15
Investment Scheduled Maturity Table
More than One to | More than Five to | ||||||||||||||
One Year or Less | Five Years | Ten Years | More than Ten Years | Total Investment Securities | |||||||||||
Carrying | Average | Carrying | Average | Carrying | Average | Carrying | Average | Carrying | Average | Market | |||||
Value | Yield | Value | Yield | Value | Yield | Value | Yield | Value | Yield | Value | |||||
(dollars in thousands) | |||||||||||||||
Investment Securities Held to Maturity | |||||||||||||||
FHLB Notes | - | $ 4,000 | 2.58% | $ 2,000 | 5.05% | - | $ 6,000 | 3.40% | $5,922 | ||||||
Interest-bearing deposits in other banks | $ 458 | 0.85% | - | - | - | 458 | 0.85% | 458 | |||||||
Federal funds sold | 3,914 | 0.88% | - | - | - | 3,914 | 0.88% | 3,914 | |||||||
Mortgage-backed securities held to maturity | - | 2,918 | 4.37% | - | $ 3,803 | 5.53% | 6,721 | 5.02% | 6,694 | ||||||
FHLB stock | - | - | - | 3,250 | 3.50% | 3,250 | 3.50% | 3,250 | |||||||
Total | $ 4,372 | 0.87 % | $ 6,918 | 2.58% | $ 2,000 | 5.05% | $ 7,053 | 4.59% | $ 20,343 | 3.41% | $20,238 | ||||
As of December 31, 2003, Bancorp owned no real estate through foreclosure.2006
| More than One to | More than Five to | ||||||||||||||
| One Year or Less | Five Years | Ten Years | More than Ten Years | Total Investment Securities | |||||||||||
| Carrying | Average | Carrying | Average | Carrying | Average | Carrying | Average | Carrying | Average | Fair | |||||
| Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Value | |||||
| (dollars in thousands) | |||||||||||||||
| FHLB Notes | 4,000 | 2.58% | - | - | $1,000 | 5.05% | - | - | $5,000 | 3.07% | $4,925 | ||||
| Mortgage-backed securities | 796 | 4.50% | - | - | - | - | 1,475 | 5.47% | 2,271 | 5.13% | 2,192 | ||||
| Total | $4,796 | 2.90% | $- | - | $1,000 | 5.05% | $1,475 | 5.47% | $7,271 | 3.62% | $7,117 | ||||
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Deposits
Deposits are attracted principally from within the Bank’s primary market areas through the offering of a variety of deposit instruments, including passbook and statement accounts and certificates of deposit ranging in terms from three months to five years. Deposit account terms vary, principally on the basis of the minimum balance required, the time periods the funds must remain on deposit and the interest rate. The Bank also offers individual retirement accounts (“IRA’s”).accounts.
The Bank’s policies are designed primarily to attract deposits from local residents rather than to solicit deposits from areas outside their primary markets. Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations.
Deposits in the Bank as of December 31, 20032006, 2005 and 20022004 consisted of savings programs described below:
2003 | 2002 | |||||||||||||
Amount | Percent | Amount | Percent | |||||||||||
Category | ||||||||||||||
NOW accounts | $ | 21,219,969 | 5.06 | % | $ | 15,980,589 | 4.23 | % | ||||||
Money market accounts | 152,412,884 | 36.31 | 132,767,052 | 35.13 | ||||||||||
Passbooks | 19,190,968 | 4.57 | 18,189,610 | 4.81 | ||||||||||
Certificates | 226,832,739 | 54.04 | 210,913,461 | 55.81 | ||||||||||
| ||||||||||||||
419,656,560 | 99.98 | 377,850,712 | 99.98 | |||||||||||
Accrued interest | 69,625 | .02 | 74,329 | .02 | ||||||||||
| ||||||||||||||
Total savings | $ | 419,726,185 | 100.00 | % | $ | 377,925,041 | 100.00 | % | ||||||
| 2006 | 2005 | 2004 | ||||||||
| (dollars in thousands) | ||||||||||
| NOW accounts | $ | 9,314 | $ | 7,683 | $ | 4,872 | ||||
| Money market accounts | 89,120 | 99,911 | 131,014 | |||||||
| Passbooks | 18,526 | 17,505 | 18,198 | |||||||
| Certificates of deposit | 490,865 | 445,592 | 356,447 | |||||||
| Non-interest bearing accounts | 18,699 | 24,202 | 16,882 | |||||||
| Total deposits | $ | 626,524 | $ | 594,893 | $ | 527,413 | ||||
2003 | |||||||
Amount | Percent | ||||||
One year or less | $ | 125,650,800 | 55.39 | % | |||
More than 1 year to 2 years | 30,261,890 | 13.34 | |||||
More than 2 years to 3 years | 39,724,600 | 17.51 | |||||
More than 3 years to 4 years | 19,889,201 | 8.77 | |||||
More than 4 years to 5 years | 11,306,248 | 4.99 | |||||
More than 5 years | - | .00 | |||||
$ | 226,832,739 | 100.00 | % | ||||
The following table contains information pertaining to the certificates of deposit held by the Bank in excess of $100,000 (“Jumbo CD’s”) as of December 31, 2003.2006.
Jumbo Certificate | ||||
of Deposits | ||||
Time Remaining Until Maturity | (dollars inthousands | ) | ||
Less than three months | $ | 10,046 | ||
3 months to 6 months | 7,852 | |||
6 months to 12 months | 8,739 | |||
Greater than 12 months | 31,242 | |||
Total | $ | 57,879 | ||
| Jumbo Certificate | ||
| of Deposits | ||
| Time Remaining Until Maturity | (dollars in thousands) | |
| Less than three months | $52,452 | |
| 3 months to 6 months | 38,567 | |
| 6 months to 12 months | 67,112 | |
| Greater than 12 months | 42,464 | |
| Total | $200,595 |
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Liquidity and Asset/Liability Management
Two major objectives of asset and liability management are to maintain adequate liquidity and to control the interest sensitivity of the balance sheet.
Liquidity is the measure of a company’s ability to maintain sufficient cash flow to fund operations and to meet financial obligations to depositors and borrowers. Liquidity is provided by the ability to attract and retain deposits and by principal and interest payments on loans and maturing securities in the investment portfolio. A strong core deposit base, supplemented by other deposits of varying maturities and rates, contributes to the Bank’s liquidity.
Funds available through short-term borrowings and asset maturities are considered adequate to meet all current needs, and Managementmanagement 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 savingsswings in net interest income resulting from interest rate movements through GAPgap analysis and income simulation modeling techniques.
Short Term Borrowings
The Bank has an available line of credit, secured by various loans in its residential mortgage portfolio, in the amount of Twenty-Five Percent (25%thirty percent (30%) of its total assets, with the Federal Home Loan Bank of Atlanta.FHLB-Atlanta. As of year-endDecember 31, 2006, the total available line of credit with the Federal Home Loan Bank of AtlantaFHLB-Atlanta for short term and long-term borrowings was $135,118,000.$273,575,000. The Bank, from time to time, utilizes the line of credit when interest rates are more favorable then obtaining deposits from the public. The following table sets forth short-term borrowings with the Federal Home Loan Bank of Atlanta,FHLB-Atlanta, with original maturities of one year or less.
Year ended December 31, | Years ended December 31, | |||||||||||||||||||
2003 | 2002 | 2001 | 2006 | 2005 | 2004 | |||||||||||||||
(dollars in thousands) | (dollars in thousands) | |||||||||||||||||||
Short term borrowings and notes payable | ||||||||||||||||||||
Average balance outstanding during the period | $ | 1,500 | $ | 4,917 | $ | 21,917 | $ | 8,250 | $ | 25,833 | $ | 15,567 | ||||||||
Maximum amount outstanding at any month-end during | ||||||||||||||||||||
the period | 8,000 | 14,000 | 27,000 | 26,000 | 41,000 | 41,000 | ||||||||||||||
Weighted Average interest rate during the period | 0.62 | % | 3.16 | % | 5.38 | % | 5.31 | % | 3.30 | % | 1.67 | % | ||||||||
Total short term borrowings at period end | 6,000 | - | 17,000 | 18,000 | 26,000 | - | ||||||||||||||
Weighted average interest rate at period end | 1.15 | % | 0.00 | % | 4.40 | % | 5.41 | % | 3.33 | % | 0.00 | % | ||||||||
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Employees
As of December 31, 2003, the Bank employed 76 persons on a2006, Bancorp and its subsidiaries had approximately 121 full-time basis and 7 persons on a part-time basis. The Bank’sequivalent employees. Bancorp’s employees are not represented by any collective bargaining group, and management considers its relations with its employees to be excellent. The holding company has no employees.
Severn Capital
The Bank formed Severn Capital in 1997. Severn Capital was created1997 for the purpose of acquiring, holding and managing mortgage loans. Severn Capital hashad elected to be subject to tax as a real estate investment trust under the Internal Revenue Code of 1986, as amended, and regulations promulgated thereunder.thereunder (the “Code”). The Bank ownsowned all of the Common Stockcommon stock of Severn Capital and administersadministered the day-to-day operations of Severn Capital for a fee. There arewere 200,002 shares of preferred stock of Severn Capital outstanding.outstanding, which were held by third parties and which were reflected as minority interest in the consolidated financial statements. Dividends on the preferred stock arewere payable quarterly, in an amount equal to $1.80 per annum per preferred share. The preferred stock is redeemable,On January 31, 2005, the Bank liquidated Severn Capital and redeemed the shares at $20 per share any time after June 30, 2001, at the option of the Bank.share.
Hyatt Real EstateCommercial
Bancorp acquired Hyatt Real Estate,Commercial, a real estate brokerage and property management company, in June 2001. Hyatt Real EstateCommercial is a real estate brokerage company specializing in commercial real estate sales, leasing and property management. It owns the facility within which it is located,property at 1919 West Street, and is also the owner of the property known as 1919A West Street, which is leased to unrelated parties. Hyatt Commercial has entered into an agreement to sell these properties, and is expected to settle on them in the Bank for its administrative offices. Asfirst quarter of December 31, 2003 Hyatt Real Estate had 16 licensed real estate agents and 7 employees.2007.
Crownsville Development Corporation
Crownsville, which is doing business as AEG, is a subsidiary of SBI and is engaged in the business of acquiring real estate for investment and syndication purposes. In 2006, AEG brokered the acquisition of three properties in Delaware and facilitated the syndication of the properties.
SBI Mortgage Company
SBI is a subsidiary of Bancorp that has engaged in the origination of mortgages not suitable for the Bank. It owns subsidiary companies that have or are negotiating to purchase real estate for investment purposes. As of December 31, 2003,2006, SBI had $298,143$1,685,000 in outstanding mortgage loans and it had $520,180$408,000 invested in subsidiaries, which funds were held in cash, pending potential acquisition of investment real estate.
HS West, LLC
HS West, LLC (“HS”) is a subsidiary of the Bank. It owns certainBank, and is constructing a building in Annapolis, Maryland that effective January 2007 will serve as Bancorp’s and the Bank’s administrative headquarters. A branch office of the Bank is included. As of December 31, 2006, HS West, LLC has incurred approximately $26,312,000 of costs, which are included in land beingand construction in progress. The total cost, which includes build-out costs on leased space, is expected to be approximately one acre in size, which is located$28,000,000 with completion mid 2007. HS has entered into agreements to lease all the remaining space in the City of Annapolis, Maryland fronting on Westgate Circle. HS has obtained a special exception approval from the City of Annapolis to construct an 82,000± square foot office building with parking garage on the site. A grading permit has been issuednot occupied by the City of AnnapolisBank and a building permit has been applied for. Estimates have been received for construction and revisions are currently being made in an attempt to reach a figure for construction deemed reasonable by the Bank. It is expected that construction of the office building will commence in the spring of 2004.Bancorp.
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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 most financial institutions, is primarily dependent on interest rate differentials. In general, the difference between the interest rates paid by us on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans extended to its clients and securities held in its investment portfolio, will initially comprise the major portion of our earnings. These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic and foreign economic conditions might have on us cannot be predicted.
General
Savings and loan holding companies and savings associations are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors and the Savings Association Insurance Fund (“SAIF”)DIF and not for the benefit of stockholders of Bancorp. The following information describes certain aspects of that regulation applicable to Bancorp and the Bank, and does not purport to be complete. The discussion is qualified in its entirety by reference to all particular statutory or regulatory provisions.
Regulation of Bancorp
General. Bancorp is a unitary savings and loan holding company subject to regulatory oversight by the Office of Thrift Supervision (“OTS”).OTS. As such, Bancorp is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over Bancorp and its subsidiaries, which also permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings association.
Activities Restriction Test. As a unitary savings and loan holding company, Bancorp generally is not subject to activity restrictions, provided the Bank satisfies the Qualified Thrift Lender (“QTL”) test or meets the definition of domestic building and loan association pursuant to the Internal Revenue Code of 1986, as amended (the “Code”).Code. Bancorp presently intends to continue to operate as a unitary savings and loan holding company. Recent legislation terminated the “unitary thrift holding company exemption” for all companies that apply to acquire savings associations after May 4, 1999. Since Bancorp is grandfathered, its unitary holding company powers and authorities were not affected. See “Financial“Regulation of Bancorp - Financial Modernization Legislation.” However, if Bancorp acquires control of another savings ass ociationassociation as a separate subsidiary, it would become a multiple savings and loan holding company, and the activities of Bancorp and any of its subsidiaries (other than the Bank or any other SAIF-insuredDIF-insured savings association) would become subject to restrictions applicable to bank holding companies unless such other associations each also qualify as a QTL or domestic building and loan association and were acquired in a supervisory acquisition. Furthermore, if Bancorp were in the future to sell control of the Bank to any other company, such company would not succeed to Bancorp grandfathered status under the GLB (as defined below in “Regulation of Bancorp - Financial Services Modernization Legislation”) and would be subject to the same business activity restrictions.restrictions as any other bank holding company. See “- Regulation of the Bank - Qualified Thrift Lender Test.”
Restrictions on Acquisitions. Bancorp must obtain approval from the OTS before acquiring control of any other SAIF-insuredDIF-insured association. Such acquisitions are generally prohibited if they result in a multiple savings and loan holding company controlling savings associations in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings association.
Federal law generally provides that no “person,” acting directly or indirectly or through or in concert with one or more other persons, may acquire “control,” as that term is defined in OTS regulations, of a federally insured savings association without giving at least 60 days written notice to the OTS and providing the OTS an opportunity to disapprove the proposed acquisition. In addition, no company may acquire control of such an institution without prior OTS approval. These provisions also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of a savings and loan holding company, from acquiring control of any savings association not a subsidiary of the savings and loan holding company, unless the acquisition is approved by the OTS. For additional restrictions on the acquisition of a unitary thrift holding company, see “Financial“Regulation of Bancorp - Financial Services Modernization Legislation.” Certain individuals, including Alan J. Hyatt, Louis Hyatt, and Melvin Hyatt, and their respective spouses (“Applicants”), filed an Application for Notice of Change In Control (“Notice”) in April 2001 pursuant to 12CFR12 CFR Section 574.3(b). The Notice called for the Applicants to acquire up to 32.32% of the Company’sBancorp’s issued and outstanding shares of stock of Bancorp by April 16, 2002. The OTS approved requests by the Applicants to extend the time to consummate such acquisition of shares to February 9, 2005.January 4, 2008. The Applicants currently own approximately 28.65%29.25% of the total outstanding shares of the CompanyBancorp as of December 31, 2003.2006.
20
Federal Securities Law. Bancorp’s securities are currently registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. As such, Bancorp is subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Securities Exchange Act of 1934.
The Sarbanes-Oxley Act of 2002
. On July 30, 2002, President Bush signed into lawthe Sarbanes-Oxley Act of 2002 was enacted. The Sarbanes-Oxley Act represents a comprehensive revision of 2002. This new legislation addresseslaws affecting corporate governance, accounting oversightobligations and corporate governance matters, including:
- reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered or that file reports under the
creationSecurities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) new and increased civil and criminal penalties for violations of the securities laws. Many of the provisions were effective immediately while other provisions became effective over afive-member oversight board appointedperiod of time and are subject to rulemaking by the SEC. Because Bancorp’s common stock is registered with the SEC,that will set standards for accountantsit is currently subject to the Sarbanes-Oxley Act.Throughout 2002 andhave investigative2003, the SEC anddisciplinary powers; - Nasdaq Stock Market issued new regulations affecting Bancorp’s corporate governance and heightening its disclosure requirements. Among the
prohibition of accounting firms from providing various types of consulting services to public clients and requiring accounting firms to rotate partners among public client assignments every five years; increased penalties for financial crimes;expanded disclosure ofmany new changes are enhanced proxy statement disclosures on corporateoperations and internal controls and required executive certification of financial presentations;increasedgovernance, stricter independence requirements forboard auditthe Board of Directors and its committees, andtheir members;enhanced controlsposting of various SEC reports on our website. The full impact of the Sarbanes-Oxley Act is still uncertain andreporting of, insider trading; andstatutory separations between investment bankers and analysts.
We cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on our operations.
USA Patriot Act of 2001
. On October 26, 2001, President Bush signedthe Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA Patriot Act of 2001.2001 was enacted. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money laundering measures affecting insured depository institutions, broker-dealers and other financial institutions. The Patriot Act is intended isrequires U.S. financial institutions to strengthen U.S. law enforcement'sadopt new policies and the intelligence communities' abilities to work cohesivelyprocedures to combat terrorism on a variety of fronts. The potential impactmoney laundering and grants the Secretary of the ActTreasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including:institutions.
due diligence requirements for financial institutions that administer, maintain, or manage private banks accounts or correspondent accounts for non-US personsstandards for verifying customer identification at account openingrules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money launderingreports by nonfinancial trades and businesses filed with the Treasury Department's Financial Crimes Enforcement Network for transactions exceeding $10,000, andfiling of suspicious activities reports securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.
Financial Services Modernization Legislation
The general effect of the lawGLB is to establish a comprehensive framework to permit affiliations among commercial banks, other depository institutions, insurance companies and securities firms and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system to engageenter into combinations that result in a full rangesingle financial services organization to offer customers a wider array of financial activitiesservices and products, through a new entity known as a “Financial Holding Company.“financial holding company.” “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additionalother activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financia lfinancial activities or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
21
The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a Financial Holding Company.financial holding company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation.
Maryland Corporation Law. Bancorp may only be acquired by other unitary savings and loan holding companies or Finan cial Holding Companies, the legislation may have an anti-takeover effect by limiting the number of potential acquirors or by increasing the costs of an acquisition transaction by a bank holding company that has not made the election to be a Financial Holding Companyis incorporated under the new legislation.laws of the State of Maryland, and is therefore subject to regulation by the state of Maryland. The rights of Bancorp’s stockholders are governed by the Maryland General Corporation Law.
Regulation of the Bank
General. As a federally chartered, SAIF-insuredDIF-insured savings association, the Bank is subject to extensive regulation by the OTS and the Federal Deposit Insurance Corporation (“FDIC”).FDIC. Lending activities and other investments of the Bank must comply with various statutory and regulatory requirements. The Bank is also subject to certain reserve requirements promulgated by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”).FRB.
The OTS, in conjunction with the FDIC, regularly examines the Bank and prepares reports for the consideration of the Bank’s Board of Directors on any deficiencies found in the operations of the Bank. The relationship between the Bank and depositors and borrowers is also regulated by federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents utilized by the Bank.
The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the SAIFDIF and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulations, whether by the OTS, the FDIC or the Congress could have a material adverse impact on B ancorp,Bancorp, the Bank, and their operations.
initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates;annual notices of their privacy policies to current customers; anda reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.
interprets previously issued interagency customer information security guidelines that require financial institutions to implement information security programs designed to protect their customers’ information; anddescribes the components of a response program and sets a standard for providing notice to customers affected by unauthorized access to or use of customer information that could result in substantial harm or inconvenience to those customers, thereby reducing the risk of losses due to fraud or identity theft.
Regulatory Capital Requirements. The federal banking agencies have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk federal banking agencies, to 100% for assets with relatively high credit risk.
The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risk. Under the capital guidelines, a banking organization’s total capital is divided into tiers. “Tier I capital” consists of (1) common equity, (2) qualifying noncumulative perpetual preferred stock, (3) a limited amount of qualifying cumulative perpetual preferred stock and (4) minority interests in the equity accounts of consolidated subsidiaries (including trust-preferred securities), less goodwill and certain other intangible assets. Not more than 25% of qualifying Tier I capital may consist of trust-preferred securities. “Tier II capital” consists of hybrid capital instruments, perpetual debt, mandatory conve rtibleconvertible debt securities, a limited amount of subordinated debt, preferred stock that does not qualify as Tier I capital, a limited amount of the allowance for loan and lease losses and a limited amount of unrealized holding gains on equity securities. “Tier III capital” consists of qualifying unsecured subordinated debt. The sum of Tier II and Tier III capital may not exceed the amount of Tier I capital.
22
In addition, the guidelines require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
The Bank is not subject to any such individual minimum regulatory capital requirement.
As shown below, the Bank’s regulatory capital exceeded all minimum regulatory capital requirements applicable to it as of December 31, 2003.2006.
Actual | For Capital Adequacy Purposes | To Be Well Capitalized Under Prompt Corrective Action Provisions | Actual | Required For Capital Adequacy Purposes | Required To Be Well Capitalized Under Prompt Corrective Action Provisions | |||||||||||||||||||||||||||||||||
Amount | % | Amount |
| % |
|
| Amount |
| % | Amount | % | Amount | % | Amount | % | |||||||||||||||||||||||
December 31, 2003 | ||||||||||||||||||||||||||||||||||||||
| (dollars in thousands) | ||||||||||||||||||||||||||||||||||||||
| December 31, 2006 | ||||||||||||||||||||||||||||||||||||||
Tangible (1) | $ | 49,568,918 | 9.2 | % | $ | 8,095,323 | 1.50 | % | N/A | N/A | $ | 99,445 | 11.0 | % | $ | 13,513 | 1.50 | % | N/A | N/A | ||||||||||||||||||
Tier I capital (2) | 49,568,918 | 12.0 | % | N/A | N/A | $ | 24,692,400 | 6.00 | % | 99,445 | 13.1 | % | N/A | N/A | $ | 45,582 | 6.00 | % | ||||||||||||||||||||
Core (1) | 49,568,918 | 9.2 | % | 21,587,529 | 4.00 | % | 26,984,411 | 5.00 | % | 99,445 | 11.0 | % | 36,034 | 4.00 | % | 45,043 | 5.00 | % | ||||||||||||||||||||
Risk-weighted (2) | 54,313,918 | 13.2 | % | 32,923,200 | 8.00 | % | 41,154,000 | 10.00 | % | |||||||||||||||||||||||||||||
| Total (2) | 108,452 | 14.3 | % | 60,776 | 8.00 | % | 75,971 | 10.00 | % | |||||||||||||||||||||||||||||
December 31, 2002 | ||||||||||||||||||||||||||||||||||||||
| December 31, 2005 | ||||||||||||||||||||||||||||||||||||||
Tangible (1) | $ | 39,898,384 | 8.8 | % | $ | 6,837,788 | 1.50 | % | N/A | N/A | $ | 86,354 | 10.3 | % | $ | 12,619 | 1.50 | % | N/A | N/A | ||||||||||||||||||
Tier I capital (2) | 39,898,384 | 12.1 | % | N/A | N/A | $ | 19,768,800 | 6.00 | % | 86,354 | 12.2 | % | N/A | N/A | $ | 42,395 | 6.00 | % | ||||||||||||||||||||
Core (1) | 39,898,384 | 8.8 | % | 18,234,100 | 4.00 | % | 22,792,625 | 5.00 | % | 86,354 | 10.3 | % | 33,651 | 4.00 | % | 42,064 | 5.00 | % | ||||||||||||||||||||
Risk-weighted (2) | 43,781,865 | 13.3 | % | 26,358,400 | 8.00 | % | 32,948,000 | 10.00 | % | |||||||||||||||||||||||||||||
| Total (2) | 93,851 | 13.3 | % | 56,527 | 8.00 | % | 70,659 | 10.00 | % | |||||||||||||||||||||||||||||
____________
(1) To adjusted total assets.
(2) To risk-weighted assets.
The Home Owners’ Loan Act (“HOLA”) permits savings associations not in compliance with the OTS capital standards to seek an exemption from certain penalties or sanctions for noncompliance. Such an exemption will be granted only if certain strict requirements are met, and must be denied under certain circumstances. If an exemption is granted by the OTS, the savings association still may be subject to enforcement actions for other violations of law or unsafe or unsound practices or conditions.
making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation ("asset-based lending")inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced ("loan flipping")engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.
interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities,subordinate-lien loans of 10 percentage points above Treasury securities. andfees such as optional insurance and similar debt protection costsamounts paidin connection withare unreasonable or disproportionate to thecredit transaction, when combined with points and fees if deemed excessive.
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In addition, the regulation bars loan flippingOTS adopted regulations to require a savings bank that is given notice by the same lender or loan servicer withinOTS that it is not satisfying any such safety and soundness standards to submit a year. Lenders also will be presumed to have violated the law -- which says loans shouldn't be made to people unable to repay them -- unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equalcompliance plan to the finance charges paid.
Prompt Corrective Action. The prompt corrective action regulation of the OTS, requires certain mandatory actions and authorizes certain other discretionary actions to be taken by the OTS against a savings association that falls within certain undercapitalized capital categories specified in the regulation.
The regulation establishes five categories of capital classification:
“well capitalized;”· “well capitalized”; “adequately capitalized;”· “adequately capitalized”; “undercapitalized;”· “undercapitalized”; “significantly undercapitalized;”· “significantly undercapitalized”; and “critically undercapitalized.”· “critically undercapitalized”.
Under the regulation, the risk-based capital, leverage capital, and tangible capital ratios are used to determine an institution’s capital classification. At December 31, 2003,2006, the Bank met the capital requirements of a “well capitalized” institution under applicable OTS regulations.
In general, the prompt corrective action regulation prohibits an insured depository institution from declaring any dividends, making any other capital distribution, or paying a management fee to a controlling person if, following the distribution or payment, the institution would be within any of the three undercapitalized categories. In addition, adequately capitalized institutions may accept Brokered Depositsbrokered deposits only with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll-over Brokered Deposits.brokered deposits.
If the OTS determines that an institution is in an unsafe or unsound condition, or if the institution is deemed to be engaging in an unsafe and unsound practice, the OTS may, if the institution is well capitalized, reclassify it as adequately capitalized; if the institution is adequately capitalized but not well capitalized, require it to comply with restrictions applicable to undercapitalized institutions; and, if the institution is undercapitalized, require it to comply with certain restrictions applicable to significantly undercapitalized institutions. Finally, pursuant to an interagency agreement, the FDIC can examine any institution that has a substandard regulatory examination score or is considered undercapitalized –- without the express permission of the institution’s primary regulator.
Premiums for Deposit Insurance. Until recently, the deposits in the Bank were insured by the Savings Association Insurance Fund (“SAIF”), administered by the FDIC. On February 8, 2006 the Federal Deposit Insurance Reform Act of 2005 was enacted, which among other things, merged the SAIF with the Bank Insurance Fund (“BIF”), creating the DIF, effective as of March 31, 2006.
The FDIC has also adopted a new risk-based premium system that provides for quarterly assessments based on an insured institution's ranking in one of four risk categories that are based upon supervisory and capital evaluations. The FDIC’s regulations establish four risk categories. Risk Category I, for well-capitalized institutions that are financially sound with only a few minor weaknesses, includes about 95% of FDIC-insured institutions based on FDIC estimates. Bancorp is within Risk Category I. Risk Categories II, III and IV present progressively greater risks to the DIF. Effective January 1, 2007, Risk Category I institutions pay quarterly assessments for deposit insurance at annual rates of 5 to 7 basis points (i.e., $0.05 to $0.07 per $100 of assessable deposits). The rates for Risk Categories II, III and IV are 10, 28 and 43 basis points, respectively. With advance notice to insured institutions, rates are subject to change. Within Risk Category I, the precise rate for an individual institution with less than $10 billion in assets is generally determined by a formula using CAMELS ratings, which are bank ratings assigned in examinations, and financial ratios. A different method applies for larger institutions. The rate for an individual institution is applied to its assessment base, consisting generally of its deposit liabilities subject to certain adjustments. An institution insured by the FDIC on December 31, 1996 which had previously paid assessments (or its successor) is eligible for certain credit against deposit insurance assessments. Any increase in assessments or the assessment rate could have a material adverse effect on Bancorp’s earning, depending on the amount of the increase.
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The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for one or more of Bancorp’s subsidiary depository institutions could have a material adverse effect on Bancorp’s earnings, depending on the collective size of the particular institutions involved.
All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, commonly referred to as Financing Corporation (“FICO”) bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. The annual FICO assessment rate as of the first quarter of 2007 is 1.22 basis points (i.e. $0.0122 for every $100 of assessable deposits). The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.
Privacy. Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide:
| · | initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; |
| · | annual notices of their privacy policies to current customers; and |
| · | a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties. |
These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. Since GLB’s enactment, a number of states have implemented their own versions of privacy laws. The Bank has implemented its privacy policies in accordance with the law.
Interagency Guidance on Response Programs for Unauthorized Access to Customer Information and Customer Notice. On March 30, 2005, the federal bank and thrift regulatory agencies jointly issued a guidance that required financial institutions to develop programs to respond to incidents of unauthorized access to customer information, including procedures for notifying customers under certain circumstances. The proposed guidance:
| · | interprets section 501(b) of the GLB Act and previously issued interagency customer information security guidelines that require financial institutions to implement information security programs designed to protect their customer’s information; and |
| · | describe the components of a response program and sets a standard for providing notice to customers affected by unauthorized access to or use of customer information that could result in substantial harm or inconvenience to those customers, thereby reducing the risk of losses due to fraud or identify theft. |
| · | Among other security measures, requires financial institutions to notify law enforcement authorities and their primary federal regulator when such institutions become aware of an incident involving unauthorized access to or use of sensitive customer information |
The Bank is required to and intends to comply with the guidance as it is interpreted and applied by the OTS.
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Predatory Lending. The term “predatory lending” much like the terms “safety and soundness” and “unfair deceptive practices,” is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But, typically predatory lending involves at least one, and perhaps all three, of the following elements:
| · | making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation (“asset-based lending”) |
| · | inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced (“loan flipping”) |
| · | engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower. |
On October 1, 2002, FRB regulations aimed at curbing such lending became effective. The rule significantly widens the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. The following triggers coverage under the act:
| · | interest rates for first lien mortgage loans in excess of 8 percentage points above the comparable U.S. Treasury securities, |
| · | subordinate-lien loans of 10 percentage points above U.S. Treasury securities; and |
| · | fees such as optimal insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive. |
In addition, the regulations bar loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law - which says the loans shouldn’t be made to people unable to repay them - unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid.
The Bank is unable at this time to determine the impact of these rule changes and potential state action in this area on its financial condition or results of operation.
Loans-to-One Borrower Limitations. Savings associations generally are subject to the lending limits applicable to national banks. With certain limited exceptions, the maximum amount that a savings association or a national bank may lend to any borrower (including certain related entities of the borrower) at one time may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. Savings associations are additionally authorized to make loans to one borrower, for any purpose, in an amount not to exceed $500,000 or, by order of the Director of the OTS, in an amount not to exceed the lesser of $30,000,000 or 30% of unimpaired capital and surplus to develop residential housing, provided:
| · | the purchase price of each single-family dwelling in the development does not exceed $500,000; |
| · |
| · | the loans comply with applicable loan-to-value requirements; and |
· |
| the aggregate amount of loans made under this authority does not exceed 150% of unimpaired capital and surplus. |
the purchase price of each single-family dwelling in the development does not exceed $500,000;the savings association is in compliance with its fully phased-in capital requirements;the loans comply with applicable loan-to-value requirements; andthe aggregate amount of loans made under this authority does not exceed 150% of unimpaired capital and surplus.
At December 31, 2003,2006, the Bank’s loans-to-one-borrower limit was $7,435,000$14,917,000 based upon the 15% of unimpaired capital and surplus measurement. At December 31, 2003,2006, the Bank’s largest single lending relationship had an outstanding balance of $5,200,000,$7,000,000, and consisted of a loanline of credit secured by two office buildings in Reston, Virginia,assignments of notes, Deeds of Trust, pledged stock and certificates of deposit. The loan was performing in accordance with its terms.
Qualified Thrift Lender Test. Savings associations must meet a QTL test, which test may be met either by maintaining a specified level of assets in qualified thrift investments as specified in HOLA or by meeting the definition of a “domestic building and loan association” as defined in the Code. Qualified thrift investments are primarily residential mortgages and related investments, including certain mortgage-related securities. The required percentage of investments under HOLA is 65% of assets while the Code requires investments of 60% of assets. An association must be in compliance with the QTL test or the definition of domestic building and loan association on a monthly basis in nine out of every 12 months. Associations that fail to meet the QTL test will generally be prohibited from engaging in any activity not permitted for both a national ban kbank and a savings association. As of December 31, 2003,2006, the Bank was in compliance with its QTL requirement and met the definition of a domestic building and loan association.
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Affiliate Transactions. Transactions between a savings association and its "affiliates" are quantitatively and qualitatively restricted under the Federal Reserve Act and regulations adopted by the Federal Reserve. Affiliates of a savings association include, among other entities, the savings association's holding company and companies that are under common control with the savings association. In general, a savings association or its subsidiaries are limited in their ability to engage in "covered transactions" with affiliates:
to an amount equal to 10% of the association's capital and surplus, in the case of covered transactions with any one affiliate; andto an amount equal to 20% of the association's capital and surplus, in the case of covered transactions with all affiliates.· to an amount equal to 10% of the association's capital and surplus, in the case of covered transactions with any one affiliate; and
| · | to an amount equal to 20% of the association's capital and surplus, in the case of covered transactions with all affiliates. |
In addition, a savings association and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the savings association or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A "covered transaction" includes:
a loan or extension of credit to an affiliate;a purchase of investment securities issued by· a loan or extension of credit to an affiliate; a purchase of assets from an affiliate, with some exceptions;· a purchase of investment securities issued by an affiliate; the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; or· a purchase of assets from an affiliate, with some exceptions; the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.· the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; or
| · | the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. |
In addition, under the OTS regulations:
· a savings association may not make a loan or extension of credit to an affiliate unless the affiliate is engaged only in activities permissible for bank holding companies; a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary;a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate;covered transactions and other specified transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; andwith some exceptions, each loan or extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.27· a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary; · a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate; · covered transactions and other specified transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and · with some exceptions, each loan or extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, the amount of the loan, or extension of credit. Regulations generally exclude all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except for:a financial subsidiary,a subsidiary controlled by one or more affiliates,· a financial subsidiary; an ESOP,· a subsidiary controlled by one or more affiliates; a subsidiary determined by the OTS or the Federal Reserve to be an affiliate.· an ESOP; or
· a subsidiary determined by the OTS or the Federal Reserve to be an affiliate. The regulations also require savings associations to make and retain records that reflect affiliate transactions in reasonable detail andprovidesprovide that specified classes of savings associations may be required to give the OTS prior notice of affiliate transactions.Some of the entities included in the definition of an affiliate are parent companies, sister banks, sponsored and advised companies, investment companies whereby the bank its affiliate serves as investment advisor, and financial subsidiaries of the bank. Additional restrictions on transactions with affiliates may be imposed on us under the prompt corrective action provisions of federal law. See“- Prompt“Prompt CorrectiveAction and Other Enforcement Mechanisms.Action.”27Capital Distribution Limitations. OTS regulations impose limitations upon all capital distributions by savings associations,likesuch 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 OTS regulations require a savings association to file an application if:it is not eligible for expedited treatment of its other applications under OTS regulations;the total amount of all of capital distributions, including the proposed capital distribution, for the applicable calendar year exceeds its net income for that year to date plus retained net income for the preceding two years;· it is not eligible for expedited treatment of its other applications under OTS regulations; it would not be at least adequately capitalized, under the prompt corrective action regulations of the OTS following the distribution; or· 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's proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the savings association and the OTS, or the FDIC, or violate a condition imposed on the savings association in an OTS-approved application or notice.· it would not be at least adequately capitalized, under the prompt corrective action regulations of the OTS following the distribution; or
· the association's proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the savings association and the OTS, or the FDIC, or violate a condition imposed on the savings association in an OTS-approved application or notice. In addition, a savings association must give the OTS notice of a capital distribution if the savings association is not required to file an application, but:would not be well capitalized under the prompt corrective action regulations of the OTS following the distribution;the proposed capital distribution would reduce the amount of or retire any part of the savings association's common or preferred stock or retire any part of debt instruments like notes or debentures included in capital, other than regular payments required under a debt instrument approved by the OTS; or· would not be well capitalized under the prompt corrective action regulations of the OTS following the distribution; the savings association is a subsidiary of a savings and loan holding company.· the proposed capital distribution would reduce the amount of or retire any part of the savings association's common or preferred stock or retire any part of debt instruments like notes or debentures included in capital, other than regular payments required under a debt instrument approved by the OTS; or
· the savings association is a subsidiary of a savings and loan holding company. If neither the savings association nor the proposed capital distribution meets any of the above listed criteria, the OTS does not require the savings association to submit an application or give notice when making the proposed capital distribution. The OTS may prohibit a proposed capital distribution that would otherwise be permitted if the OTS determines that the distribution would constitute an unsafe or unsound practice.Interstate Banking and Branching.BranchingA. Under OTS branching regulations, the Bank is generally authorized to open branches within or beyond the State of Maryland if the Bank (1) continues to meet the requirements of a “highly-rates” federal savingsassociation hasbank. And (2) publishes public notice at least 35 days before opening a branch and no one opposes theabilitybranch. If a comment in opposition toestablish branches outside its home state.a branch opening is filed and the OTS determines the comment to be relevant to the approval process standards, and to require action in response, the OTS may, among other things, require a branch application or elect to hold a meeting with the Bank and the person who submitted the comment. The OTS authority preempts any state law purporting to regulate branching by federal savings banks. Commercial banks can also branch across state lines, subject to any state law limitations or prohibitions. Competition may increase further as banks branch across state lines and enter new markets.28Community Reinvestment Act and the Fair Lending Laws. Savings associations have a responsibility under the Community Reinvestment Act and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities and the denial of applications. In addition, an institution's failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in the OTS, other federal regulatory agencies as well as the Department of Justice taking enforcement actions. Based on an examination conducted July7,2003,7, 2003, the Bank received a satisfactory rating.28Effective January 1, 2002, the OTS raised the dollar amount limit in the definition of small business loans from $500,000 to $2.0 million, if used for commercial, corporate, business or agricultural purposes. Furthermore, the rule raises the aggregate level that a thrift can invest directly in community development funds, community centers and economic development initiatives in its communities from the greater of a quarter of one percent of total capital or $100,000 to one percent of total capital or $250,000.Anti-Money Laundering and Customer Identification. The Bank is subject to the OTS Financial Crimes Enforcement Network regulations implementing the Bank Secrecy Act, as amended by the USA Patriot Act of 2001. The USA Patriot Act gives the federal government powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA Patriot Act takes measures intended to encourage information sharing among banks, regulatory agencies and law enforcements bodies. Certain provisions of the USA Patriot Act impose affirmative obligations on a broad range of financial institutions, including savings banks like the Bank.The USA Patriot Act and the related OTS regulations impose the following requirements with respect to financial institutions:· Establishing of anti-money laundering programs, including adoption of written procedures, designation of a compliance officer and auditing of the program; · Establishment of a program specifying procedures for obtaining identifying information from customers seeking to open new accounts, including verifying the identity of customers within a reasonable period of time; · Establishment of enhanced due diligence policies, procedures and controls designed to detect and report money laundering; · Prohibition on correspondent accounts for foreign shell banks and compliance with record keeping obligations with respect to correspondent accounts of foreign banks; and · Requirements that bank regulators consider a holding company’s effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications. Federal Home Loan Bank System. The Bank is a member of theFHLB system.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. As an FHLB member, the Bank is required to own capital stock in an FHLB in an amount equal to the greater of:· 1% of its aggregate outstanding principal amount of its residential mortgage loans, home purchase contracts and similar obligations at the beginning of each calendar year; or · 5% of its FHLB advances or borrowings.
At December 31,2003,2006, the Bank was in compliance with this requirement.The GLB Act made significant reforms toA new capital plan of theFHLB system, including:Expanded Membership – (i) expandsFHLB-Atlanta was implemented on December 17, 2004. It was subsequently amended on December 8, 2005, and theuses for, and typesamendment was approved by the regulator ofcollateral for advances; (ii) eliminates bias toward QTL lenders; and (iii) removes capital limits on advances using real estate related collateral (e.g., commercial real estate and home equity loans).New Capital Structure – each FHLB is allowed to establish two classes of stock: Class A is redeemable within six months of notice; and Class B is redeemable within five years notice. Class B is valued at 1.5 timesthevalue of Class A stock. Each FHLB will be required to maintain minimum capital equal to 5% of equity. As of July 17, 2002, each FHLB, including our FHLB of Atlanta, receivedFHLB-Atlanta, the Federal Housing Finance Board,approval ofon January 25, 2006. The new capital plan, as amended, authorizes FHLB-Atlanta to issue, redeem and repurchase its capitalplan.stock at its stated par value of $100 per share. Each member of FHLB-Atlanta is required to own capital stock in an amount equal to the sum of:29· the membership stock requirement, which is the lesser of: (i) 0.20% of such member’s total assets as of December 31 of the previous calendar year; or(ii) a specified dollar cap (initially estimated at $25 million); plus· the activity-based stock requirement, which is the aggregate of: (i) a specified percentage (initially estimated at 4.50%) of the outstanding advances from FHLB-Atlanta to each member;(ii) a specified percentage (initially estimated at 0.00%) of the “acquired member assets” (as defined in FHLB regulations) sold by each member to FHLB-Atlanta; and(iii) a specified percentage (initially estimated at 8.00%) of any targeted debt/equity investment (which satisfies the criteria set forth in the FHLB regulations) sold by each member to FHLB-Atlanta.Nontraditional Mortgage Products. On September 29, 2006, the federal banking agencies published final guidance for institutions that originate or service nontraditional or alternative mortgage products, defined to include all residential mortgage loan products that allow borrowers to defer repayment on principal or interest, such as interest-only mortgages and payment option adjustable-rate mortgages. A portion of the Bank’s adjustable-rate residential mortgage loans are alternative mortgage loans.Recognized that alternative mortgage products expose the institutions to increased risks as compared to traditional loans where payments amortize or reduce the principal amount, the guidance required increased scrutiny for alternative mortgage products. Institutions that originate or service alternative mortgages should have (1) strong risk management practices that include maintenance of capital levels and allowance for loan losses commensurate with the risk; (2) prudent lending policies and underwriting standards that address the borrower’s repayment capacity; and (3) programs and practices designed to ensure that consumers receive clear and balanced information to assist in making informed decisions about mortgage products. The guidance also recommends heightened controls and safeguards when an institution combines an alternative mortgage product with features the compound risk, such as a simultaneous second-lien or the use of reduced documentation to evaluate a loan application.The Bank is required to an intends to comply with the guidance as it is interpreted and applied by the OTS.Assessments. The OTS charges assessments to recover the cost of examining federal savings banks and their affiliates. Theseplans must be implemented by July 1, 2004.Voluntary Membership – federally charteredassessments are based on three components: (1) the size of the institution on which the basic assessment is based; (2) the institution’s supervisory condition, which results in an additional assessment based on a percentage of the basic assessment for any savingsassociations,institution with a composite rating of 3,4 or 5 in its most recent safety and soundness examination; and (3) the complexity of the institution’s operations, which results in an additional assessment based on a percentage of the basic assessment for any savings institution that managed over $1 billion in trust assets, serviced for others loans aggregating more than $1 billion, or had certain off-balance sheet assets aggregating more than $1 billion.The OTS also assesses fees against savings and loan holding companies such as theBank, are no longer required to be members ofBancorp. The OTS semi-annual assessment for savings and loan holding companies includes a $3,000 base assessment with an additional assessment based on thesystem.holding company’s risk or complexity, organizational form and condition.REFCorp Payments – changes the amount paid by the system on debt incurred in connection with the thrift crisis in the late 1980s from a fixed amount to 20% of net earnings after deducting certain expenses.
Federal Reserve System. TheFederal Reserve BoardFRB requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits. At December 31,2003,2006, the Bank was in compliance with these requirements.Activities of Subsidiaries. A savings association seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through a subsidiary must provide 30 days prior notice to the FDIC and the OTS and conduct any activities of the subsidiary in compliance with regulations and orders of the OTS. The OTS has the power to require a savings association to divest any subsidiary or terminate any activity conducted by a subsidiary that the OTS determines to pose a serious threat to the financial safety, soundness or stability of the savings association or to be otherwise inconsistent with sound banking practices.30Item 1A. Risk FactorsUnless the context indicates otherwise, all references to “we,” “us,” “our” in this subsection “Risk Factors” refer to the Bancorp and its subsidiaries. You should carefully consider the risks described below as well as elsewhere in this Annual Report on Form 10-K. If any of the risks actually occur, our business, financial condition or results of future operations could be materially adversely affected. This Annual Report on Form 10-K contains forward-looking statements that involve risk 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.We may be adversely affected by changes in economic and political conditions and by governmental monetary and fiscal policies.The thrift 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 could 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, could have a material adverse impact on our ability to remain profitable.Changes in interest rates could adversely affect our financial condition and results of operations.The operations of financial institutions, such as us, 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, by the fiscal and monetary policies of the federal government and by 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 US Government and 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 financial institutions.Most of our loans are secured by real estate located in our market area. If there is a downturn in our real estate market, these borrowers may default on their loans and we may not be able to fully recover our loans.A downturn in the real estate market could hurt our business because most of our loans are secured by real estate. Substantially all of our real property collateral is located in the states of Maryland, Virginia and Delaware. As of December 31, 2006, approximately 95% of the book value of our loan portfolio consisted of loans collateralized by various types of real estate. 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. If real estate prices decline, the value of real estate collateral securing our loans could be reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans. Any such downturn could have a material adverse effect on our business, financial condition and results of operations.In addition, approximately 65% 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”.31We 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 adversely affected.Our operations are located in Anne Arundel County, Maryland, which makes our business highly susceptible to local economic conditions, and an economic downturn or recession in that area may adversely affect our ability to operate profitably.Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in Anne Arundel County, Maryland. In addition, almost 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 this market area. A deterioration or recession in economic conditions in this market could result in one or more of the following:· 29a 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 the customers’ borrowing power. Any of the foregoing factors may adversely affect our ability to operate profitably.We are subject to federal and state regulationand the monetary policies of the Federal Reserve Board. 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 Federal Reserve Board 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 Federal Reserve Board to implement its objectives are changes in the discount rate charged on bank borrowings and changes in the reserve requirements on bank deposits. It is not possible to predict what changes, if any, will be made to the monetary polices of the Federal Reserve Board or to existing federal and state legislation or the effect that such changes may have on our future business and earnings prospectsWe have established an allowance for loan losses based on our management's estimate. 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 stock.We have established an allowance for loan losses which management believes to be adequate to offset probable losses on our existing loans. However, there is no precise method of estimating loan losses and our ongoing analysis may cause this estimate to change in the future and actual losses may differ materially from this estimate. In addition, there can be no assurance that any future declines in real estate market conditions, general economic conditions or changes in regulatory policies will not require us to increase our allowance for loan losses. Any increase in the allowance for loan losses will reduce our earnings and may adversely affect the price of our common stock.32We compete with a number of local, regional and national financial institutions for customers.We face strong competition from other thrifts, banks, savings institutions 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 we do. In addition, many of our competitors have higher legal lending limits than we do. Particularly intense competition exists for sources of funds including savings and retail time deposits and for loans, deposits and other services that we offer.During the past several years, significant legislative attention has been focused on the regulation and deregulation of the financial services industry. Non-bank financial institutions, such as securities brokerage firms, insurance companies and money market funds, have been permitted to engage in activities that compete directly with traditional bank business. Competition with various financial institutions could hinder our ability to maintain profitable operations and grow our business.Our information systems may experience an interruption or breach in security, which could result in a loss of business.We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. 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, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. We depend on third-party providers for many of our systems and if these 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 create 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.There can be no assurance that we will continue to pay dividends in the future.Although we expect to continue our policy of regular quarterly dividend payments, this dividend policy will be reviewed periodically in light of future earnings, regulatory restrictions and other considerations. No assurance can be given, therefore, that cash dividends on common stock will be paid in the future at the same rate or at all.33An investment in our common stock is not insured against loss.Investments in the shares of our common stock are not deposits insured against loss by the FDIC or any other entity. As a result, you may lose some or all of your investment.Our success depends on our senior management team and if we are not able to retain them, it could have a materially adverse effect on us.We are highly dependent upon the continued services and experience of our senior management team, including Alan J. Hyatt, our 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 client 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.“Anti-takeover” provisions may make it more difficult for a third party to acquire control of us, even if the change in control would be beneficial to shareholders.Our charter presently contains certain provisions which 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, our charter provides that our board of directors may issue up to 1,000,000 shares of preferred stock without shareholder approval. 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 shareholders 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 the our board of directors.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 shareholders may lose confidence in our financial reporting and disclosure required under the Securities Exchange Act of 1934, which could adversely affect our business and we could be subject to regulatory scrutiny.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 and our registered public accounting firm’s attestation report on our management’s assessment of our internal control over financial reporting. While we have reported no or “material weaknesses in this Form 10-K, we cannot guarantee that we will not have any “significant deficiencies” or “material weaknesses” reported by our independent registered public accounting firm in the future. 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 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 establish an effective system of disclosure controls and procedures could cause our current and potential shareholders 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.34Terrorist attacks and threats or actual war may impact all aspects of our operations, revenues, costs and stock price in unpredictable ways.Recent 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 United States 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 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.Item 1B. Unresolved Staff CommentsNoneItem 2. PropertiesBancorpowns itshas four retail branch locationsat 1917 West Street,in Anne Arundel County, Maryland, of which it owns three and leases the fourth. The Bank, Homeowner’s Title, and HC all lease their executive and administrative offices located in Annapolis, Maryland21401 and 413 Crain Highway, South-East, Glen Burnie, Maryland 21061. The Bank’s executive office at 1919Afrom HS WestStreet, Annapolis, Maryland 21401 (which also serves as a loan production office) is leased from HRE,LLC, a wholly owned subsidiary ofBancorp. HREthe Bank. HS West LLC owns its office buildingat 1919 West Street,in Annapolis,Maryland 21401.TheMaryland. In addition, the Bank leases office spacefor its accounting and loan servicing officesin Annapolis Maryland from a thirdparty at 1927party.HS WestStreet, Annapolis, Maryland 21401. Homeowner’s Title,LLC is a subsidiary of the Bank,leases space at 1925 West Street, Annapolis, Maryland 21401 from a limited liability company of which Alan J. Hyatt, Bancorp’s ChairmanandChief Executive Officer,isa principal, on a term of 3 years, subject to the right of Homeowner’s Title to exercise early termination, at its option. Current monthly rental paid by Homeowner’s Title is $3,664.50.HS West, LLC, a subsidiary of Bancorp, intends to constructconstructing a building intheAnnapolis, Marylandarea tothat effective January 2007 will serve as Bancorp’s and the Bank’s administrative headquarters. A branch officewill beof the Bank is included.To date,As of December 31, 2006, HS West,LLC has incurred approximately$1,701,854$26,312,000 ofcost including the value of the land.costs, which are included in land and construction in progress. The total cost, which includes build-outs on leased space, is expected to be approximately$17,000,000,$28,000,000 with completion mid 2007. HS West LLC has entered into agreements to lease all the remaining space inNovember 2005.the building not occupied by the Bank and Bancorp.Item 3. Legal ProceedingsThere are no material pending legal proceedings to which Bancorp, the Bank or any subsidiary is a party or to which any of their property is subject.Item 4. Submission of Matters to a Vote of Security HoldersNone.PART IINone.Executive Officers of the Registrant that are not Directors.Thomas G. Bevivino, age 51, has served as the Chief Financial Officer of Bancorp since July 1, 2005. He serves in the same capacity for the Bank. Mr. Bevivino was a financial consultant from 2002 until 2004, and served as Chief Financial Officer of Luminant Worldwide Corporation from 1999 until 2002.35PART IIItem 5. Market for Registrant's Common Equity,andRelated Stockholder Matters and Issuer Purchases of Equity SecuritiesThe graph below sets forth comparative information regarding the Company’s cumulative shareholder return on its Common Stock over the last five years. Total shareholder return is measured by dividing total dividends (assuming dividend reinvestment) for the measurement period plus share price change for a period by the share price at the beginning of the measurement period. Severn Bancorp, Inc.'s cumulative shareholder return is based on an investment of $100 on December 31, 2001, and is compared to the cumulative total return of the NASDAQ Composite Index and the SNL Securities LC Thrift Index for thrifts with total assets between $500 million and $1.0 billion (the "SNL Thrift ($500M to $1.0B) Index")Comparison of Cumulative Total Return Among Severn, NASDAQ Composite Indexand SNL Thrift ($500M to $1.0B) Index from December 31, 2001 to December 31, 2006
Period EndingIndex12/31/0112/31/0212/31/0312/31/0412/31/0512/31/06Severn Bancorp, Inc. 100.00 180.88 364.92 559.00 456.67 502.73 NASDAQ Composite Index 100.00 68.76 103.67 113.16 115.57 127.58 SNL $500M-$1B Thrift Index 100.00 140.09 199.47 220.65 209.70 256.94 36Quarterly Stock Information*200320022006 Closing2006 Closing2005 ClosingStock Price Range Stock Price Range Stock Price Range Per Share Stock Price Range Per Share Quarter Low High Per Share Dividend Quarter Low High Per Share Dividend Low High Dividend Quarter Low High Dividend 1st$ 15.82 $ 22.00 $.08 1st$ 8.67 $ 11 $.06 $16.72 $19.97 $.060 1st$17.28 $21.02 $.055 2nd20.08 25.10 .08 2nd9.75 17 .06 17.86 20.13 .060 2nd15.79 17.87 .055 3rd21.60 32.00 .09 3rd14.64 16.97 .06 18.48 19.97 .060 3rd15.83 17.87 .055 4th29.85 34.20 .09 4th14.75 16.15 .06 18.55 19.80 .060 4th16.20 17.56 .055 *AdjustedRetroactively adjusted togive retroactive effect to a 3 for 1reflect 10% stocksplitdividend declared February19, 2002.21, 2006 effective for shares outstanding on March 28, 2006.Common sharesThe common stock of Bancorpareis traded on theNational Association of Security Dealers Small CapNasdaq Capital Market under the symbol “SVBI”. As of February 22, 2007, there were 214 stockholders of Bancorp’s common stock.Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016-3572, serves as the Transfer Agent and Registrar for Bancorp.Equity Compensation Plan TableBancorp’s main source of income is dividends from the Bank. As a result, Bancorp’s quarterly dividends to its shareholders will depend primarily upon receipt of dividends from the Bank. For regulatory restrictions on the Bank’s ability to pay dividends, see note 12 to the consolidated financial statements..SeePart III,Item11.12 of this Annual Report on Form 10-K and Notes 9 and 11 to the consolidated financial statements for information regarding equity compensation plans.30Item 6. Selected Financial DataFor information concerning quarterly financial data for Bancorp, see note 17 to the consolidated financial statements.The following financial information ispresentedderived from the audited financial statements of Bancorp. The information is a summary and should be read in conjunction withmanagement’s DiscussionsBancorp’s audited financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations.31At December 31, 2006 2005 2004 2003 2002 (dollars in thousands, except per share information) Balance Sheet Data Total assets $ 911,916 $ 849,774 $ 703,616 $ 540,471 $ 458,415 Total loans, net 835,477 779,333 656,967 506,026 418,825 Investment securities held to maturity 7,271 8,290 9,955 12,721 9,661 Non-performing loans 5,927 1,693 939 469 1,758 Total non-performing assets 6,897 1,693 939 469 1,982 Deposits 626,524 594,893 527,413 419,726 377,925 Short-term borrowings 18,000 26,000 - 6,000 - Long-term debt 155,000 132,000 89,000 59,000 34,000 Total liabilities 825,474 777,062 639,462 487,501 415,233 Stockholders’ equity 86,442 72,712 60,154 48,970 39,181 Book value per common share * $ 9.45 $ 7.95 $ 6.57 $ 5.35 $ 4.30 Common shares outstanding * 9,150,850 9,150,002 9,150,002 9,150,002 9,113,702 Other Data: Number of: Full service retail banking facilities 3 3 3 2 2 Full-time equivalent employees 121 111 105 81 69 * Retroactively adjusted to reflect 10% stock dividend declared February 21, 2006 effective for shares outstanding on March 28, 2006 and a two-for-one stock split declared November 17, 2004 effective for shares outstanding December 15, 2004. 38Summary of OperationsFor the Year Ended December 31,20032002200120001999(dollars in thousands, except per share data)Interest and dividend income$37,087$33,402$29,489$24,271$20,047Interest expense12,34113,79916,09413,38710,523Net interest income24,74619,60313,39510,8849,524Provision for loan losses900670708591504Net interest income after provision for loan losses23,84618,93312,68710,2939,020Noninterest income4,6744,1332,5701,4391,586Noninterest expense9,6168,4476,5885,3485,477Earnings before income tax provision18,90414,6198,6696,3845,129Provision for income taxes7,5755,6713,4132,4392,002
Net income$11,329$8,948$5,256$3,945$3,127Per Share Data:Basic earnings per share *$2.68$2.13$1.38$1.15$0.90Diluted earnings per share *$2.67$2.13$1.37$1.12$0.84Weighted number of shares outstanding basic *4,146,5664,092,1883,647,4513,237,8883,230,940Weighted number of shares outstanding diluted *4,157,3024,103,2233,683,3463,330,9153,450,831* Retroactively adjusted to reflect three-for-one stock split declared February 19, 2002.32Summary of OperationsKey Operating RatiosFor the Year Ended December 31,20032002200120001999(dollars in thousands)Performance Ratios:Return on average assets2.23%2.14%1.55%1.47%1.38%Return on average equity25.22%25.58%20.22%20.04%18.31%Net interest margin4.99%4.86%4.05%4.17%4.34%Interest rate spread4.77%4.59%3.65%3.75%3.94%Noninterest expense to average assets1.76%2.02%1.95%2.00%2.43%Efficiency ratio30.33%35.59%41.27%43.40%49.30%Asset Quality Ratios:Equity to Assets9.06%8.55%8.40%7.27%7.74%Nonperforming assets to total assetsat end of period0.09%0.43%0.66%0.51%0.68%Nonperforming loans to total grossloans at end of period0.08%0.36%0.51%0.36%0.36%Allowance for loan losses to totalgross loans at end of period0.79%0.81%0.82%0.83%0.84%Allowance for loan losses tononperforming loans at end of period1030.49%227.02%159.59%231.58%232.11%Mortgage Origination and Servicing Data:Mortgage loans originated or purchased$320,902$343,787$342,915$213,614$180,782Mortgage loans sold133,871100,53560,30236,86937,706Mortgage loans serviced for others24,01623,93517,37621,64823,186Capitalized value of mortgageservicing rights1319263339For the Year Ended December 31, 2006 2005 2004 2003 2002 (dollars in thousands, except per share information) Interest and dividend income $ 70,175 $ 57,135 $ 44,829 $ 37,087 $ 33,402 Interest expense 32,060 21,955 14,631 12,341 13,799 Net interest income 38,115 35,180 30,198 24,746 19,603 Provision for loan losses 1,561 1,570 1,200 900 670 Net interest income after provision for loan losses 36,554 33,610 28,998 23,846 18,933 Non-interest income 3,867 2,748 3,402 4,674 4,133 Non-interest expense 14,065 12,878 11,211 9,616 8,447 Income before income tax provision 26,356 23,480 21,189 18,904 14,619 Provision for income taxes 10,608 8,926 8,258 7,575 5,671 Net income $ 15,748 $ 14,554 $ 12,931 $ 11,329 $ 8,948 Per Share Data: Basic earnings per share * $ 1.72 $ 1.59 $ 1.42 $ 1.22 $ 0.96 Diluted earnings per share * $ 1.72 $ 1.59 $ 1.42 $ 1.22 $ 0.96 Weighted number of shares outstanding basic * 9,150,263 9,150,002 9,150,002 9,122,445 9,002,814 Weighted number of shares outstanding diluted * 9,153,687 9,150,002 9,150,002 9,146,064 9,027,091 * Retroactively adjusted to reflect 10% stock dividend declared February 21, 2006 effective for shares outstanding on March 28, 2006 and a two-for-one stock split declared November 17, 2004 effective for shares outstanding December 15, 2004. 3933Key Operating RatiosFor the Year Ended December 31, 2006 2005 2004 2003 2002 Performance Ratios:Return on average assets 1.77 % 1.84 % 2.02 % 2.23 % 2.14 % Return on average equity 19.59 % 21.85 % 23.56 % 25.22 % 25.58 % Dividend payout ratio 13.95 % 13.84 % 13.38 % 12.30 % 11.46 % Net interest margin 4.50 % 4.58 % 4.81 % 4.99 % 4.86 % Interest rate spread 4.20 % 4.32 % 4.60 % 4.77 % 4.59 % Non-interest expense to average assets 1.58 % 1.63 % 1.75 % 1.89 % 2.02 % Efficiency ratio 33.50 % 33.95 % 33.37 % 32.69 % 35.59 % Asset Quality Ratios:Average equity to average assets 9.02 % 8.42 % 8.57 % 8.84 % 8.38 % Nonperforming assets to total assets at end of period 0.76 % 0.20 % 0.13 % 0.09 % 0.43 % Nonperforming loans to total gross loans at end of period 0.62 % 0.18 % 0.12 % 0.08 % 0.36 % Allowance for loan losses to net loans at end of period 1.08 % 0.96 % 0.90 % 0.95 % 0.95 % Allowance for loan losses to nonperforming loans at end of period 152.29 % 443.30 % 632.10 % 1030.49 % 227.02 % 40Average Balance SheetAverage Balance Sheet. The following table contains for the periods indicated information regarding the total dollar amounts of interest income from interest-earning assets and the resulting average yields, the total dollar amount of interest expense on interest-bearing liabilities and the resulting average costs, net interest income, and the net yield on interest-earning assets.Years Ended December 31,200320022001Years Ended December 31, AverageAverageAverage2006 2005 2004 VolumeInterestYield/CostVolumeInterestYield/CostVolumeInterestYield/CostAverage Average Average Volume Interest Yield/Cost Volume Interest Yield/Cost Volume Interest Yield/Cost (dollars in thousands)(dollars in thousands) ASSETSLoans (1)$ 466,512$ 36,4037.80%$ 384,537$ 32,7238.51%$ 313,798$ 28,6179.12%$819,038 $68,610 8.38% $738,028 $56,120 7.60% $600,030 $44,091 7.35% Investments (2)6,1672433.94%7,3393624.93%7,6714505.86%5,000 154 3.08% 5,000 154 3.08% 5,250 165 3.15% Mortgage-backed securities6,5862103.18%1,346544.00%255187.09%2,823 112 3.97% 4,065 173 4.26% 5,686 254 4.46% Other interest-earning assets (3)16,7492311.38%10,1232632.60%8,7734044.60%19,886 1,299 6.53% 15,923 688 4.32% 12,656 319 2.52% Total interest-earning assets496,01437,0877.48%403,34533,4028.28%330,49729,4898.92%846,747 70,175 8.29% 763,016 57,135 7.49% 623,622 44,829 7.19% Non-interest earning assets11,89413,9797,80044,385 28,027 16,552
Total Assets$ 507,908$ 417,324$ 338,297$891,132 $791,043 $640,174 LIABILITIES AND STOCKHOLDERS' EQUITYSavings and checking deposits$ 187,979$ 2,9971.59%$ 138,961$ 3,4852.51%$ 69,846$ 2,4223.47%$138,242 $2,728 1.97% $155,513 $2,455 1.58% $192,946 $2,670 1.38% Certificates of deposits222,8197.9643.57%198,6138,8154.44%190,39111,1705.87%483,524 20,977 4.34% 408,026 13,819 3.39% 284,636 8,622 3.03% Borrowings43,8331,3803.15%36,5001,4994.11%45,2502,5025.53%162,417 8,355 5.14% 134,833 5,681 4.21% 96,250 3,339 3.47% Total interest-bearing liabilities454,63112,3412.71%374,07413,7993.69%305,48716,0945.27%784,183 32,060 4.09% 698,372 21,955 3.14% 573,832 14,631 2.55% Non-interest bearing liabilities4,3604,2712,86626,556 26,059 11,451 Minority Interest – Preferred Securities of Subsidiary4,0004,0003.946Stockholders' equity44,91734,97925,99880,393 66,612 54,891
Total liabilities and stockholders' equity$ 507,908$ 417,324$ 338,297$891,132 $791,043 $640,174 Net interest income and Interest rate spread$ 24,7464.77%$ 19,6034.59%$ 13,3953.65%$38,115 4.20% $35,180 4.35% $30,198 4.64% Net interest margin4.99%4.86%4.05%4.50% 4.61% 4.84% Average interest-earning assets toaverage interest-bearing liabilities109.10%107.82%108.19%107.98% 109.26% 108.68% (1) Non-accrual loans are included in the average balances and in the computation of yields.(1) Non-accrual loans are included in the average balances and in the computation of yields.(1) Non-accrual loans are included in the average balances and in the computation of yields. (2) The Company does not have any tax exempt securities.(2) Bancorp does not have any tax-exempt securities. (2) Bancorp does not have any tax-exempt securities. (3) Other interest earning assets includes interest bearing deposits in other banks, federal funds, and FHLB stock investments.(3) Other interest earning assets includes interest bearing deposits in other banks, federal funds, and FHLB stock investments.(3) Other interest earning assets includes interest bearing deposits in other banks, federal funds, and FHLB stock investments. 3441Rate Volume TableYear ended December 31, 2006 Year ended December 31, 2005 vs. vs. Year ended December 31, 2003 vs.Year ended December 31, 2002Year ended December 31, 2002 vs.Year ended December 31, 2001Year ended December 31, 2005 Year ended December 31, 2004 TotalChanges Due to
TotalChanges Due toTotal Changes Due to Total Changes Due to ChangeVolume (1)Rate (1)ChangeVolume (1)Rate (1)Change Volume (1) Rate (1) Change Volume (1) Rate (1) (dollars in thousands)
(dollars in thousands) Interest-earning assetsLoans$3,680$6,631$(2,951)$4,106$6,128$(2,022)$ 12,490 $ 6,160 $ 6,330 $ 12,029 $ 10,140 $ 1,889 Investments(119)(53)(66)(88)(18)(70)- - - (11 ) (8 ) (3 ) Mortgage-backed securities156170(14)3646(10)(61 ) (53 ) (8 ) (81 ) (72 ) (9 ) Other interest-earning assets(32)121(153)(141)55(196)611 171 440 369 82 287 Total interest income$3,685$6,869$(3,184)$3,913$6,211$(2,298)$ 13,040 $ 6,278 $ 6,762 $ 12,306 $ 10,142 $ 2,164 Interest-bearing liabilitiesSavings and checking deposits$(488)$1,010$(1,498)$1,063$1,867$(804)$ 273 $ (272 ) $ 545 $ (215 ) $ (518 ) $ 303 Certificates of deposits(851)1,000(1,851)(2,355)463(2,818)7,158 2,557 4,601 5,197 3,738 1,459 Borrowings(119)340(459)(1,003)(434)(569)2,674 1,162 1,512 2,342 1,338 1,004 Total interest expense$(1,458)$2,350$(3,808)$(2,295)$1,896$(4,191)$ 10,105 $ 3,447 $ 6,658 $ 7,324 $ 4,558 $ 2,766
Net change in interest income$5,143$4,519$624$6,208$4,315$1,893$ 2,935 $ 2,831 $ 104 $ 4,982 $ 5,584 $ (602 ) (1) Changes in interest income/expense not arising from volume or rate variances are allocated proportionately to rate and volume.(1) Changes in interest income/expense not arising from volume or rate variances are allocated proportionately to rate and volume.(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 ofOperationsOperationCritical Accounting PoliciesThe Company’sBancorp’s significant accounting policies are set forth in note 1 of the consolidated financial statements for the year ended December 31,20032006 which are set forth on pagesF-2AF-1 throughF-37.F-35. Of these significant accounting policies,the CompanyBancorp considers the policy regarding the allowance for loan losses to be its most critical accounting policy, given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio and the material effect that such judgments can have on the results of operations. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations.The CompanyBancorp has developedappropriatepolicies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that thispro cessprocess requires a number of assumptions and estimates with respect to its loan portfolio.The Company’sBancorp’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.4235OverviewOverviewThe primary business of Bancorp ismortgage lending. The markets in whichconsumer deposit products and residential and commercial mortgages. Bancorp operates primarily in Anne Arundel County, Maryland, as well as surrounding areas in Maryland, northern Virginia andDelaware, have enjoyed strong real estate demand. This has fueled Bancorp’s growth, along with theDelaware. The demandto refinance existing mortgages as a result of historically low interest rates. Refinancing activity began to slow down toward the end of the third quarter of 2003, and slowed considerably in the fourth quarter of 2003. However, with interest rates remaining low,for construction lending andpurchase money mortgage lending have continuedresidential mortgages has slowed during 2006 compared tobe extremely active.Bancorp has been able to take advantage ofactivity in 2005. In addition, thelowinterest rateenvironment and reduce its cost of liabilities. Interest rates paid on deposits have decreased significantly, as have interest rates paid for borrowing funds from the Federal Home Loan Bank of Atlanta. The differencespread between Bancorp’scostscost of funds and what it earns onmortgageloansishas decreased from 2005, as increases in interest rates paid on deposits and borrowings has outpaced interest earned on loans.Even though the interest rate“spread”. Thisspread has decreased throughout 2006, Bancorp’s revenues have increased asBancorp’s growingits loan portfolioof mortgage loans coupled with the fees earned on loans sold in the secondary market,hasdriven up overall revenues. Whileincreased from 2005. In addition, while variable expenses, such as compensation, have increased, Bancorp’s overall expenses have remained modest, which has resulted inincreasingincreased profitability.Bancorp’s asset quality has remainedexcellent,good, as there have been minimal losses due to defaulting loans.Going forward, Bancorp’s challenge will be to continue to grow assets in the form of mortgage loans, while earning a profitable spread, and continuing to maintain good asset quality. In addition, Bancorp will be challenged to keep overhead low as costs of its new headquarters are realized starting in 2007.Interest rates are outside the control of Bancorp, so it must attempt to balance its pricing and duration of its loan portfolio against the risks of rising costs of its deposits and borrowings.The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to Bancorp’s ability to originate and grow its mortgage loans, as will Bancorp’s continued focus on maintaining a low overhead.Financial ConditionAt December 31, 2003 totalTotal assetswere $540,471,000 compared to $458,415,000increased by $62,142,000, or 7.3%, at December 31,2002, which represents an increase of $82,056,000 or 17.9%.2006 to $911,916,000, compared to $849,774,000 at December 31, 2005. The following discusses the material changes between the December 31,20032006 and20022005 balance sheets.LoansLoans Held For Sale.At December 31, 2003 loansLoans held for salewas $3,175,0000 compared to $17,481,000decreased by $246,000, or 7.6% at December 31,2002.2006 to $2,970,000, compared to $3,216,000 at December 31, 2005. This decreaseof $14,306,000 or 81.8%was primarily due to areductionslowdown inthe loan portfolio intended to be sold to investors in the secondary market. Most of theloans soldinon the secondary market,have beenand the timing of loansthat refinanced existing mortgages. Beginning in late third quarter, and continuing into the fourth quarter of 2003, loans that refinanced existing mortgages were significantly reduced and, as a result, there were less loans available forpending salein the secondary market as of December 31, 2003.at year-end.Loans Receivable.Total net portfolio loans receivablewere $502,851,000increased by $56,390,000, or 7.3% at December 31,2003, an increase of $101,508,000 or 25.3% from $401,343,0002006, to $832,507,000, compared to $776,117,000 at December 31,2002.2005. The increase in the loan portfolio resulted from thecontinuing increasesstrong loan demand during the first half of 2006; however, Bancorp experienced a general slowdown in loan demandresulting fromduring thecontinued historically low interest rates.second half of 2006. The increase in the loan portfolio included increases in residentialmortgageloans,residential constructioncommercial real estate loans andcommercial mortgageland loans.Federal Home Loan Bank of Atlanta Stock.Premises and EquipmentTotal Federal Home Loan Bank of Atlanta stock ownedPremises and equipment increased byBancorp$10,448,000, or 52.3% at December 31,2003 was $3,250,000,2006 to $30,411,000, compared to$1,900,000 of Federal Home Loan Bank of Atlanta Stock owned as of$19,963,000 at December 31,2002. This2005. The increaseof $1,350,000, or 71.1%, resulted from an increase in the advances taken by Bancorp from the Federal Home Loan Bank of Atlanta outstanding as of December 31, 2003 comparedwas primarily due toDecember 31, 2002, as the Bank is obligated to purchase Federal Home Loan Bank stock based upon the amount outstanding in advances at any given time.construction costs incurred during 2006 for Bancorp’s new administrative headquarters that opened January 2007.3643Premises and Equipment.LiabilitiesDeposits.Premises and equipment totaled $5,327,000Total deposits increased by $31,631,000, or 5.3% at December 31,20032006 to $626,524,000, compared to$4,738,000$594,893,000 at December 31,2002.2005. This increase was primarily attributable to growth in certificates of$589,000 or 12.4%, primarily represents the continued investmentdeposit partially offset by a decrease inthe property owned by HS West, LLC, a subsidiary of the Bank, as it prepares to construct an office building for use by Bancorp and its subsidiaries for its corporate headquarters at West Gate Circle in Annapolis, Maryland.money market accounts. Thefollowing table contains for the periods indicated information regarding the financial obligations owing by the Company for leases of certain properties.Contractual ObligationsPayments due by period(dollars in thousands)TotalLess than 1 year1-3years3-5yearsMore than 5 yearsLong term debt $ 59,000 $ 5,000 $ 12,000 $ 15,000 $ 27,000 Operating lease obligations 30 28 2 - - Certificates of Deposit 226,833 125,651 69,987 31,195 - Other long term liabilities reflected on the Company’s balance sheet under GAAP - - - - - Total $ 285,863 $ 130,679 $ 81,989 $ 46,195 $ 27,000 LiabilitiesDeposits.Total deposits were $419,726,000 at December 31, 2003 compared to $377,925,000 at December 31, 2002. This represents an increase of $41,801,000 or 11.1%. Thenet increase in deposits was primarily used to fund loangrowth, however,growth.FHLB Advances. FHLB advances increased $15,000,000, or 9.5% at December 31, 2006 to $173,000,000, compared to $158,000,000 at December 31, 2005. This increase was theBank found it increasinglyresult of management’s decision to borrow funds from FHLB at moredifficult to generate deposits at reasonablefavorable ratesthroughout the year and implemented a plan to utilize wholesale funds, in the form of Federal Home Loan Bank advances, which had more attractive pricingthanrates thatwould havehadbeen necessary tobe paidattract the needed funds through customer deposits.Subordinated Debentures. Bancorp has a non-consolidated subsidiary trust, Severn Capital Trust I, of which 100% of the common equity is owned by Bancorp. The trust was formed forretail deposits.the purpose of issuing corporation-obligated mandatorily redeemable capital securities (“capital securities”) to third-party investors and investing the proceeds from the sale of such capital securities solely in subordinated debt securities of Bancorp (“debentures”). The debentures held by the trust are the sole assets of the trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. Bancorp has entered into an agreement which, taken collectively, fully and unconditionally guarantees the capital securities subject to the terms of the guarantee. The debentures held by Severn Capital Trust I are first redeemable, in whole or in part, by Bancorp on January 7, 2010.The subordinated debentures from Bancorp to the trust consist of a $20,619,000 note, which is at a floating rate of interest of LIBOR (5.37% at December 31, 2006) plus 200 basis points, and matures in 2035.FHLB Advances.FHLB advances were $65,000,000 at December 31, 2003 compared to $34,000,000 at December 31, 2002, which is an increase of $31,000,000 or 91.2%. This increase was due to the fact that rates paid on Federal Home Loan Bank advances were less expensive than what the Bank was able to generate through retail deposits and the Bank implemented a strategy to lock in interest rates for a longer term in the form of advances from the Federal Home Loan Bank for terms of three years and longer.Stockholders’ Equity.Total stockholders’ equity was $48,970,000 as of December 31, 2003, which compared to $39,181,000 as of December 31, 2002. This increase of $9,789,000, or 25.09%, resulted primarily from net income, offset by dividend declarations.Off-Balance Sheet Arrangements.The CompanyBancorp has certain outstanding commitments and obligations that could impactthe Company’sBancorp’s financial condition, liquidity, revenues or expenses. These commitments and obligations include standby letters of credit, home equityloans,lines of credit, loan commitments, lines of credit, and loans sold and serviced with limited repurchase provisions.Standby letters of credit, which are obligations ofthe CompanyBancorp to guarantee performance of borrowers to governmental entities,were $7,982,000decreased $585,000, or 8.8% as of December 31,20032006 to $6,032,000, compared to$6,694,000$6,617,000 as of December 31,2002. This increase of $1,288,000 or 19.2% was a result of increased2005. Bancorp continues to see demand bythe Company’sits borrowers for letter of credit requirements.37Home equityConstruction loansincreased $4,128,000,in process decreased $31,492,000, or51.5%, from $8,014,00023.1% as of December 31,20022006 to$12,142,000$104,747,000, compared to $136,239,000 as of December 31,2003.2005. Construction loan demand has decreased from 2005, and the amount of construction loans in process has decreased.Home equityloans are loans thatlines of credit increased $5,282,000, or 26.7%, as of December 31, 2006 to $25,084,000, compared to $19,802,000 as of December 31, 2005. Home equity lines of credit allow the borrowers to draw funds up to a specified loan amount, from time to time.The Company’sBancorp’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans. This increase was a result of thegeneral increase in loan demand andcompetitively low interest rates offered on home equity loans.Loan commitments decreased $4,700,000, or 24.1%, as of December 31,2003 were $24,520,000,2006 to $14,815,000, compared to$24,772,000$19,515,000 as of December 31,2002. This was a decrease of $252,000, or 1%.2005. Loan commitments are obligations ofthe CompanyBancorp to provide loans, and such commitments are made in the usual course of business. This decrease was a result of a general slowdown in the demand for new loans at the end of 2006.Lines of credit, which are obligations ofthe CompanyBancorp to fund loans made to certain borrowers,were $20,436,000decreased $287,000, or 0.8%, to $33,495,000 as of December 31,2003,2006, compared to$22,368,000$33,782,000 as of December 31,2002. This decrease of $1,932,000, or 8.6%, was a result of less2005. The demand for this type of loanproduct. The Company’sproduct has remained constant during 2006. Bancorp’s management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans.44Loans sold and serviced with limited repurchase provisionsincreased $22,714,000,decreased $4,959,000, or223.5%44.9%,from $10,163,000as of December 31,2002,2006 to$32,877,000$6,089,000, compared to $11,048,000 as of December 31,2003.2005. Thisincreasedecrease wasathe result of theincreaseslowdown in the market for loans sold on the secondary market.The CompanyBancorp uses the same credit policies in making commitments and conditional obligations as it does for its on-balance sheet instruments.Comparison of Results ofOperationOperations for the Years Ended December 31,20032006 and2002.2005.General.Bancorp’s net income for the year ended December 31,20032006 was$11,329,000$15,748,000, or$2.67$1.72 per share diluted. This is compared to $14,554,000, or $1.59 per share dilutedcompared to $8,948,000 or $2.13 per share, diluted, for the year ended December 31, 2002.in 2005. This increase of$2,381,000$1,194,000, or26.6%8.2%, was primarily the result ofincreasesthe growth inloan origination volumeBancorp’s mortgage portfolio andthe increase in interest income coupled with a reduction in the cost of deposits and other borrowings, as well as the maintenance of relativelyBancorp’s continued ability to maintain lownon-interestoperating expenses.It is uncertain whether Bancorp will be able to generate the volume of loan originations that it has done over the past two years as the trend, beginning in the third quarter of 2003, was that refinances of mortgages were significantly slowing down. However, loan originations, overall, remain strong, and provided the real estate market in the Bank’s primary lending areas rema in positive, the Bank may continue with strong loan originations.Net Interest Income.Net interest income (interest earned net of interest charges)totaled $24,746,000increased $2,935,000, or 8.3% to $38,115,000 for the year ended December 31,2003, as2006, compared to$19,603,000$35,180,000 for the year ended December 31,2002, or an increase of $5,143,000 or 26.2%.2005. This increase was primarily due to the growth in the loan portfolio,andwhich offset a 0.15% decrease in Bancorp’s interest rate spread to 4.20% for thereduction on the interest on deposits and Federal Home Loan Bank advances. The net interest margin increased to 4.99% atyear ended December 31,2003 from 4.86% at2006, compared to 4.35% for the year ended December 31,2002. The Bank’s net2005. Bancorp’s interestmargin increasedrate spread decreased over the past year because interest rates earned on the Bank’s loans have risen slower than the rise in interest rates paid on the Bank’sdeposits have fallen faster than theinterestrates earned on the Bank’s assets. However, the increase in the net interest margin slowed from the increase between December 31, 2001 and December 31, 2002 and the Bank does not expect that interest on its deposits and F ederal Home Loan Bank advances will continue to drop as it has over the last two years. The Bankbearing liabilities. Bancorp is uncertain whether it will be able to continue to attractlowlower costliabilities,deposits, as it has done in the lasttwo yearsyear, due to the general expectation ofrisingcontinued increased competition for deposit accounts and the possibility for interestratesrate increases in thefuture and the recent flow of depositor funds into the stock market.future.Provision for Loan Losses.Bancorp’sTheBank’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 whatBancorpthe Bank determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio at least as often as quarterly and its loan delinquencies at least as often as monthly. All loans that are delinquent and all loans within the various categories of the Bank’s portfolio as a group areevalulated.evaluated. The Bank’s Board, with the advice and recommendation of the Bank’s delinquency committee, estimates an allowance to be set aside for loan losses. Included in determining the calculation are such factorsa sas the inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectibility. An increase in the loan loss provision from the beginning of theperiodyear to the end of aperiod would have come aboutyear is the result after an analysis of the aforementioned factors and applying that rationale to the total portfolio.38The greater the construction,As more commercial and higher loan-to-value loansthatare contained in the portfolio, the greaterwill bethe allowance for loanlosses.losses will be. Changes in estimation methods may take place based upon the status of the economy and the estimate of the value of collateral and, as a result, the allowance may increase or decrease. The Bank believes that some portions of its loan portfolio have greater actual risk and, in other areas, there is greater inherent risk. The loan loss allowance has increased when the Board believes trends are negative and contributions to the allowance have decreased when trends are more positive. Management believes that the allowance for loan losses is adequate.As of December 31, 2003, theThe total allowance for loan losseswas $4,833,000 as comparedincreased $1,521,000, or 20.3% to$3,991,000$9,026,000 as of December 31,2002, which is an increase2006, compared to $7,505,000 as of$842,000 or 21.1%.December 31, 2005. The increase was a result of the current year’s addition to the allowance and minimal charge offs being incurred. During the year ended December 31,2003,2006, the provision for loan losses was$900,000$1,561,000 compared to$670,000$1,570,000 for the year ended December 31,2002.2005. Thisincreasedecrease of$230,000$9,000 or34.3%0.6%, was a result ofManagement’sslower loan growth and management’s determination that adding to the provision for loan losses wasmore or less,appropriate for the level of inherent risk in its portfolio as compared to the year ended December 31,2002.2005.Other Income and Non InterestExpense.Expenses.Gain on sale of loans was $1,563,000Revenues from mortgage banking activities decreased $599,000, or 42.3% to $817,000 for the year ended December 31,20032006, compared to$1,264,000$1,416,000 for the year ended December 31,2002.2005. Thisincrease of $299,000, or 23.7%,decrease wasaprimarily the result ofan increasing volume of loan originations due to the continued low interest rate environment that resulteda $159,000 decrease inthe continuing refinance of residential mortgages. However, beginning in the late third quarter of 2003 the refinance of residential mortgages began to decline significantlymortgage processing andthe Bank anticipates, but is not certain, that loan originations in the form of residential refinances are likely toservicing fees and a $440,000 decrease in thefuture. If this happens, there is likely to be a reduction in the amount ofgain on sale of loanswhich will also cause a reduction in mortgage processing fees. Compensation paid to loan officers for the originations of loans would also commensurately be reduced.Real estate commissions and real estate management feesfor the year ended December 31,2003 were $1,160,000 and $369,000, respectively, as2006 compared to the year ended December 31,2002 when real estate commissions and real estate management fees2005. These decreases were$1,237,000 and $383,000, respectively. In the aggregate, this wasattributable to adecrease of $91,000 or 5.6%. Real estate management fees are a steadier recurring source of revenue and provided Hyatt Real Estate maintains property management accounts, there is a likelihood that management fees will continuegeneral slowdown inthe future. It is Bancorp’s intention to acquire real estate through subsidiaries of SBI Mortgage Company, where such subsidiaries will serve as managing members or general partners of entities that expect to own real estate for investment purposes. Equity will be raised through private placements of securities and, if successful, Hyatt Real Estate sho uld be able to earn commissions and/or acquisition feesloan activity, which resulted in fewer loans sold on theproperties acquired as well as receive leasing commission revenuesecondary market during 2006 andreal estate management fees for services rendered.Mortgageless mortgage processing and servicing fees during 2006.45Real estate commissions increased $1,473,000, or 270.3% to $2,018,000 for the year ended December 31,2003 were $928,0002006, compared to$724,000$545,000 for the year ended December 31,2002.2005. This increase was primarily the result of commissions earned on several large settlements that took place during 2006. Real estate management fees increased $152,000, or 35.7% for the year ended December 31, 2006, compared to $426,000 for the year ended December 31, 2005. This increase was primarily due to additional properties being managed in 2006.Other non-interest income increased $93,000, or 25.8% to $454,000 for the year ended December 31, 2006, compared to $361,000 for the year ended December 31, 2005. This increase was primarily a result of an increase in rents collected and savings charges.Compensation and related expenses increased $1,254,000, or 13.8% to $10,334,000 for the year ended December 31, 2006, compared to $9,080,000 for the year ended December 31, 2005. This increase was the result of additional Bank employees hired, higher commissions paid on loan growth, and salary rate increases. As of December 31, 2006, Bancorp had 121 full-time equivalent employees compared to 111 at December 31, 2005.Occupancy decreased $13,000, or 1.8% to $706,000 for the year ended December 31, 2006, compared to $719,000 for the year ended December 31, 2005. Beginning in 2007, the Bank and Bancorp’s administrative offices will move to its new headquarters in a building owned by HS West, LLC. It is not expected that this move will have a material impact on occupancy costs.Other non-interest expense decreased $54,000, or 1.8% to $3,025,000 for the year ended December 31, 2006, compared to $3,079,000 for the year ended December 31, 2005. This decrease was primarily a result of a one-time cash reconciliation charge off of $135,000 in 2005 and a decrease in miscellaneous expenses of approximately $67,000, partially offset by increases in professional fees of approximately $68,000 and an increase in advertising expenses of approximately $97,000.Income Taxes. Income taxes increased $1,682,000, or 18.8% to $10,608,000 for the year ended December 31, 2006, compared to $8,926,000 for the year ended December 31, 2005. The effective tax rate for the years ended December 31, 2006 and 2005 was 40.2% and 38.0%, respectively.Comparison of Operating Results for the Years Ended December 31, 2005 and 2004General. Bancorp’s net income for the year ended December 31, 2005 was $14,554,000, or $1.59 per share diluted. This is compared to $12,931,000, or $1.42 per share diluted for the year ended December 31, 2004. This increase of$204,000,$1,623,000, or28.2%12.6%, wasaprimarily the result of the continued growth inthe Bank’s originations and loan portfolio.Bancorp’s mortgage portfolio coupled with Bancorp’s continued ability to maintain low operating expenses.Compensation and related expensesNet Interest Income. Net interest income (interest earned net of interest charges) totaled$6,976,000$35,180,000 for the year ended December 31,20032005, compared to$6,065,000$30,198,000 for the year ended December 31,2002, which was2004, an increase of$911,000$4,982,000 or15.02%16.5%. This increaseduring 2003wasattributableprimarily due to thefact thatgrowth in theBank increased its personnelloan portfolio, which offset a .29% decrease in Bancorp’s interest rate spread to81 full time equivalent employees as of December 31, 2003 compared to 69 full time equivalent employees as of December 31, 2002.39Other non-interest expense totaled $2,106,0004.35% for the year ended December 31,20032005, compared to$1,883,0004.64% for the same period in 2004. Bancorp’s interest rate spread decreased during 2005 year because interest rates earned on the Bank’s loans had risen slower than the rise in interest rates paid on the Bank’s interest bearing liabilities.Provision for Loan Losses. As of December 31, 2005, the total allowance for loan losses was $7,505,000 as compared to $5,935,000 as of December 31, 2004, which was an increase of $1,570,000, or 26.5%. The increase was a result of the 2005 addition to the allowance and no charge offs being incurred. During the year ended December 31, 2005, the provision for loan losses was $1,570,000 compared to $1,200,000 for the year ended December 31,2002 which2004. This increase of $370,000 or 30.8%, was a result of increased loan growth and management’s determination that adding to the provision for loan losses was appropriate for the level of inherent risk in its portfolio as compared to the year ended December 31, 2004.46Other Income and Non Interest Expenses. Mortgage banking activities decreased $19,000, or 1.3% to $1,416,000 for the year ended December 31, 2005, compared to $1,435,000 for the year ended December 31, 2004. This decrease was primarily the result of a $32,000 decrease in mortgage processing and servicing fees partially offset by a $13,000 increase in the gain on sale of loans for the year ended December 31, 2005 compared to the year ended December 31, 2004. The increase in the gain on sale of loans was attributable to increased amount of loans sold on the secondary market during 2005. The decrease in mortgage processing and servicing fees related to a slowdown during 2005 of residential mortgages being refinanced.Real estate commissions totaled $545,000 for the year ended December 31, 2005, compared to $1,234,000 for the year ended December 31, 2004, a decrease of $689,000 or 55.8%. This decrease was primarily due to a slowdown in commercial property sales and leasing. Real estate management fees totaled $426,000 for the year ended December 31, 2005, compared to $404,000 for the year ended December 31, 2004, an increase of$223,000$22,000 or11.8%5.4%. This increase was primarily due to an increase in the amount of managed real estate.Other non-interest income totaled $361,000 for the year ended December 31, 2005, compared to $329,000 for the year ended December 31, 2004, an increase of $32,000, or 9.7%. This increase was primarily a result of an increase in fees collected on loans.Compensation and related expenses totaled $9,080,000 for the year ended December 31, 2005, compared to $8,167,000 for the year ended December 31, 2004, an increase of $913,000 or 11.2%. This increase was the result of hiring additional Bank employees, higher commissions paid on loan growth, and salary rate increases. As of December 31, 2005, Bancorp had 111 full-time equivalent employees compared to 95 at December 31, 2004.Other non-interest expenseconsiststotaled $3,079,000 for the year ended December 31, 2005, compared to $2,434,000 for the year ended December 31, 2004, an increase of $645,000, or 26.5%. This increase was primarily a result of increases in professional fees of $183,000, a cash reconciliation charge off of approximately $135,000 and an increase in officeand computer supplies, mailexpensestelephone and other expenses. In 2003 Bancorp underwent a conversionofits data service bureau.approximately $75,000.Income taxes. Income taxes for the year ended December 31,20032005 were$7,575,000$8,926,000, compared to$5,671,000$8,258,000 for the year ended December 31,2002. This increase of $1,904,000 or 33.6% was a result of an increase in income before income tax provision to $18,904,000 for the year ended December 31, 2003 compared to $14,619,000 for the year ended December 31, 2002, being2004, an increase of$4,285,000$668,000 or29.3%8.1%. The effective tax rate for the years ended December 31,20032005 and2002 were 40.07%2004 was 38.0% and38.79%39.0%, respectively.Liquidity and Capital Resources.Bancorp’s liquidity is determined by its ability to raise funds through loan payments, maturing investments, deposits, borrowed funds, capital, or the sale of loans. Based on the internal and external sources available, Bancorp’s liquidity position exceeded anticipated short-term and long-term needs at December 31,2003.2006. Core deposits, considered to be stable funding sources and defined to include all deposits except time deposits of $100,000 or more, equaled86%68% of total deposits at December 31,2003.2006. The Bank’s experience is that a substantial portion of certificates of deposit will renew at time of maturity and will remain on deposit with the Bank. Additionally, loan payments, maturities, deposit growth and earnings contribute a flow of funds available to meet liquidity requirements.In addition to its ability to generate deposits, Bancorp has external sources of funds, which may be drawn upon when desired. The primary source of external liquidity is an available line of credit equal to25%30% of the Bank’s assets withthe Federal Home Loan Bank of Atlanta.FHLB-Atlanta. The available line of credit withthe Federal Home Loan Bank of AtlantaFHLB-Atlanta was$135,000,000$273,575,000 at December 31,2003,2006, of which$65,000,000$173,000,000 was outstanding at that time. For interest rates on these advances, see note 7 to the consolidated financial statements.In assessing its liquidity the management of Bancorp considers operating requirements, anticipated deposit flows, expected funding of loans, deposit maturities and borrowing availability, so that sufficient funds may be available on short notice to meet obligations and business opportunities as theyarise so that Bancorp may take advantage of business opportunities. A further consideration relating to liquidity concerns the need for funds to construct the administrative headquarters building at Westgate Circle, the construction of which should begin in 2004.arise. As of December 31,20032006, Bancorp had$24,520,151$14,815,000 outstanding in loan commitments, which Bancorp expects to fund from the sources of liquidity described above. This amount does not include undisbursed lines of credit, home equityloanslines of credit and standby letters of credit, in the aggregate amount of$40,559,919,$64,611,000, which Bancorp anticipates it will be able to fund, if required, from these liquidity sources in the regular course ofbusi ness.business.47In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on liquidity.Comparison of Operating Results forThe Bank is subject to various regulatory capital requirements administered by theYears Ended December 31, 2002federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and2001General.Bancorp’s net income forpossible additional discretionary, actions by theyear ended December 31, 2002 was $8,948,000 or $2.13 per share, diluted, compared to $5,256,000 or $1.37 per share, diluted, for the year ended December 31, 2001. The increase of $3,692,000 or 70.2% was primarily the result of increases in loan origination volume and in the loan portfolio, as well as the increase in interest income, coupled withregulators that, if undertaken, could have areduction in the cost of deposits and other liabilities.Net Interest Income.Net interest income (interest earned net of interest charges) totaled $19,603,000 for the year ended December 31, 2002, as compared to $13,395,000 for the year ended December 31, 2001, or an increase of $6,208,000 or 46.3%. The change was primarily due to growth in the loan portfolio and reduction of interest on deposits. The net interest margin increased to 4.86% at December 31, 2002 compared to 4.05% at December 31, 2001. The Bank’s net interest margin increased because interest rates earneddirect material effect on the Bank’sassets have increased faster than its cost of funds. This was due tofinancial statements. Under capital adequacy guidelines and thehistorically low interest rate environment thatregulatory framework for prompt corrective action, the Bankis operated in.Provision for Loan Losses.Bancorp’s loan portfolio is subject to varying degrees of credit risk and an allowance for loan losses is maintained to absorb losses inherent in its loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what Bancorp determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio at least as often as quarterly and its loan delinquencies at least as often as monthly. All loansmust meet specific capital guidelines thatare delinquent and all loans within the various categoriesinvolve quantitative measures of the Bank’sportfolioassets, liabilities, and certain off-balance sheet items asa group are tabulated.calculated under regulatory accounting practices. The Bank’sBoard, withcapital amounts and classifications are also subject to qualitative judgments by theadviceregulators about components, risk weightings, andrecommendation of the Bank’s delinquency committee, estimates an allowance to be set aside for loan losses. Included in determining the calculation are such factors as the inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectibility. An increase in the loan loss provision from the beginning of the period to the end of a period would have come about after an analysis of the aforementioned factors and applying that rationale to the total portfolio.40The greater the construction, commercial and higher loan-to-value loans that are contained in the portfolio, the greater will be the allowance for loan losses. Changes in estimation methods may take place based upon the status of the economy and the estimate of the value of collateral and, as a result, the allowance may increase or decrease. The Bank believes that some portions of its loan portfolio have greater actual risk and, inotherareas, there is greater inherent risk. The loan loss allowance has increased when the Board believes trends are negative and contributions to the allowance have decreased when trends are more positive.factors. Management believes,that the allowance for loan losses is adequate.During the year ended December 31, 2002, the provision for loan losses was $670,000 compared to $709,000 for the year ended December 31, 2001. This decrease of $39,000 or 5.5%, was a result of the Bank’s management having determined that the provision for loan losses contributed was commensurate to the inherent risk in the portfolio. As of December 31, 2002 the allowance for loan losses was $3,991,000 compared to $3,353,000as of December 31,2001 which is an increase of $638,000 or 19%. This increase was a result of contributions made to the provision for loan losses without any material charge offs to reduce the overall allowance for loan losses.Other Income and Non Interest Expense.Gain on sale of loans was $1,264,000 for the year ended December 31, 2002 compared to $983,000 for the year ended December 31, 2001. This increase of $281,000 or 28.6% was a result of increased loan originations primarily from a lower interest rate environment which resulted in significant residential mortgage loan refinancings. Should loan originations decrease in the future, gain on sale of loans will also likely decrease. Loan originations may decrease as a result of greater competition, increases in general interest rates or a loss of personnel experienced in loan origination. A reduction in loan originations will also cause a reduction in mortgage processing fees.Real estate commissions and real estate management fees for the year ended December 31, 2002 were $1,237,000 and $383,000, respectively, compared to $499,000 and $213,000, respectively for the year ended December 31, 2001. The increase in 2002, being an aggregate of $908,000 or 127.5% was due in part to the fact2006, thatHyatt Real Estate was acquired by Bancorp in 2001 and the total year’s revenues were not included in 2001 and that real estate commission revenue is volatile and may be substantially different, from year to year.Mortgage processing and servicing fees for the year ended December 31, 2002 were $724,000 compared to $607,000 for the year ended December 31, 2001. This increase of $117,000 or 19.3% was primarily attributable to the increase in operations and staffing and compensation levels ofthe Bankcaused by the volume of loan production.Compensation and related expenses totaled $6,065,000 for the year ended December 31, 2002 comparedmeets all capital adequacy requirements to$4,572,000 for the year ended December 31, 2001, or an increase of $1,493,000 or 32.7%. The increase during 2002 was primarily attributable to the increase in operations and staffing and compensation levels of the Bank caused by the increase in loan production and increases in commissions at Hyatt Real Estate.Other non-interest expense totaled $1,883,000 for the year ended December 31, 2002 compared to $1,520,000 for the year ended December 31, 2001which it isan increase of $363,000 or 23.9%. Other non-interest expense consists primarily of office and computer supplies, mail expenses, telephone and other expenses. The increase during 2002 was primarily attributable to the increase in operations caused by an increase in loan production and expenses related to the registration of Bancorp’s shares with the Securities and Exchange Commission.41Income taxes for the year ended December 31, 2002 were $5,671,000 compared to $3,413,000 for the year ended December 31, 2001. This increase of $2,258,000 or 66.2% was a result of an increase in income before income tax provision to $14,619,000 for the year ended December 31, 2002 compared to $8,669,000 for the year ended December 31, 2001, being an increase of $5,950,000 or 68.6%. The effective tax rate for the years ended December 31, 2002 and 2001 were 38.79% and 39.37%, respectively.subject.Contractual ObligationsThe following table contains for the periods indicated information regarding the financial obligations owing by Bancorp under contractual obligations.Payments due by period(dollars in thousands)Total20072008-20092010-20112012 +Long term debt $ 155,000 $ 15,000 $ 35,000 $ 10,000 $ 95,000 Subordinated debentures 20,619 - - - 20,619 Operating lease obligations 214 60 120 34 - Certificates of Deposit 490,865 409,469 50,842 30,509 45 Total $ 666,698 $ 424,529 $ 85,962 $ 40,543 $ 115,664 Item 7A. Quantitative and Qualitative Disclosures About Market RiskQualitative Information About Market Risk.The principal objective of Bancorp’s interest rate risk management is to evaluate the interest rate risk included in balance sheet accounts, determine the level of risks appropriate given Bancorp’s business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with Bancorp’s interest rate risk management policy. Through this management, Bancorp seeks to reduce the vulnerability of its operations to changes in interest rates. The Board of Directors of Bancorp is responsible for reviewing assets/liability policies and interest rate risk position. The Board of Directors reviews the interest rate risk position on a quarterlybasis. Inbasis and, in connection with this review,the Board of Directorsevaluates Bancorp’s business activities and strategies, the effect of those strategies on Bancorp’s net interest margin and the effect that changes in interest rates will have on Bancorp’s loan portfolio.ContinuousWhile continuous movement of interest rates is certain,however,the extent and timing of these movements is not always predictable. Any movement in interest rates has an effect on Bancorp’s profitability. Bancorp faces the risk that rising interest rates could cause the cost ofinterest bearing liabilities, such as deposits and borrowings, to rise faster than the yield on interest earning assets, such as loans and investments. Bancorp’s interest rate spread and interest rate margin may be negatively impacted in a declining interest rate environment even though Bancorp generally borrows at short-term interest rates and lends at longer-term interest rates. This is because loans and other interest earning assets may be prepaid and replaced with lower yielding assets before the supporting interest bearing liabilities reprice downward. Bancorp’s interest rate margin may also be negatively impacted in a flat or inverse-yield curve environment. Mortgage origination activity tends to increase when interest rates trend lower and decrease when interest rates rise.48Bancorp’s primary strategy to control interest rate risk is to sell substantially alllong term fixed ratelong-term fixed-rate loans in the secondary market. To further control interest rate risk related to its loan servicing portfolio, Bancorp originates a substantial amount of construction loans that typically have terms of one year or less. The turnover in construction loan portfolio assists Bancorp in maintaining a reasonable level of interest rate risk.Quantitative Information About Market Risk.The primary market risk facing Bancorp is interest rate risk. From an enterprise prospective, Bancorp manages this risk by striving to balance its loan origination activities with the interest rate market. Bancorp attempts to maintain a substantial portion of its loan portfolio in short-term loans such as construction loans. This has proven to be an effective hedge against rapid increases in interest rates as the construction loan portfolio reprices rapidly.The matching of maturity or repricing of interest earning assets and interest bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring the Bank’s interest rate sensitivity gap. An interest earning asset or interest bearing liability is interest rate sensitive within a specific time period if it will mature or reprice within that time period. The difference between rate sensitive assets and rate sensitive liabilities represents the Bank’s interest sensitivity gap.Exposure to interest rate risk is actively monitored by Bancorp’s management. Its objective is to maintain a consistent level of profitability within acceptable risk tolerances across a board range of potential interest rate environments. Bancorp uses the OTS Net Portfolio Value(NPV)(“NPV”) model to monitor its exposure to interest rate risk, which calculates changes in NPV. The following table represents Bancorp’s NPV at December 31,2003.2006. The NPV was calculated by the OTS, based upon information provided to the OTS.42INTEREST RATE SENSITIVITY OF NET PORTFOLIO VALUE (NPV)Net Portfolio Value NPV as % of PV of Assets Net Portfolio Value NPV as % of PV of Assets Change In Rates$ Amount$ Change% ChangeNPV RatioChange$ Amount$ Change% ChangeNPV RatioChange(dollars are in thousands) +300 bp 63,590 -13,527 -18% 11.64% -188 bp 108,903 (17,518) (14%) 12.22% (148bp) +200 bp 69,494 - 7,623 -10% 12.51% -100 bp 115,804 (10,617) (8%) 12.83% (87bp) +100 bp 74,216 - 2,901 - 4% 13.17% -35 bp 121,130 (5,292) (4%) 13.27% (42bp) 0 bp 77,116 13.52% 126,421 13.69% -100 bp 79,959 2,842 + 4% 13.85% +34 bp 130,260 3,838 3% 13.96% 27bp -200 bp --- 0 0% 0.00% 0 bp 132,417 5,995 5% 14.05% 36bp -300 bp --- 0 0% 0.00% 0 bp - -% -bp RISK MEASURES: FOR GIVE RATE SHOCK Pre-Shock NPV Ratio: NPV as % of PV of Assets 13.52% 12.73% 12.68% Post-Shock NPV Ratio 12.51% 11.38% 12.33% Sensitivity Measure: Decline in NPV Ratio 100 bp 134 bp 36 bp TB 13a Level of Risk Minimal Minimal Minimal Note: Calculations of 3/1/2004 using CMR data edited 02/12/2004. CMR Report filing required. For this quarter, the Sensitivity Measure is defined as the decline in the pre-shock NPV ratio caused by a 100 basis point decrease of a 200 basis point increase in interest rates, whichever produced the larger decline.Due to the abnormally low prevailing interest rate environment, this report no longer provides NPV estimates for changes in interest rates of –400 or +400 basis points (beginning with the March 1999 cycle), -300 basis points (beginning with the September 2001 Cycle), and –200 basis points (beginning with the December 2001 cycle).Item 8. Financial Statements and Supplementary DataFinancial statements and supplementary data are included herein at pages F1 throughF37.F35 .Item 9. Changes in and Disagreements with Accountants on Accounting and FinancialDisclosuresDisclosureReference is made to the section captioned “Relationship With Independent Auditors” in Bancorp's Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.None.49On January 2, 2004, Anderson Associates LLP (“Anderson”) announced that it was joining Beard Miller Company LLP (“Beard Miller”) to become the Baltimore office of Beard Miller. As a result, on January 2, 2004, Anderson resigned as independent auditors of the Company.On January 2, 2004, the Company engaged Beard Miller as its successor independent audit firm. The Company's engagement of Beard Miller was approved by the Company’s Audit Committee on January 5, 2004.Anderson served as the Registrant's independent accountants to audit the Registrant's consolidated financial statements as of and for the fiscal years ended December 31, 2002 and 2001. Anderson’s reports on the Registrant's consolidated financial statements as of and for the years ended December 31, 2002 and 2001 did not contain an adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles.During the Registrant's fiscal years ended December 31, 2002 and 2001 and the subsequent interim period from January 1, 2003 through January 2, 2004, there were no disagreements with Anderson on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Anderson, would have caused Anderson to make reference to the subject matter of the disagreements in their report on the financial statements for such years.43Item 9A. Controls and ProceduresEvaluation of Bancorp’s Disclosure Controls and Internal Controls. As of December 31, 2003, Bancorp evaluated the effectiveness of the design and operation of its “disclosure controls and procedures” (“Disclosure Controls”). This evaluation (“Controls Evaluation”) was done underUnder the supervision and with the participation of Bancorp's management, including its Chief Executive Officer and Chief Financial Officer, Bancorp has evaluated the effectiveness of its disclosure controls and procedures (as defined in Securities Exchange Act Rule 13a-15(e)) as of December 31, 2006. Based upon this evaluation, the Chief Executive Officer(“CEO”)and Chief Financial Officer(“CFO”).Limitations onhave concluded that, as of theEffectiveness of Controls.period covered by this report, Bancorp’smanagement, including the CEO and CFO, does not expect that its Disclosure Controls or its “internaldisclosure controls and proceduresforwere effective in reaching a reasonable level of assurance that (i) information required to be disclosed by Bancorp 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 Bancorp 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 financialreporting” (“Internal Controls”) will prevent all errorofficers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.Bancorp’s management, with the participation of its Chief Executive Officer andall fraud.Chief Financial Officer, also conducted an evaluation of Bancorp’s internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f), to determine whether any changes occurred during the quarter ended December 31, 2006, that have materially affected, or are reasonably likely to materially affect, Bancorp’s internal control over financial reporting. Based on that evaluation, there were no such changes during the quarter ended December 31, 2006.A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Bancorp have been detected.These inherent limitations i nclude the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.50MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGSevern Bancorp, Inc. (“Bancorp”) 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 United States generally accepted accounting principals, and as such, include some amounts that are based on management’s best estimates and judgments.Bancorp’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 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.ConclusionsManagement assessed the effectiveness of Bancorp’s internal control over financial reporting as of December 31, 2006. In making this assessment, it used the criteria set forth by the Committee of Sponsorship Organizations of the Treadway Commission (COSO) in Internal Control - IntegratedFramework. Basedupon the Controls Evaluation, the CEO and CFO haveon its assessment, management concluded thatsubject toas of December 31, 2006, Bancorp’s internal control over financial reporting is effective and meets thelimitations noted above,criteria of theDisclosure Controls are effective to timely alert management to material information relating to Bancorp during the period when its periodic reports are being prepared.Internal Control - Integrated Framework.Bancorp’s independent registered public accounting firm, Beard Miller Company LLP, has issued as attestation report on management’s assessment of Bancorp’s internal control over financial reporting. This report appears on pages 50 and 51./s/ Alan J. Hyatt /s/ Thomas G. Bevivino Alan J. Hyatt Thomas G. Bevivino President and Chief Executive Officer Principal Financial Officer 51
In accordance with SEC requirements,Report of Independent Registered Public Accounting FirmTo theCEOBoard of Directors andCFO note that during the fourth quarterStockholders of2003 there have been no significant changes in Internal Controls or in other factors that could significantly affect Internal Controls, including any corrective actions with regard to significant deficiencies and material weaknesses.Severn Bancorp, Inc.We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Severn Bancorp, Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established inPART IIIInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.A company’s internal control over financial reporting is a process designed 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. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.52In our opinion, management’s assessment that Severn Bancorp, Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Severn Bancorp, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Severn Bancorp, Inc. and Subsidiaries as of and for the year ended December 31, 2006 and our report dated March 6, 2007 expressed an unqualified opinion on those financial statements.
Beard Miller Company LLPBaltimore, MarylandMarch 6, 200753Item 9B. Other InformationBancorp does not have any employees. The executive officers of Bancorp are employees at-will of the Bank. The Board of Directors of the Bank has a Compensation Committee, which determines the compensation of the executive officers of Bancorp. Annually, the Compensation Committee of the Bank’s Board of Directors evaluates profiles of comparable financial institutions to assure that the compensation to its executive officers is comparable to its peer group. Other factors used by the Compensation Committee in determining compensation for its executive officers include an assessment of the overall financial condition of the Bank, including an analysis of the Bank’s asset quality, interest rate risk exposure, capital position, net income and consistency of earnings. The Bank’s return on average assets and return on equity is considered and compared to its peer group. The complexity of the activities of the executive officers are considered, and intangible items are considered such as the reputation and general standing of the Bank within the community and the likelihood of continuing successful and profitable results.Based on the considerations set forth above, at its meeting on November 21, 2006, the Compensation Committee approved bonuses for the Bank’s executive officers for fiscal year 2006 as follows: Alan J. Hyatt, $191,000; Melvin E. Meekins, Jr., $135,300; S. Scott Kirkley, $82,500; and Thomas G. Bevivino, $50,000. In addition, the Compensation Committee, at its meeting on November 21, 2006, approved the annual base salaries of the Bank’s executive officers for fiscal year 2007 as follows: Alan J. Hyatt, $278,000; Melvin E. Meekins, Jr., $330,000; S. Scott Kirkley, $236,000; and Thomas G. Bevivino, $167,000.PART IIIItem 10. Directors and Executive Officers of the Registrant and Corporate GovernanceReference is made to the section captioned “Proposal 1: Election of Directors” in Bancorp's Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Reference is made to the section captioned “Stock Ownership” in Bancorp’s Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Reference is made to the section captioned“Director Independence”“”Section 16(a) Beneficial Ownership Reporting Compliance” in Bancorp’s Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Reference is made to the section captioned “Report of the Audit Committee” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.On March 16, 2004, the Company adopted a written Code of Ethics, attached hereto as an Exhibit, that applies to the Company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The Company intends to disclose waivers and amendments to the Code of Ethics on its website in the event that any such waiver or amendment is granted.44��Item 11. Executive CompensationReference is made to the section captioned “Director and Executive Officer Compensation” in Bancorp's Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.54Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersReference is made to thesectionssection captioned “Stock Ownership” and “Director and Executive Officer Compensation” in Bancorp's Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Number ofNumber ofsecurities to besecuritiesissued uponWeighted-averageremaining availableexercise ofexercise price offor future issuanceoutstandingoutstandingUnder equityoptions, warrantsoptions, warrantscompensationPlan Categoryand rightsand rightsplansEquity compensation plan approved by security holders112,400 $17.43 45,100 Equity compensation plans not approved by security holders- - - Total112,400 $17.43 45,100 Item 13. Certain Relationships and Related Transactions, and Director IndependenceReference is made to thesectionsections captioned “Compensation Committee Interlocks, and Insider Participation,” and “CertainRelationships andTransactionsWhere Certain Persons Have Material Interests”With Related Persons” in Bancorp's Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Reference is made to the section captioned “Director Independence” in Bancorp’s Proxy Statement dated March 21, 2007 for the information required by this Item, which is hereby incorporated by reference.Item 14. PrincipalAccountingAccountant Fees and ServicesReference is made to the section captioned “Relationship with Independent Auditors” in Bancorp's Proxy Statement dated March25, 200421, 2007 for the information required by this Item, which is hereby incorporated by reference.Reference is made to the section captioned “Report of the Audit Committee” in Bancorp’s Proxy Statement dated March 25, 2004 for the information required by this Item, which is hereby incorporated by reference.55
PART IVItem 15. Exhibits and FinancialStatements,Statement Schedulesand Reports on Form 8-K(a) The following consolidated financial statements of Bancorp and its wholly ownedsubsidiariessub-sidiaries are filed as part of this report:1. Financial Statements·REPORTS OF BEARD MILLER COMPANY LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM.· CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AT DECEMBER 31,20032006 AND DECEMBER 31,20022005· CONSOLIDATED STATEMENTS OFOPERATIONSINCOME FOR THE YEARS ENDED DECEMBER 31,2003, 2002,2006, 2005, AND20012004· CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,2003, 20022006, 2005, AND20012004· CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31,2003, 20022006, 2005 AND2001.2004.· NOTES TO CONSOLIDATED FINANCIAL STATEMENTSPAGES F1- F37·REPORT OF BEARD MILLER COMPANY, LLP, INDEPENDENT AUDITORS PAGE F1.2.Financial Statement SchedulesAll financial statement schedules have been omitted, as required information is either inapplicable or included in the consolidated financial statements or related notes.453. ExhibitsThe following exhibits are filed as part of this report:Exhibit No.Description of Exhibit3.1Articles of Incorporation of Severn Bancorp, Inc.(1)3.2Bylaws of Severn Bancorp, Inc.(1)10.5Employee Stock Ownership Plan(1)14Code of Ethics31.1Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 200231.2Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 20023.1 Articles of Incorporation of Severn Bancorp, Inc. (1)3.2 Bylaws of Severn Bancorp, Inc. (1)3.3 Amendment to Bylaws 10.1+ Description of compensation of directors and officers 10.2+ Stock Option Plan (3)10.3+ Employee Stock Ownership Plan (1)10.4+ Form of Common Stock Option Agreement(4)14 Code of Ethics (2)21.1 Subsidiaries of Severn Bancorp, Inc. 23.1 Consent of Independent Registered Public Accounting Firm 31.1 Certification of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002 31.2 Certification of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002 32 Certification of CEO and CFO pursuant to Section 906 of Sarbanes-Oxley Act of 2002 32.Certification of CEO and CFO pursuant to Section 906 of Sarbanes-Oxley Act of 2002
+ Denotes management contract, compensatory plan or arrangement.(1) Incorporated by referenceto Exhibit bearing the same number infrom Bancorp's Registration Statement of Form 10 filed with the Securities and Exchange Commission on June 7,20022002.(2) Incorporated by reference from Bancorp's 2003 Form 10-K filed with the Securities and Exchange Commission on March 25, 2004.(b)(3)ReportsIncorporated by reference from Bancorp's 2004 Form 10-K filed with the Securities and Exchange Commission on March 21, 2005.(4) Incorporated by reference from Bancorp’s Current Report on Form 8-K filedforwith theperiod January 1, 2003 through December 31, 2003 as follows:Form 8-K dated May 12, 2003. Reporting the resignation of Dimitri Sfakiyanudis as Director.Form 8-K dated December 16, 2003. Reporting the appointment of Albert W. Shields as Director.TheSecurities and Exchange Commissionmaintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission including Bancorp. That address is http://www.sec.gov.on March 20, 2006.56SIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.SEVERN BANCORP, INC.March 25, 2004/s/Alan J. HyattChairman of the Board and Director46SEVERN BANCORP, INC.
March 6, 2007/s/ Alan J. Hyatt Alan J. Hyatt Chairman of the Board, President, Chief Executive Officer and Director 57Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.March 25, 2004/s/Alan J. HyattChairman of the Board,President, Chief Executive Officerand DirectorMarch 25, 2004/s/Melvin Hyatt, DirectorMarch 25, 2004/s/S. Scott Kirkley, DirectorMarch 25, 2004/s/Melvin E. Meekins, Jr., DirectorMarch 25, 2004/s/Ronald P. Pennington, DirectorMarch 25, 2004/s/T. Theodore Schultz, DirectorMarch 25, 2004/s/Albert W. Shields, DirectorMarch 25, 2004/s/Louis DiPasquale, Jr., DirectorMarch 25, 2004/s/Keith Stock, DirectorUnder the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. Each of the undersigned signatures certifies pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:(1)This Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and(2)The information contained in this Report fairly presents, in all material respects, the financial condition and result of operations of the Registrant.SEVERN BANCORP, INC.RegistrantDate: March 25, 2004/s/Alan J. Hyatt, President, Chief Executive Officerand Chairman of the Board(Principal Executive Officer)Date: March 25, 2004/s/Cecelia Lowman, Chief Financial Officer(Principal Financial and Accounting Officer)March 6, 2007 /s/ Alan J. Hyatt Alan J. Hyatt Chairman of the Board, President, Chief Executive Officer and Director March 6, 2007 /s/ Thomas G. Bevivino Thomas G. Bevivino, Executive Vice President and Chief Financial Officer March 6, 2007 /s/ S. Scott Kirkley S. Scott Kirkley, Executive Vice President, Secretary, Treasurer and Director March 6, 2007 /s/ Melvin E. Meekins, Jr. Melvin E. Meekins, Jr., Executive Vice President and Director March 6, 2007 /s/ Melvin HyattMelvin Hyatt, Director March 6, 2007 /s/ Ronald P. Pennington Ronald P. Pennington, Director March 6, 2007 /s/ T. Theodore Schultz T. Theodore Schultz, Director March 6, 2007 /s/ Albert W. Shields Albert W. Shields, Director March 6, 2007 /s/ Louis DiPasquale, Jr. Louis DiPasquale, Jr., Director March 6, 2007 /s/ Keith Stock Keith Stock, Director 5847