% 8.00% N/A N/A N/A N/A N/A N/A 6.6% $ 5.1% 4.6% 8.6% $ N/A N/A N/A N/A N/A N/A 47,969 38,975 38,292 59,962 N/A 46,168 37,512 38,076 57,710 N/A 8.00% 6.50% 5.00% 10.00% N/A 8.00% 6.50% 5.00% 10.00% $ $ Actual Amount 98,970 98,970 98,970 98,970 106,517 112,959 112,959 112,959 112,959 120,193 December 31, 2016 Tangible (1) Tier 1 capital (2) Common Equity Tier 1 Leverage (1) Total (2) December 31, 2015 Tangible (1) Tier 1 capital (2) Common Equity Tier 1 Leverage (1) Total (2) (1) To adjusted total assets. (2) To risk-weighted assets. The Bank operated under a Formal Agreement dated April 13, 2013 with the Office of the Comptroller of the Currency (the” OCC ”). This agreement replaced the former Supervisory Agreement dated November 23, 2009 that the Bank had with the now defunct Office of Thrift Supervision (the “OTS”). The Bank satisfied all of the conditions of the Formal Agreement and on October 15, 2015 it was notified by the OCC that the agreement was terminated. The Company previously operated under a Supervisory Agreement dated November 23, 2009 with the now defunct OTS. Upon the abolishment of the OTS on July 21, 2011, the Federal Reserve Bank assumed the regulation of the Company. The Company satisfied all of the conditions of the Supervisory Agreement and on January 21, 2016 it was notified by the Federal Reserve Bank that agreement was terminated. On April 23, 2013, the Bank was notified by the OCC that the OCC established minimum capital ratios for the Bank requiring it to immediately maintain a Tier I 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%. On October 15, 2015, the Bank was notified by the OCC that these additional minimum capital ratios were no longer required. F-46 Table of Contents Note 14 - Income Taxes SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The income tax provision consists of the following for the years ended December 31: Current Federal State Deferred Federal State Valuation allowance Total income tax provision $ 2016 2015 94 $ 30 124 1,909 438 2,347 (12,485) 83 7 90 1,486 321 1,807 (1,807) $ (10,014) $ 90 The amount computed by applying the statutory federal income tax rate to income before taxes is less than the tax provision for the following reasons for the years ended December 31: Statutory Federal income tax rate State tax net of Federal income tax benefit Valuation allowance change Other adjustments 2016 2015 Amount 1,879 323 (12,485) 269 (10,014) $ $ Percent of Pretax Income 34.0% $ 5.8% (225.9%) 4.9% (181.2%) $ Percent of Pretax Income 34.0% 4.7% (39.1)% 2.4% 2.0% Amount 1,572 216 (1,807) 109 90 The Company does not have a liability related to tax positions at December 31, 2016 or 2015. F-47 Table of Contents Note 14 - Income Taxes - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2016 and 2015 are presented below: Deferred Tax Assets: Allowance for loan losses Reserve on foreclosed real estate Reserve for uncollected interest Reserve for contingent liability Federal net operating loss carryforwards State net operating loss carryforwards Charitable contribution carryforwards AMT Other Total deferred tax assets Valuation allowance Total deferred tax assets, net of valuation allowance Deferred Tax Liabilities: Federal Home Loan Bank stock dividends Loan origination costs Accelerated depreciation Prepaid expenses Mortgage servicing rights Other Total deferred tax liabilities $ 2016 2015 (dollars in thousands) 4,636 $ 161 433 56 5,850 1,298 297 192 - 12,923 - 12,923 (82) (801) (1,473) (264) (220) (2) (2,842) 5,456 552 143 57 7,306 1,457 319 - 88 15,378 (12,485) 2,893 (84) (733) (1,544) (278) (252) (2) (2,893) Net deferred tax assets $ 10,081 $ - At December 31, 2016, federal net operating losses totaled $17,205,000 and expire in 2033 and 2034. The state net operating losses totaled $23,573,000 and expire at various times from 2023 through 2033. In assessing the realizability of federal or state deferred tax assets at December 31, 2016, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and prudent, feasible and permissible as well as available tax planning strategies in making this assessment. Given the consistent earnings and improving asset quality, the Company’s analysis concluded that, as of June 30, 2016, it is more likely than not that it will generate sufficient taxable income within the applicable carry-forward periods to realize its net deferred tax asset. As such, the full valuation allowance of $11,837,000 was reversed to income tax expense at June 30, 2016. The Company’s net deferred tax asset was $10,081,000 as of December 31, 2016. Based on its review of all available evidence management determined it was more likely than not that the deferred tax assets will not be realized and accordingly determined that a valuation allowance should be recorded as of December 31, 2015. F-48 Table of Contents Note 14 - Income Taxes - Continued SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company will continue to have the benefit of the net operating loss carryforward relating to the deferred tax asset, and will have the ability to utilize the carryforward against future federal and state income taxes. The statute of limitations for Internal Revenue Service examination of the Company’s federal consolidated tax returns remains open for tax years 2013 through 2016. Note 15 - Related Party Transactions During the years ended December 31, 2016 and 2015, the Bank engaged in the transactions described below with parties that are deemed affiliated. During January 2007, a law firm, in which the President of the Company and the Bank is a partner, entered into a five year lease agreement with a subsidiary of the Company. The term of the lease is five years with the option to renew the lease for three additional five year terms. The second option to renew was exercised in January 2017. The total payments received by the subsidiary, which includes rent, common area maintenance and utilities were $270,000 and $266,000 for the years ended December 31, 2016 and 2015, respectively. In addition, the law firm represents the Company and the Bank in certain legal matters. The fees for services rendered by that firm were $228,000, and $206,000 for the years ended December 31, 2016 and 2015 respectively. Members of the Board of Directors of the Company had loans outstanding totaling $3,060,000 and $3,186,000 at December 31, 2016 and 2015, respectively. The following table shows loan activity for the year ended December 31, 2016: Beginning balance as of December 31, 2015 Loan funding Loan pay off/payment Ending balance as of December 31, 2016 Note 16 - Fair Value of Financial Instruments 2016 3,186,000 133,000 (259,000) 3,060,000 $ $ 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: Significant other observable inputs other than level 1 such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, inputs that are observable or can be corroborated by observable market data. Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumption that market participants would use in pricing an asset or liability. F-49 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments - Continued 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 the Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at December 31, 2016 and December 31, 2015. 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. Impaired loans are those for which the Company 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 $15,292,000 and $16,166,000 at December 31, 2016 and December 31, 2015, respectively, less their valuation allowances of $2,373,000 and $2,282,000 at December 31, 2016 and December 31, 2015, respectively. The fair value of four impaired collateral-dependent loans that were partially charged off during the year ended December 31, 2016 totaled $2,137,000 net of charge-offs of $90,000. The fair value of seven impaired collateral-dependent loans that were partially charged off during the year ended December 31, 2015 totaled $3,219,000 net of charge-offs of $622,000. F-50 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments – Continued Foreclosed Real Estate: Real estate acquired through foreclosure is included in the following disclosure at the fair value of the property, 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. 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 December 31, 2016: Nonrecurring fair value measurements Impaired loans Foreclosed real estate Total nonrecurring fair value measurements Recurring fair value measurements Mortgage servicing rights Rate lock commitments Mandatory forward contracts Total recurring fair value measurements December 31, 2016 Fair Value Measurement Using: QuotedPrices in Active Markets For Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (dollars in thousands) - $ - - $ - $ - - - $ - $ - - $ 15,056 767 15,823 - $ 162 153 315 $ 557 - - 557 December 31, 2016 15,056 $ 767 15,823 $ 557 $ 162 153 872 $ $ $ $ $ F-51 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments – Continued 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 December, 31, 2015: December 31, 2015 Fair Value Measurement Using: Quoted Prices in Active Markets For Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (dollars in thousands) - $ - - $ - $ - - - $ - $ - - $ 17,103 543 17,646 - $ 141 111 252 $ 623 - - 623 December 31, 2015 $ $ $ $ 17,103 $ 543 17,646 $ 623 $ 141 111 875 $ Nonrecurring fair value measurements Impaired loans Foreclosed real estate Total nonrecurring fair value measurements Recurring fair value measurements Mortgage servicing rights Rate lock commitments Mandatory forward contracts Total recurring fair value measurements There were no liabilities that were required to be re-measured on a nonrecurring basis at December 31, 2016 or December 31, 2015. F-52 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments – Continued The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value: December 31, 2016 Impaired loans Foreclosed real estate December 31, 2015 Impaired loans Foreclosed real estate $ $ $ $ $ $ Quantitative Information about Level 3 Fair Value Measurements Fair Value Estimate Valuation Techniques Unobservable Input Range (Weighted Average) 12,919 2,137 PV of future cash flows (1) Appraisal of collateral (2) Discount Rate Liquidation expenses (3) -6.00% -6.00% 767 Appraisal of collateral (2),(4) Appraisal adjustments (3) -10.0% to -10.0% (-10.0%) 13,884 3,219 PV of future cash flows (1) Appraisal of collateral (2) Discount Rate Liquidation expenses (3) -6.00% -6.00% 543 Appraisal of collateral (2),(4) Appraisal adjustments (3) -6.12% to -7.31% (-6.24%) (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. Includes qualitative adjustments by management and estimated liquidation expenses. (4) F-53 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments – Continued The estimated fair values of the Company's financial instruments as of December 31, 2016 and December 31, 2015 were as follows: Fair Value Measurement at December 31, 2016 Quoted Prices in Active Markets For Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Carrying Amount Fair Value Financial Assets Cash and cash equivalents Investment securities (HTM) Loans held for sale Loans receivable, net FHLB stock Accrued interest receivable Mortgage servicing rights Rate lock commitments Mandatory forward contracts Financial Liabilities Deposits Long-Term Borrowings Subordinated debentures Accrued interest payable Off Balance Sheet Commitments Financial Assets Cash and cash equivalents Investment securities (HTM) Loans held for sale Loans receivable, net FHLB stock Accrued interest receivable Mortgage servicing rights Rate lock commitments Mandatory forward contracts Financial Liabilities Deposits Long-Term Borrowings Subordinated debentures Accrued interest payable Off Balance Sheet Commitments $ $ $ $ $ $ 67,114 $ 62,757 10,307 601,309 4,933 2,249 557 162 153 571,946 $ 103,500 20,619 538 67,114 $ 62,827 10,313 602,953 4,933 2,249 557 162 153 (dollars in thousands) 67,114 $ 13,165 - - - - - - - 572,556 101,461 20,619 538 - $ - $ - - - - - $ - $ 49,662- 10,313 - 4,933 2,249 - 162 153 572,556 97,961 - 538 - - - 601,609 - - 557 - - - - 20,619 - - $ - Fair Value Measurement at December 31, 2015 Quoted Prices in Active Markets For Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Carrying Amount Fair Value 43,591 $ 76,310 13,295 593,742 5,626 2,218 623 141 111 (dollars in thousands) 43,591 $ 21,325 - - - - - - - 524,458 110,759 24,119 3,137 - $ - - - - - $ - $ 54,985 13,295 - 5,626 2,218 - 141 111 524,458 110,759 - 3,137 - $ - - - 593,742 - - 623 - - - - 24,119 - - 43,591 $ 76,133 13,203 589,656 5,626 2,218 623 141 111 523,771 $ 115,000 24,119 3,137 - $ F-54 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 16 - Fair Value of Financial Instruments – Continued The foregoing information should not be interpreted as an estimate of the fair value of the Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at December 31, 2016 and 2015. Cash and cash equivalents: The carrying amounts reported in the consolidated statements of financial condition for cash and cash equivalents approximate those assets’ fair values. Investment Securities: The Company 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 of the Company’s investments are considered Level 2. 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 December 31, 2016 and 2015. Loans held for sale: The fair value of loans held for sale is based primarily on mandatory contracts. Loans receivable:s The fair values of loans receivable was 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 OCC Quarterly Report. Accrued interest receivable and payable: The carrying amounts of accrued interest receivable and accrued interest payable approximates its fair value. 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 the Company’s derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from observable market inputs that can generally be verified and do not typically involve significant judgment by the Company. Forward contracts and rate lock loan commitments are classified as Level 2 in the fair value hierarchy. F-55 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED Note 16 - Fair Values of Financial Instruments – Continued 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 quarterly 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. 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. Long-term borrowings: 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, the Company 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, the Company has disclosed that the carrying value approximates the fair value. Off-balance sheet financial instruments: Fair values for the Company’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. F-56 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 17 - Condensed Financial Information (Parent Company Only) Information as to the financial position of Severn Bancorp, Inc. as of December 31, 2016 and 2015 and results of operations and cash flows for each of the years ended December 31, 2016 and 2015 is summarized below. Statements of Financial Condition Cash Equity in net assets of subsidiaries: Bank Non-Bank Other assets Total assets Subordinated debentures Other liabilities Total liabilities Stockholders’ equity December 31, 2016 2015 (dollars in thousands) $ 2,012 $ 993 $ $ 105,898 3,014 1,265 113,294 3,881 912 112,189 $ 119,080 20,619 $ 3,640 24,119 8,505 24,259 32,624 87,930 86,456 Total liabilities and stockholders’ equity $ 112,189 $ 119,080 Statements of Operations Interest income Interest expense on subordinated debentures Net interest expense General and administrative expenses Provision for loan losses Loss before income taxes and equity in undistributed net income of subsidiaries Income tax (benefit) expense Equity in undistributed net income of subsidiaries December 31, 2016 2015 $ - $ 973 - 1,322 (973) (1,322) 229 - (1,202) (1,004) 15,738 243 - (1,565) - 6,100 Net income $ 15,540 $ 4,535 F-57 Table of Contents SEVERN BANCORP, INC. AND SUBSIDIARIES Annapolis, Maryland NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 17 - Condensed Financial Information (Parent Company Only) - Continued Statements of Cash Flows Cash Flows from Operating Activities: Net income Adjustments to reconcile net income to net cash used in operating activities: Equity in undistributed earnings of subsidiaries Deferred tax benefit Provision for loan losses Decrease in other assets Stock-based compensation expense Increase in other liabilities Cash used in operating activities Cash Flows from Investing Activities: Contributions from subsidiaries Cash used in investing activities Cash Flows from Financing Activities: Repayment of borrowed funds, long-term Additional borrowed funds, long-term Series A Preferred Stock dividend Series B Preferred Stock dividend Stock redemption of Series B Preferred Stock Net proceeds from Common Stock issuance Proceeds from exercise of options Cash (used in) provided by financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year For the Years Ended December 31, 2016 2015 (dollars in thousands) $ 15,540 $ 4,535 (15,738) (531) - 178 184 (1,965) (6,100) - - 8 120 1,018 (2,332) (419) 24,000 24,000 (3,500) 3,500 (210) (7,630) (23,393) 10,510 74 (20,649) 1,019 993 - - - 96 96 (323) 1,316 Cash and cash equivalents at end of year $ 2,012 $ 993 F-58 Subsidiaries of Severn Bancorp, Inc. Exhibit 21.1 The following is a list of subsidiaries of Severn Bancorp, Inc. at December 31, 2016. All entities listed below are subsidiaries of Severn Bancorp, Inc. and, if indented, subsidiaries of the entity under which they are listed. Entity Severn Savings Bank, FSB. Louis Hyatt, Inc. (d/b/a Hyatt Commercial) HS West, LLC Severn Financial Services Corporation SSB Realty Holdings, LLC SSB Realty Holdings II, LLC Homeowners Title and Escrow Corporation SBI Mortgage Company Crownsville Development Corporation (d/b/a Annapolis Equity Group) Crownsville Holdings I, LLC Severn Mortgage Company Jurisdiction of Formation United States of America (federally chartered savings association) Maryland Maryland Maryland Maryland Maryland Maryland Maryland Maryland Maryland Maryland Exhibit 21.1 - - Page 1 - - Consent of Independent Registered Public Accounting Firm Exhibit 23.1 Severn Bancorp, Inc. Annapolis, Maryland We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (No. 333-156343) and Forms S-8 (No. 333-152657 and No. 333- 133242) of Severn Bancorp, Inc. of our report dated March 22, 2017, relating to the consolidated financial statements, which is incorporated by reference in this Annual Report on Form 10-K. /s/BDO USA, LLP Harrisburg, Pennsylvania March 22, 2017 Exhibit 23.1 -- Page 1 -- Exhibit 31.1 I, Alan J. Hyatt, certify that: 1) I have reviewed this annual report on Form 10-K of Severn Bancorp, Inc.; Certification of Principal Executive Officer 2) Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3) Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) b) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 22, 2017 /s/ Alan J. Hyatt President and Chief Executive Officer (Principal Executive Officer) Exhibit 31.1 -- Page 1 -- Exhibit 31.2 I, Paul B. Susie, certify that: 1) I have reviewed this annual report on Form 10-K of Severn Bancorp, Inc.; Certification of Principal Financial Officer 2) Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3) Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) b) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 22, 2017 /s/ Paul B. Susie Executive Vice President and Chief Financial Officer (Principal Financial Officer) Exhibit 31.2 -- Page 1 -- CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Exhibit 32 Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Section 1350 of Chapter 63 of Title 18 of the United States Code), each of the undersigned officers of Severn Bancorp, Inc. (“Bancorp”) does hereby certify with respect to the Annual Report of Bancorp on Form 10-K for the period ended December 31, 2016 (the “Report”) that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Bancorp. Date: March 22, 2017 Date: March 22, 2017 SEVERN BANCORP, INC. /s/ Alan J. Hyatt Alan J. Hyatt, President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer) /s/ Paul B. Susie Paul B. Susie, Executive Vice President, and Chief Financial Officer (Principal Financial Officer) The foregoing certification is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Section 1350 of Chapter 63 of Title 18 of the United States Code) and is not being filed as part of the Report or as a separate disclosure document. Exhibit 32 -- Page 1 -- 

Continue reading text version or see original annual report in PDF format above