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

FORM 10-Q
(Mark One)

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

For the quarterly period ended September 30, 20162017

or

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

For the transition period from                           to                          .

Commission File Number 0-49731

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

Maryland 52-1726127
(State or other jurisdiction of incorporation or organization) (I.R.S. employer identification no.)

200 Westgate Circle, Suite 200
 Annapolis, Maryland
 
 
21401
(Address of principal executive offices) (Zip Code)

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  ☑   No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  ☑   No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company, or an emerging growth company.  See definition of “large accelerated filer,”filer”, “accelerated filer”, “smaller reporting company”, and “smaller reporting“emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐
Accelerated filer  ☐
  
Non- accelerated filer ☐ (Do not check if a smaller reporting company)
Smaller reporting company ☑

Emerging growth company  ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes.☐Yes ☐No No ☑

NumberIndicate the number of shares outstanding of each of the registrant’s issuer’s classes of common stock, as of the latest practicable date:

Common Stock, $0.01 par value – 12,245,425 shares outstanding as of the close of business on November 10, 2016: 12,104,379 shares.13, 2017
 
SEVERN BANCORP, INC. AND SUBSIDIARIES
Table of Contents


PART I – FINANCIAL INFORMATIONPage
Item 1.
Financial Statements(Unaudited)
 
   
 
Consolidated Statements of Financial Condition as of September 30, 20162017 (unaudited) and December 31, 20152016
1
 
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2017 and 2016 (unaudited)
2
Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2017 and 2016 and 2015(unaudited)
23
 
Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2017 and 2016 and 2015(unaudited)
34
 
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016 and 2015(unaudited)
45
 
Notes to Consolidated Financial Statements (unaudited)
6
   
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
4526
   
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
5641
   
Item 4.
Controls and Procedures
5642
   
PART II – OTHER INFORMATION 
   
Item 1.
Legal Proceedings
5642
   
Item 1A.
Risk Factors
5742
   
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
5742
   
Item 3.
Defaults Upon Senior Securities
5742
   
Item 4.
Mine Safety Disclosures
5742
   
Item 5.
Other Information
5743
   
Item 6.
Exhibits
5743
   
EXHIBIT INDEX
44
SIGNATURES
5845
 
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Caution Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q, as well as other periodic reports filed with the Securities and Exchange Commission (“SEC”), and written or oral communications made from time to time by or on behalf of Severn Bancorp and its subsidiaries (the “Company”), may contain statements relating to future events or future results of the Company that are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as “believe,” “expect,” “anticipate,”  “plan,” “estimate,” “intend,” and “potential,” or words of similar meaning, or future or conditional verbs such as “should,” “could,” or “may.”  Forward-looking statements include statements of our goals, intentions and expectations; statements regarding our business plans, prospects, growth, and operating strategies; statements regarding the quality of our loan and investment portfolios; and estimates of our risks and future costs and benefits.
Forward-looking statements reflect our expectation or prediction of future conditions, events, or results based on information currently available. These forward-looking statements are subject to significant risks and uncertainties that may cause actual results to differ materially from those in such statements.  These risks and uncertainties include, but are not limited to, the risks identified in Item 1A of the Company’s 2016 Annual Report on Form 10-K, Item 1A of Part II of the Company’s March 31, 2017 quarterly report on Form 10-Q, Item 1A of Part II of the Company’s June 30, 2017 quarterly report on Form 10-Q, Item 1A of Part II of this quarterly report on Form 10-Q, and the following:
·general business and economic conditions nationally or in the markets that the Company serves could adversely affect, among other things, real estate prices, unemployment levels, and consumer and business confidence, which could lead to decreases in the demand for loans, deposits, and other financial services that we provide and increases in loan delinquencies and defaults;

·changes or volatility in the capital markets and interest rates may adversely impact the value of securities, loans, deposits, and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;

·our liquidity requirements could be adversely affected by changes in our assets and liabilities;

·our investment securities portfolio is subject to credit risk, market risk, and liquidity risk as well as changes in the estimates we use to value certain of the securities in our portfolio;

·the effect of legislative or regulatory developments including changes in laws concerning taxes, banking, securities, insurance, and other aspects of the financial services industry;

·competitive factors among financial services companies, including product and pricing pressures, and our ability to attract, develop, and retain qualified banking professionals;

·the effect of fiscal and governmental policies of the United States (“U.S.”) federal government;

·the effect of any mergers, acquisitions, or other transactions to which we or our subsidiaries may from time to time be a party;

·costs and potential disruption or interruption of operations due to cyber-security incidents;

·the effect of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, and other regulatory agencies; and

·geopolitical conditions, including acts or threats of terrorism, actions taken by the U.S. or other governments in response to acts or threats of terrorism, and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad.
Forward-looking statements speak only as of the date of this report.  The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of this report or to reflect the occurrence of unanticipated events except as required by federal securities laws.
ii
Table of Contents
PART I–I – FINANCIAL INFORMATION

Item 1.
Financial Statements

SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
(dollars in thousands, except per share amounts)data)

  
September 30,
2016
  
December 31,
2015
 
ASSETS   
Cash and due from banks $31,451  $28,366 
Interest earning deposits in other banks  13,042   15,225 
Cash and cash equivalents  44,493   43,591 
Investment securities held to maturity (fair value: $68,975 at September 30, 2016; $76,310 at December 31, 2015)  67,677   76,133 
Loans held for sale  12,961   13,203 
Loans receivable, net of allowance for loan losses of $8,985 and $8,758, respectively  603,473   589,656 
Premises and equipment, net  24,167   24,290 
Foreclosed real estate  1,343   1,744 
Federal Home Loan Bank stock, at cost  5,230   5,626 
Deferred tax asset  10,916   - 
Accrued interest receivable and other assets  7,496   7,836 
         
Total assets $777,756  $762,079 
         
LIABILITIES AND STOCKHOLDERS' EQUITY        
Liabilities
        
Deposits $556,610  $523,771 
Short-term borrowings  7,000   - 
Long-term borrowings  103,500   115,000 
Subordinated debentures  20,619   24,119 
Accrued interest payable and other liabilities  3,244   12,733 
         
Total liabilities  690,973   675,623 
         
Stockholders’ Equity
        
Preferred stock, $0.01 par value, 1,000,000 shares authorized:        
Preferred stock series “A”, 437,500 shares issued and outstanding; $3,500 liquidation preference  4   4 
Preferred stock series “B”, 0 and 23,393 shares issued and outstanding; and $0 and $23,393 liquidation preference, respectively  -   - 
Common stock, $0.01 par value, 20,000,000 shares authorized;12,104,379 and 10,088,879 shares issued and outstanding, respectively  121   101 
Additional paid-in capital  63,778   76,335 
Retained earnings  22,880   10,016 
         
Total stockholders' equity  86,783   86,456 
         
Total liabilities and stockholders' equity $777,756  $762,079 
  
September 30,
2017
  
December 31,
2016
 
ASSETS (unaudited)    
Cash and due from banks $1,654  $39,396 
Federal funds sold and interest-bearing deposits in other banks  39,981   27,718 
Cash and cash equivalents  41,635   67,114 
Securities available for sale, at fair value  3,129   - 
Securities held to maturity (fair value of $58,959 at September 30, 2017 and $62,827 at December 31, 2016)  58,764   62,757 
Loans held for sale, at fair value at September 30, 2017  4,871   10,307 
Loans receivable  650,964   610,278 
Allowance for loan losses  (7,936)  (8,969)
Loans, net  643,028   601,309 
Real estate acquired through foreclosure  1,104   973 
Restricted stock investments  4,699   5,103 
Premises and equipment, net  23,398   24,030 
Accrued interest receivable  2,503   2,249 
Bank owned life insurance  5,023   - 
Deferred income taxes  8,002   10,081 
Other assets  5,174   3,562 
Total assets $801,330  $787,485 
         
LIABILITIES AND STOCKHOLDERS’ EQUITY        
Liabilities:        
Deposits:        
Noninterest bearing $71,515  $58,145 
Interest-bearing  521,977   513,801 
Total deposits  593,492   571,946 
Short-term borrowings  4,950   - 
Long-term borrowings  88,500   103,500 
Subordinated debentures  20,619   20,619 
Accrued expenses and other liabilities  1,759   3,490 
Total liabilities  709,320   699,555 
         
Stockholders’ Equity:        
Preferred stock, $0.01 par value, 1,000,000 shares authorized:        
Preferred stock series “A,” 437,500 shares issued and outstanding and $3,500 liquidation preference at both September 30, 2017 and December 31, 2016  4   4 
Common stock, $0.01 par value, 20,000,000 shares authorized; 12,245,425 and 12,123,179 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively  122   121 
Additional paid-in capital  65,290   63,960 
Retained earnings  26,598   23,845 
Accumulated other comprehensive loss  (4)  - 
Total stockholders’ equity  92,010   87,930 
Total liabilities and stockholders’ equity $801,330  $787,485 

TheSee accompanying notes to consolidated financial statements are an integral part of these statements.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)OPERATIONS
(dollars in thousands, except per share data)

 
For the Three Months Ended
September 30,
  
For the Nine Months Ended
September 30,
  Three Months Ended September 30,  Nine Months Ended September 30, 
 2016  2015  2016  2015  2017  2016  2017  2016 
Interest Income
            
Loans, including fees $7,479  $7,549  $21,847  $22,541 
Interest income: (unaudited) 
Loans $7,742  $7,479  $22,267  $21,847 
Securities  280   314   890   788   330   280   927   890 
Other  83   69   251   242 
Other earning assets  167   83   498   251 
Total interest income  7,842   7,932   22,988   23,571   8,239   7,842   23,692   22,988 
                
Interest Expense
                
Interest expense:                
Deposits  1,019   1,032   3,002   3,055   1,011   1,019   2,924   3,002 
Borrowings and subordinated debentures  1,106   1,252   3,493   3,673   897   1,106   2,844   3,493 
Total interest expense  2,125   2,284   6,495   6,728   1,908   2,125   5,768   6,495 
                
Net interest income  5,717   5,648   16,493   16,843   6,331   5,717   17,924   16,493 
Provision for loan losses  50   -   150   200 
Net interest income after provision for loan losses  5,667   5,648   16,343   16,643 
                
Non-interest Income
                
Mortgage banking activities  861   859   1,893   2,278 
Provision for (reversal of) loan losses  -   50   (650)  150 
Net interest income after provision for (reversal of) loan losses  6,331   5,667   18,574   16,343 
Noninterest income:                
Mortgage-banking revenue  334   1,042   1,150   2,693 
Real estate commissions  455   298   1,246   896   311   455   959   1,246 
Real estate management fees  214   166   564   491   197   214   513   564 
Other  185   146   1,076   1,036 
Total non-interest income  1,715   1,469   4,779   4,701 
                
Non-Interest Expenses
                
Credit report and appraisal fees  137   99   390   304 
Deposit service charges  190   32   265   105 
Other noninterest income  230   54   485   667 
Total noninterest income  1,399   1,896   3,762   5,579 
Noninterest expense:                
Compensation and related expenses  4,028   3,758   11,478   11,659   3,288   3,928   10,719   11,218 
Occupancy  486   377   1,387   1,255   354   333   1,015   942 
Legal  81   70   217   199 
Foreclosed real estate, net  41   132   184   119 
FDIC assessments and regulatory expense  175   307   469   917 
Legal fees  41   81   104   217 
Write-downs, losses, and costs of real estate acquired through foreclsoure, net  126   41   166   184 
Federal Deposit Insurance Corpation insurance premiums  69   126   133   296 
Professional fees  252   179   659   680   124   189   377   528 
Advertising  134   88   475   221   198   158   649   510 
Online charges  117   233   617   640   237   117   661   617 
Credit report and appraisal fees  148   170   480   646   203   148   478   480 
Licensing and software  152   115   326   345 
Mortgage leads purchased  48   205   234   559 
Other  487   524   1,535   1,463   681   689   2,158   2,405 
Total non-interest expenses  5,949   5,838   17,501   17,799 
Income before income tax provision/(benefit)  1,433   1,279   3,621   3,545 
Income tax provision/(benefit)  378   52   (10,816)  88 
Total noninterest expense  5,521   6,130   17,020   18,301 
Income before income tax provision (benefit)  2,209   1,433   5,316   3,621 
Income tax provision (benefit)  950   378   2,150   (10,816)
Net income  1,055   1,227   14,437   3,457   1,259   1,055   3,166   14,437 
Amortization of discount on preferred stock  (68)  (68)  (203)  (203)  (68)  (68)  (203)  (203)
Dividends on preferred stock  (448)  (526)  (1,370)  (1,579)  (70)  (448)  (210)  (1,370)
Net income available to common stockholders $539  $633  $12,864  $1,675  $1,121  $539  $2,753  $12,864 
Basic income per share $0.04  $0.06  $1.14  $0.17 
Diluted income per share $0.04  $0.06  $1.13  $0.17 
Net income per common share - basic $0.09  $0.04  $0.23  $1.14 
Net income per common share - diluted $0.09  $0.04  $0.22  $1.13 

TheSee accompanying notes to consolidated financial statements are an integral part of these statements.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED)COMPREHENSIVE INCOME
 (dollars(dollars in thousands)

  Three Months Ended September 30,  Nine Months Ended September 30, 
  2017  2016  2017  2016 
  (unaudited) 
Net income $1,259  $1,055  $3,166  $14,437 
Other comprehensive loss items:                
Unrealized holding losses on available-for-sale securities arising during the period (net of income tax benefit of $6 and $2, respectively, in 2017)  (9)  -   (3)  - 
Realized gains, net of income taxes of $1 and $1, respectively, in 2017  (1)  -   (1)  - 
Total other comprehensive loss  (10)  -   (4)  - 
Total comprehensive income $1,249  $1,055  $3,162  $14,437 
Nine Months Ended September 30, 2016

  
Preferred
Stock
  
Common
Stock
  
Additional
Paid-In
Capital
  
Retained
Earnings
  
Total
Stockholders’
Equity
 
Balance - December 31, 2015 $4  $101  $76,335  $10,016  $86,456 
                     
Net Income  -   -   -   14,437   14,437 
Stock issuance (2,015,500 shares) net of expenses of $575      20   10,490       10,510 
Stock-based compensation  -   -   143   -   143 
Dividend declared on Series A preferred stock  -   -   -   (140)  (140)
Stock redemption on Series B preferred stock (23,393 shares)  -   -   (23,393)  -   (23,393)
Dividend declared on Series B preferred stock  -   -   -   (1,230)  (1,230)
Amortization of discount on                    
Series B preferred stock warrants          203   (203)  - 
                     
Balance – September 30, 2016 $4  $121  $63,778  $22,880  $86,783 

Nine Months Ended September 30, 2015

  
Preferred
Stock
  
Common
Stock
  
Additional
 Paid-In
Capital
  
Retained
Earnings
  
Total
Stockholders’
Equity
 
Balance - December 31, 2014 $4  $101  $75,848  $7,857  $83,810 
                     
Net Income  -   -   -   3,457   3,457 
Stock-based compensation  -   -   92   -   92 
Dividend declared on Series B preferred stock  -   -   -   (1,579)  (1,579)
Amortization of discount on                    
Series B preferred stock warrants          203   (203)  - 
Exercised Options (21,500 shares)  -   -   96       96 
                     
Balance – September 30, 2015 $4  $101  $76,239  $9,532  $85,876 

TheSee accompanying notes to consolidated financial statements are an integral part of these statements.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)CHANGES IN STOCKHOLDERS’ EQUITY
(dollars in thousands)thousands, except per share data)
  
Nine Months Ended September 30, 2017 (unaudited)
 
  
Number of
Shares of
Preferred
Stock
  
Number of
Shares of
Common
Stock
  
Preferred
Stock
  
Common
Stock
  
Additional
Paid-In
Capital
  
Retained
Earnings
  
Accumulated
Comprehensive
Loss
  
Total
Stockholders’
Equity
 
Balance at January 1, 2017  437,500   12,123,179  $4  $121  $63,960  $23,845  $-  $87,930 
Net income  -   -   -   -   -   3,166   -   3,166 
Stock-based compensation  -   -   -   -   146   -   -   146 
Stock issued in acquisition  -   108,084   -    1    774    -    -    775 
Stock issued, net of expense  -   14,162   -   -   207   -   -   207 
Dividend declared on Series A preferred stock  -   -   -   -   -   (210)  -   (210)
Amortization of discount on Series B preferred stock  -   -   -   -   203   (203)  -   - 
Other comprehensive loss  -   -   -   -   -   -   (4)  (4)
Balance at September 30, 2017  437,500   12,245,425  $4  $122  $65,290  $26,598  $(4) $92,010 

  
For the Nine Months Ended
September 30,
 
  2016  2015 
       
Cash Flows from Operating Activities
      
       
Net income $14,437  $3,457 
Adjustments to reconcile net income to net cash provided by operating activities:        
Amortization of deferred loan fees  (889)  (1,013)
Net amortization of premiums and discounts  318   299 
Provision for loan losses  150   200 
Provision for depreciation  863   851 
Provision for losses on foreclosed real estate  196   - 
Gain on sale of loans  (1,893)  (2,278)
Gain on sale of foreclosed real estate  (46)  (79)
Proceeds from loans sold to others  106,668   125,385 
Loans originated for sale  (104,533)  (128,925)
Stock-based compensation expense  143   92 
Deferred income tax benefit  (10,916)  - 
Decrease in accrued interest receivable and other assets  340   1,132 
(Decrease) increase in accrued interest payable and other liabilities  (2,938)  
1,172
 
         
Net cash provided by operating activities  1,900   294 
         
Cash Flows from Investing Activities
        
         
Purchase of investment securities held to maturity  (3,562)  (24,199)
Proceeds from maturing investment securities held to maturity  7,000   4,000 
Principal collected on mortgage-backed securities held to maturity  4,700   2,565 
Net (increase) decrease in loans  (14,448)  44,416 
Proceeds from sale of foreclosed real estate  1,621   2,014 
Investment in premises and equipment  (740)  (242)
Redemption of FHLB stock  396   310 
         
Net cash (used in) provided by investing activities  (5,033)  28,864 
  
Nine Months Ended September 30, 2016 (unaudited)
 
  
Number of
Shares of
Preferred
Stock
  
Number of
Shares of
Common
Stock
  
Preferred
Stock
  
Common
Stock
  
Additional
Paid-In
Capital
  
Retained
Earnings
  
Accumulated
Comprehensive
Income
  
Total
Stockholders’
Equity
 
Balance at January 1, 2016  460,893   10,088,879  $4  $101  $76,335  $10,016  $-  $86,456 
Net income  -   -   -   -   -   14,437   -   14,437 
Stock-based compensation  -   -   -   -   143   -   -   143 
Stock issued, net of expense  -   2,015,500   -   20   10,490   -   -   10,510 
Stock redemption on Series B preferred stock  (23,393)  -   -   -   (23,393)  -   -   (23,393)
Dividend declared on Series A preferred stock  -   -   -   -   -   (140)  -   (140)
Dividend declared on Series B preferred stock  -   -   -   -   -   (1,230)  -   (1,230)
Amortization of discount on Series B preferred stock  -   -   -   -   203   (203)  -   - 
Balance at September 30, 2016  437,500   12,104,379  $4  $121  $63,778  $22,880  $-  $86,783 

See accompanying notes to consolidated financial statements
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) CONTINUED
(dollars in thousands)thousands, except per share data)

  
For the Nine Months Ended
September 30,
 
  2016  2015 
       
Cash Flows from Financing Activities
      
       
Net increase (decrease) in deposits  32,839   (7,168)
Net increase in short-term borrowings  7,000   - 
Additional borrowed funds, long term  3,500   - 
Repayment of borrowed funds, long term  (18,500)           - 
Series A preferred stock dividends  (140)  - 
Series B preferred stock dividends  (7,781)  - 
Stock redemption of Series B preferred stock  (23,393)  - 
Net proceeds from common stock issuance  10,510   - 
Proceeds from exercise of options  -   96 
Net cash provided by (used in) financing activities  4,035   (7,072)
Increase in cash and cash equivalents  902   22,086 
Cash and cash equivalents at beginning of year  43,591   33,335 
         
Cash and cash equivalents at end of period $44,493  $55,421 
         
Supplemental disclosure of cash flows information:        
         
Cash paid (received) during period for:        
         
Interest $9,104  $6,003 
         
Income taxes $(852) $(298)
         
Transfer of loans to foreclosed real estate $1,370  $1,907 
  Nine Months Ended September 30, 
  2017  2016 
Cash flows from operating activities: (unaudited) 
Net income $3,166  $14,437 
Adjustments to reconcile net income to net cash from operating activities:        
Depreciation and amortization  919   863 
Amortization of deferred loan fees  (847)  (889)
Net amortization of premiums and discounts on securities  (202)  318 
(Reversal of) provision for loan losses  (650)  150 
Write-downs and losses on real estate acquired through foreclosure, net of gains  139   149 
Gain on sale of mortgage loans  (1,150)  (2,693)
Gain on sale of securities  (2)  - 
Proceeds from sale of mortgage loans held for sale  28,482   107,468 
Originations of loans held for sale  (22,556)  (104,533)
Stock-based compensation  146   143 
Increase in cash surrender value of bank owned life insurance  (23)  - 
Deferred income taxes  2,081   (10,916)
Increase in accrued interest receivable  (254)  (44)
(Increase) decrease in other assets  (837)  384 
Decrease in accrued expenses and other liabilities  (1,731)  (2,938)
Net cash provided by operating activities  6,681   1,899 
Cash flows from investing activities:        
Loan principal (disbursements), net of repayments  (40,265)  (14,448)
Redemption of restricted stock investments  404   396 
Purchases of premises and equipment, net  (287)  (740)
Purchase of bank owned life insurance  (5,000)  - 
Activity in securities held to maturity:        
Purchases  (6,679)  (3,562)
Maturities/calls/repayments  10,730   11,700 
Activity in available-for-sale securities:        
Purchases  (7,184)  - 
Sales  4,011   - 
Maturities/calls/repayments  184   - 
Proceeds from sales of real estate acquired through foreclosure  433   1,622 
Net cash used in investing activities  (43,653)  (5,032)
Cash flows from financing activities:        
Net increase in deposits  21,546   32,839 
Additional borrowings  39,950   10,500 
Repayment of borrowings  (50,000)  (18,500)
Series A preferred stock dividends  (210)  (140)
Series B preferred stock dividends  -   (7,781)
Stock redemption of Series B preferred stock  -   (23,393)
Proceeds from common stock issuance  207   10,510 
Net cash provided by financing activities  11,493   4,035 
(Decrease) increase in cash and cash equivalents  (25,479)  902 
Cash and cash equivalents at beginning of period  67,114   43,591 
Cash and cash equivalents at end of period $41,635  $44,493 
Supplemental Information:        
Interest paid on deposits and borrowed funds $5,828  $9,104 
Income taxes paid (recovered)  50   (852)
Real estate acquired in satisfaction of loans  703   1,370 
Transfers of loans held for sale to portfolio  660   - 

TheSee accompanying notes to consolidated financial statements are an integral part of these statements.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESSevern Bancorp, Inc. and Subsidiaries
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Information as of and for the three and nine months ended September 30, 2017 and 2016 is unaudited)

Note 1 -  Summary of Significant Accounting Policies
Basis of Presentation
The accounting and reporting policies of Severn Bancorp, Inc. and subsidiaries (the “Company”) conform to accounting principles generally accepted in the United States of America (“U.S.”) (“GAAP”) and prevailing practices within the financial services industry for interim financial information and Rule 8-01 of Regulation S-X.  Accordingly, they do not include all of the information and notes required for complete financial statements and prevailing practices within the banking industry.  In the opinion of management, all adjustments (comprising only of those of a normal recurring nature) necessary for a fair presentation of the results of operations for the interim periods presented have been made. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2017 or any other interim or future period.  Events occurring after the date of the financial statements up to November 14, 2017, the date the financial statements were available to be issued, were considered in the preparation of the consolidated financial statements.
These statements should be read in conjunction with the financial statements and accompanying notes included in the Company’s 2016 Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”).
Principles of Consolidation

The unaudited consolidated financial statements include the accounts of Severn Bancorp, Inc. (“Bancorp”), and its wholly-owned subsidiaries, Mid-Maryland Title Company, Inc., SBI Mortgage Company and SBI Mortgage Company’s subsidiary, Crownsville Development Corporation, and its subsidiary, Crownsville Holdings I, LLC, and Severn Savings Bank, FSB (the “Bank”), and the Bank’s subsidiaries, Louis Hyatt, Inc., Homeowners Title and Escrow Corporation, Severn Financial Services Corporation, SSB Realty Holdings, LLC, SSB Realty Holdings II, LLC, and HS West, LLC.  All intercompany accounts and transactions have been eliminated in the accompanying consolidated financial statements.

Note 2 -  Basis of Presentation
Acquisition

Bancorp follows accounting standards setOn September 1, 2017, we acquired Mid-Maryland Title Company, Inc. (the “Title Company”) by the Financial Accounting Standards Board, commonly referred to as the “FASB”.  The FASB sets generally accepted accounting principlesissuing stock in a business combination. We issued 108,084 shares in the United States (“GAAP”) that Bancorp follows. References to GAAP issued bytransaction valued at $775,000.  We recorded $759,000 in goodwill in the FASB in these footnotes are totransaction.  The acquisition continues our growth strategy and focus on being a full-service provider and complements the FASB Accounting Standards Codification, sometimes referred to asmortgage services, commercial banking services, and commercial real estate services we provide. The acquisition of the CodificationTitle Company has not had a material effect on the Company’s financial condition or ASC.results of operations.

Use of Estimates
The accompanying unaudited consolidatedpreparation of financial statements have been prepared in accordance with GAAP for interim financial informationrequires management to make estimates and in accordance withassumptions that affect the instructions to Form 10-Q.  Accordingly, they do not include allreported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the disclosures required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments necessary for a fair presentationdate of the results of operations for the interim periods presented have been made. Such adjustments were of a normal recurring nature.  The results of operations for the three and nine months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2016 or any other interim period.  The unaudited consolidated financial statements for the three and nine months ended September 30, 2016 should be read in conjunction with the audited consolidated financial statements, and affect the reported amounts of revenues earned and expenses incurred during the reporting period. Actual results could differ from those estimates. Estimates that could change significantly relate to the provision for loan losses and the related notes, which were included in Bancorp’s Annual Report on Form 10-Kallowance for loan losses (“Allowance”), determination of impaired loans and the fiscal year ended December 31, 2015.  These consolidated financial statements consider eventsrelated measurement of impairment, valuation of investment securities, valuation of real estate acquired through foreclosure, valuation of share-based compensation, the assessment that occurred througha liability should be recognized with respect to any matters under litigation, and the datecalculation of current and deferred income taxes and the consolidated financial statements were issued.realizability of net deferred tax assets.

Note 3 -  Cash Flow PresentationFlows

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

Note 4 – Reclassifications

Amounts in the prior year’s consolidated financial statementsCertain reclassifications have been reclassified whenever necessarymade to amounts previously reported to conform to current period presentation.
Recent Accounting Pronouncements
Pronouncements Adopted
In March 2016, the current year’s presentation.  Such reclassifications had no impactFinancial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09,  Stock Compensation:  Improvements to Employee Share-Based Payment Accounting, the purpose of which is to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liability, and classification on net income.the statement of cash flows.  ASU No. 2016-09 is effective for interim and annual reporting periods beginning after December 15, 2016. Early application is permitted. The adoption of the guidance did not have a material effect on the Company’s financial position, results of operation, or cash flows. We have elected to account for stock option forfeitures when they occur.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESPronouncements Issued
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 5 -In May 2014, FASB issued ASU No. 2014-09, Earnings Per ShareRevenue from Contracts with Customers,

Basic earnings per shareas amended by ASU 2015-14, Revenue from Contracts with Customers:  Deferral of the Effective Date, ASU 2016-08, Revenue from Contracts with Customers:  Principal Versus Agent Considerations (Reporting Revenue Gross Versus Net), ASU 2016-10, Revenue from Contracts with Customers, Identifying Performance Obligations and Licensing, ASU 2016-12, Revenue from Contracts with Customers:  Narrow-Scope Improvements and Practical Expedients, ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue form Contracts with Customers, that provides accounting guidance for all revenue arising from contracts with customers and affects all entities that enter into contracts to provide goods or services to customers. The guidance also provides for a model for the measurement and recognition of gains and losses on the sale of certain nonfinancial assets, such as property and equipment, including real estate. This standard may affect an entity’s financial statements, business processes and internal control over financial reporting. The standard is computed by dividing net income availableeffective for interim and annual periods beginning after December 15, 2017. The standard must be adopted using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach. The following revenue streams were identified to common stockholders bybe within the weighted average numberscope of sharesASU No. 2014-09:  real estate commissions, real estate management fees, and deposit service charges.  For all affected revenue streams, we are currently planning to use a modified retrospective approach to uncompleted contracts at the date of common stock outstandingadoption. Periods prior to the date of adoption are not retrospectively revised, but a cumulative effect of adoption is recognized for each period.  Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Potential common sharesthe impact of the ASU on uncompleted contracts at the date of adoption.  We are still evaluating the impact of guidance in this update, including method of implementation, and related changes to disclosures that may be required.
 In January 2016, FASB issued ASU No. 2016-01, Financial Instruments – Overall:  Recognition and Measurement of Financial Assets and Financial Liabilities, which requires entities to measure equity investments at fair value and recognize changes on fair value in net income. The guidance also provides a new measurement alternative for equity investments that do not have readily determinable fair values and don’t qualify for the net asset value practical expedient. Entities will have to record changes in instrument–specific credit risk for financial liabilities measured under the fair value option in other comprehensive income, except for certain financial liabilities of consolidated collateralized financing entities. Entities will also have to reassess the realizability of a deferred tax asset related to an available-for-sale (“AFS”) debt security in combination with their other deferred tax assets. For public entities, the guidance in this ASU is effective for the first interim or annual period beginning after December 15, 2017. Early adoption by Bancorp relatepublic entities is permitted as of the beginning of the year of adoption for selected amendments by a cumulative effect adjustment to outstanding stock options, warrants,the balance sheet. The adoption of this standard is not expected to have a material impact on the Company’s financial position, results of operations, or cash flows.
In February 2016, FASB issued ASU 2016-02, Leases, which requires a lessee to recognize the assets and convertible preferred stock,liabilities that arise from all leases with a term greater than 12 months. The core principle requires the lessee to recognize a liability to make lease payments and a “right-of-use” asset. The accounting applied by the lessor is relatively unchanged. The ASU also requires expanded qualitative and quantitative disclosures. For public business entities, the guidance is effective for interim and annual reporting periods beginning after December 15, 2018 and mandates a modified retrospective transition for all entities. Early application is permitted. We have determined that the provisions of ASU No. 2016-02 may result in an increase in assets to recognize the present value of the lease obligations, with a corresponding increase in liabilities, however, we do not expect this to have a material impact on our financial position, results of operations, or cash flows.
In June 2016, FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses, which sets forth a current expected credit loss (“CECL”) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. While we are determined using the treasury stock method.

Not includedcurrently in the diluted earnings per share calculationprocess of evaluating the impact of the amended guidance on our Consolidated Financial Statements, we currently expect the Allowance to increase upon adoption given that the Allowance will be required to cover the full remaining expected life of the portfolio upon adoption, rather than the incurred loss model under current U.S. GAAP. The extent of this increase is still being evaluated and will depend on economic conditions and the composition of our loan and lease portfolio at the time of adoption.
In August 2016, FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments, which provides guidance regarding the presentation of certain cash receipts and cash payments in the statement of cash flows, addressing eight specific cash flow classification issues, in order to reduce existing diversity in practice. The standard is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted. We do not expect the adoption of ASC No. 2016-15 to have a material impact on our financial position, results of operations, or cash flows.
In March 2017, FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other costs, which provides guidance that calls for the three monthshortening of the amortization period ended September 30, 2016 because they were anti-dilutive were 437,500 sharesfor certain callable debt securities held at a premium. The standard is effective for interim and annual reporting periods beginning after December 15, 2018. Early adoption is permitted. We do not expect the adoption of common stock issuable upon conversion of Bancorp’s Series A Preferred Stock.  Not included in the diluted earnings per share calculation for the nine month period ended September 30, 2016 because they were anti-dilutive, were 126,600 shares of common stock issuable upon exercise of outstanding stock options, 556,976 shares of common stock issuable upon the exercise of a warrant and 437,500 shares of common stock issuable upon conversion of Bancorp’s Series A Preferred Stock.  Not included in the diluted earnings per share calculation for the three and nine month periods ended September 30, 2015, because they were anti-dilutive, were 40,000 and 121,500 shares, respectively, of common stock issuable upon exercise of outstanding stock options, 556,976 shares of common stock issuable upon the exercise of a warrant and 437,500 shares of common stock issuable upon conversion of Bancorp’s Series A Preferred Stock.

  
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
 
  2016  2015  2016  2015 
Common shares – weighted average (basic)  12,104,379   10,088,879   11,324,660   10,082,278 
Common share equivalents – weighted average  79,360   27,181   51,193   24,688 
Common shares – weighted average (diluted)  12,183,739   10,116,060   11,375,853   10,106,966 

Note 6 -  Guarantees

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

Note 7 -  Regulatory Matters

The Bank is subjectASC No. 2017-08 to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional discretionary actions by the regulators that, if undertaken, could have a direct material effectimpact on Bancorp’s consolidatedour financial statements.

Asposition, results of September 30, 2016, Bancorp’s reservable liability was below the threshold established by the Federal Reserve Bank and therefore, Bancorp was not required to maintain reserves (in the form of deposits with the Federal Reserve Bankoperations, or a correspondent bank on behalf of the Federal Reserve Bank.)

Federal banking agencies have adopted proposals that have substantially amended the regulatory capital rules applicable to Bancorp and the Bank.  The amendments implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act.  The amended rules establish new higher capital ratio requirements, narrow the definitions of capital, impose new operating restrictions on banking organizations with insufficient capital buffers and increase the risk weighting of certain assets.  The amended rules were effective with respect to Bancorp and the Bank in January 2015, with certain requirements to be phased in beginning in 2016.cash flows.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 72 - Regulatory Matters–ContinuedSecurities
 
Under capital adequacy guidelinesThe amortized cost and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measuresestimated fair values of the Bank’s assets, liabilities, and certain off-balance sheet itemsour AFS securities portfolio were as calculated under regulatory accounting practices.  The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined).

As of September 30, 2016, the most recent notification from the regulators categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, Common Equity Tier 1 and Tier 1 leverage ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and ratios are also presented in the table below.

Under the final capital rules that became effective on January 1, 2015, there is a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases or for the payment of discretionary bonuses to senior executive management. The capital buffer requirement is being phased in over three years beginning in 2016. We have included the 0.625% increase for 2016 in our minimum capital adequacy ratios in the table below. The capital buffer requirement effectively raises the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5%, and the total capital ratio to 10.5% on a fully phased-in basis on January 1, 2019. Management believes that,follows as of September 30, 2016,2017:

  
Amortized
Cost
  
Unrealized
Gains
  
Unrealized
Losses
  
Estimated
Fair Value
 
  (dollars in thousands) 
U.S. government agency notes $3,135  $-  $6  $3,129 

We did not hold any AFS securities as of December 31, 2016.
The amortized cost and estimated fair values of our held-to-maturity (“HTM”) securities portfolio were as follows:

  September 30, 2017 
  
Amortized
Cost
  
Unrealized
Gains
  
Unrealized
Losses
  
Estimated
Fair Value
 
  (dollars in thousands) 
U.S. Treasury securities $7,996  $106  $-  $8,102 
U.S. government agency notes  19,008   137   43   19,102 
Mortgage-backed securities  31,760   97   102   31,755 
  $58,764  $340  $145  $58,959 
  December 31, 2016 
  
Amortized
Cost
  
Unrealized
Gains
  
Unrealized
Losses
  
Estimated
Fair Value
 
  (dollars in thousands) 
U.S. Treasury securities $12,998  $167  $-  $13,165 
U.S. government agency notes  20,027   133   54   20,106 
Mortgage-backed securities  29,732   52   228   29,556 
  $62,757  $352  $282  $62,827 

Three AFS securities were in an unrealized loss position as of September 30, 2017 for less than twelve months, with the Bank meets all capital adequacy requirements underlargest single unrealized loss in any one security amounting to $3,000.
Gross unrealized losses and fair value by length of time that the Basel III Capital Rules, includingindividual HTM securities have been in an unrealized loss position at the capital conservation buffer, ondates indicated are presented in the following tables:

  September 30, 2017 
  Less than 12 months  12 months or more  Total 
  
Estimated
Fair Value
  
Unrealized
Losses
  
Estimated
Fair Value
  
Unrealized
Losses
  
Estimated
Fair Value
  
Unrealized
Losses
 
  (dollars in thousands) 
U.S. government agency notes $4,000  $2  $7,005  $41  $11,005  $43 
Mortgage-backed securities  11,687   39   7,501   63   19,188   102 
  $15,687  $41  $14,506  $104  $30,193  $145 
  December 31, 2016 
  Less than 12 months  12 months or more  Total 
  
Estimated
Fair Value
  
Unrealized
Losses
  
Estimated
Fair Value
  
Unrealized
Losses
  
Estimated
Fair Value
  
Unrealized
Losses
 
  (dollars in thousands) 
U.S. government agency notes $5,002  $54  $-  $-  $5,002  $54 
Mortgage-backed securities  23,457   228   -   -   23,457   228 
  $28,459  $282  $-  $-  $28,459  $282 

In the HTM securities portfolio, 21 securities were in a fully phased-in basisloss position as if all such requirements were currentlyof September 30, 2017, with the largest single unrealized loss in effect.any one security amounting to $29,000.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 7 -  Regulatory Matters–Continued

  Actual  
For Capital
Adequacy Purposes
  
Minimum Capital
Adequacy with
Capital Buffer
  
To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
  Amount %  Amount  %  Amount %  Amount % 
  (dollars in thousands)   
September 30, 2016                     
Tangible (1) $97,733  12.7% $11,548   1.5%  N/A  N/A   N/A  N/A 
Tier 1 capital (2)  97,733  16.3%  36,056   6.0% $39,811  6.6% $48,074  8.0%
Common Equity Tier 1 (2)  97,733  16.3%  27,042   4.5%  30,797  5.1%  39,060  6.5%
Leverage (1)  97,733  12.7%  30,795   4.0%  35,606  4.6%  38,494  5.0%
Total (2)  105,299  17.5%  48,074   8.0%  51,830  8.6%  60,093  10.0%

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

Note 8 -  Stock-Based Compensation

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

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

There were no options granted during the nine months ended September 30, 2016 and September 30, 2015.

Stock-based compensation expense for the three and nine months ended September 30, 2016 totaled $48,000 and $143,000, respectively. Stock-based compensation expense for the three and nine months ended September 30, 2015 totaled $30,000 and $92,000, respectively. There were no options exercised during the nine months ended September 30, 2016 and 21,500 options were exercised during the nine months ended September 30, 2015.
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 8 - Stock-Based Compensation–Continued
Information regarding Bancorp’s stock-based compensation plan as of and for the nine months ended September 30, 2016 is as follows:

  2016 
  Shares  
Weighted Average
Price
 
Options outstanding, December 31, 2015  339,800  $4.83 
Options granted  -   - 
Options exercised  -   - 
Options forfeited  (54,500)  5.07 
Options outstanding, September 30, 2016  285,300  $4.79 
Options exercisable, September 30, 2016  136,125  $4.37 

The aggregate intrinsic value of the options outstanding as of September 30, 2016 and December 31, 2015 was $491,000 and $323,000, respectively.  The aggregate intrinsic value of the options exercisable as of September 30, 2016 and December 31, 2015 was $292,000 and $165,000, respectively.

The following table summarizes the nonvested options in Bancorp’s stock option plan as of September 30, 2016.

  
Shares
  
Weighted
Average
Grant Date
Exercise Price
 
Nonvested options outstanding, December 31, 2015  235,570  $5.13 
Nonvested options granted  -   - 
Nonvested options vested  (31,895) $5.01 
Nonvested options forfeited  (54,500) $5.07 
Nonvested options outstanding, September 30, 2016  149,175  $5.18 

As of September 30, 2016, there was $407,000 of total unrecognized stock-based compensation expense related to nonvested stock options, which is expected to be recognized over a period of fifty-one months.
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 9 - Investment Securities

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

  
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized Losses
  
Fair
Value
 
September 30, 2016:
            
             
US Treasury securities $15,006  $282  $-  $15,288 
US Agency securities  21,034   392   6   21,420 
US Government sponsored mortgage-backed securities  31,637   630   -   32,267 
Total $67,677  $1,304  $6  $68,975 
                 
December 31, 2015:
                
                 
US Treasury securities $21,057  $276  $8  $21,325 
US Agency securities  20,011   139   76   20,074 
US Government sponsored mortgage-backed securities  35,065   41   195   34,911 
Total $76,133  $456  $279  $76,310 

The following table shows fair value and unrealized losses, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position as of September 30, 2016 and December 31, 2015. There was one Agency securitycurrently in a gross unrealized loss position at September 30, 2016. Four US Treasury securities, thirteen Agency securities and twelve Mortgage-backed securities wereare so due to declines in a gross unrealized loss position at December 31, 2015.  Management believes that the unrealized lossesfair values resulting from changes in 2016 and 2015 were the result of interest rate levels differing from those existing atrates or increased liquidity spreads since the time of purchase ofthey were purchased.  We have the securitiesintent and actual and estimated prepayment speeds.  The Bank does not consider any ofability to hold these debt securities to be other than temporarily impaired at September 30, 2016maturity (including the AFS securities) and December 31, 2015, because the unrealized losses were related primarily to changes in market interest rates and widening of sector spreads and were not necessarily related to the credit quality of the issuers of the securities.

In addition, the Bank doesdo not intend to sell, nor does itdo we believe it will be more likely than not that itwe will be required to sell, any impaired securities prior to a recovery of amortized cost.  We expect these securities will be repaid in full, with no losses realized. As such, management considers any impairment to be temporary.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 9 -  Investment Securities-Continued

  Less than 12 months  12 Months or More  Total 
  Fair Value  
Unrealized
Losses
  Fair Value  
Unrealized
Losses
  Fair Value  
Unrealized
Losses
 
September 30, 2016:
 (dollars in thousands) 
                   
US Treasury securities $-  $-  $-  $-  $-  $- 
US Agency securities  1,021   6   -   -   1,021   6 
US Government sponsored mortgage-backed securities  -   -   -   -   -   - 
Total $1,021  $6  $-  $-  $1,021  $6 

  Less than 12 months  12 Months or More  Total 
  Fair Value  
Unrealized
Losses
  Fair Value  
Unrealized
Losses
  Fair Value  
Unrealized
Losses
 
December 31, 2015:
 (dollars in thousands) 
                   
US Treasury securities $3,992  $8  $-  $-  $3,992  $8 
US Agency securities  12,958   76   -   -   12,958   76 
US Government sponsored mortgage-backed securities  31,091   195   -   -   31,091   195 
Total $48,041  $279  $-  $-  $48,041  $279 

The amortized cost and estimated fair valueContractual maturities of debt securities at September 30, 2016, by contractual maturity2017 are shown in the following table.below.  Actual maturities may differ from contractual maturities because issuers mayborrowers have the right to call or prepay obligations with or without call or prepayment penalties.

  
Held to Maturity
(dollars in thousands)
 
  
Amortized
Cost
  
Estimated
Fair Value
 
       
Due in one year or less $9,008  $9,035 
Due from greater than one year to five years  25,072   25,511 
Due from greater than five years to ten years  1,960   2,162 
US Government sponsored mortgage-backed securities  
31,637
   
32,267
 
  $67,677  $68,975 
  AFS Securities  HTM Securities 
  
Amortized
Cost
  
Estimated
Fair Value
  
Amortized
Cost
  
Estimated
Fair Value
 
  (dollars in thousands) 
Due in one year or less $-  $-  $10,009  $10,014 
Due after one through five years  3,135   3,129   15,030   15,112 
Due after five years through ten years  -   -   1,965   2,078 
Mortgage-backed securities  -   -   31,760   31,755 
  $3,135  $3,129  $58,764  $58,959 

During both the three and nine months ended September 30, 2017, we recognized gross gains and losses on the sale of securities of $4,000 and $2,000, respectively. We did not sell any securities during 2016.
There were no securities pledged as collateral as of September 30, 2017 or December 31, 2016.

Note 3 -  Loans Receivable and Allowance for Loan Losses
Loans receivable are summarized as follows:
  September 30, 2017  December 31, 2016 
  (dollars in thousands) 
Residential mortgage $292,068  $260,603 
Commercial  37,485   46,468 
Commercial real estate  223,167   195,710 
Construction, land acquisition, and development  84,164   90,102 
Home equity/2nds  15,861   19,129 
Consumer  1,118   1,210 
Total loans receivable  653,863   613,222 
Unearned loan fees  (2,899)  (2,944)
Net loans receivable $650,964  $610,278 

Certain loans in the amount of $210.4 million have been pledged under a blanket floating lien to the Federal Home Loan Bank of Atlanta (“FHLB”) as collateral against advances.

Credit Quality

An Allowance is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible based on evaluations of the collectability of loans and prior loan loss experience.  Management has an established methodology to determine the adequacy of the Allowance that assesses the risks and losses inherent in the loan portfolio.  The methodology takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay.  Determining the amount of the Allowance requires the use of estimates and assumptions. Actual results could differ significantly from those estimates.  While management uses available information to estimate losses on loans, future additions to the Allowance may be necessary based on changes in economic conditions.  In addition, various regulatory agencies periodically review the Allowance as an integral part of their examination process.  Such agencies may require us to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination.  Management believes the Allowance is adequate as of September 30, 2017 and December 31, 2016.

For purposes of determining the Allowance, we have segmented our loan portfolio by product type.  Our portfolio loan segments are residential mortgage, commercial, commercial real estate, construction, land acquisition, and development (“ADC”), Home equity/2nds, and consumer.  We have looked at all segments and have determined that no additional subcategorization is warranted based upon our credit review methodology and our portfolio classes are the same as our portfolio segments.
 
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Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable
Loans receivable, including unfunded commitments consist of the following:

  September 30,  December 31, 
  2016  2015 
  (dollars in thousands) 
Residential mortgage, total $271,924  $285,930 
Individually evaluated for impairment  22,521   26,087 
Collectively evaluated for impairment  249,403   259,843 
Construction, land acquisition and development, total  63,879   77,478 
Individually evaluated for impairment  71   309 
Collectively evaluated for impairment  63,808   77,169 
Land, total  34,861   28,677 
Individually evaluated for impairment  1,375   1,608 
Collectively evaluated for impairment  33,486   27,069 
Lines of credit, total  26,254   20,188 
Individually evaluated for impairment  495   299 
Collectively evaluated for impairment  25,759   19,889 
Commercial real estate, total  198,915   174,912 
Individually evaluated for impairment  5,696   6,321 
Collectively evaluated for impairment  193,219   168,591 
Commercial non-real estate, total  16,105   9,296 
Individually evaluated for impairment  -   122 
Collectively evaluated for impairment  16,105   9,174 
Home equity, total  19,739   24,529 
Individually evaluated for impairment  3,519   2,285 
Collectively evaluated for impairment  16,220   22,244 
Consumer, total  1,209   1,224 
Individually evaluated for impairment  100   10 
Collectively evaluated for impairment  1,109   1,214 
Total Loans  632,886   622,234 
Less
        
Unfunded commitments included above  (17,400)  (21,101)
  $615,486   601,133 
Individually evaluated for impairment  33,777   37,041 
Collectively evaluated for impairment  581,709   564,092 
   615,486   601,133 
Allowance for loan losses  (8,985)  (8,758)
Deferred loan origination fees and costs, net  (3,028)  (2,719)
Net Loans $603,473  $589,656 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - ContinuedInherent Credit Risks

The inherent credit risks within the loan portfolio vary depending upon the loan class as follows:

Residential mortgage loans are- secured by one to four family dwelling units. The loans have lowerlimited risk as they are secured by first mortgages on the unit, which are generally the primary residence of the borrower, at a loan to valueloan-to-value ratio (“LTV”) of 80% or less.

Construction, land acquisitionCommercial - underwritten in accordance with our policies and developmentinclude evaluating historical and projected profitability and cash flow to determine the borrower’s ability to repay the obligation as agreed. Commercial loans are underwrittenmade primarily based upon a financial analysis of the developers and property owners and construction cost estimates, in addition to independent appraisal valuations. These loans will rely on the value associated with the project upon completion. These cost and valuation estimates may be inaccurate. Construction loans generally involve the disbursement of substantial funds over a short period of time with repayment substantially dependent upon the success of the completed project rather than the abilityidentified cash flow of the borrower or guarantor to repay principal and interest. Ifsecondarily on the Bank is forced to forecloseunderlying collateral supporting the loan. Accordingly, the repayment of a commercial loan depends primarily on a project prior to or at completion, due to a default, there can be no assurance that the Bank will be able to recover allcreditworthiness of the unpaid balanceborrower (and any guarantors), while liquidation of the loan as well as related foreclosurecollateral is a secondary and holding costs.  In addition, the Bank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified periodoften insufficient source of time. Sourcesrepayment.  Additionally, lines of repayment of these loans typically are permanent financing expected to be obtained upon completion or sales of developed property. These loans are closely monitored by onsite inspections and are considered to be of a higher risk than other real estate loans due to their ultimate repayment being sensitive to general economic conditions, availability of long-term financing, interest rate sensitivity, and governmental regulation of real property.

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

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

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

Note 10 – Loans Receivable - Continued

Commercial non-real estateADC - underwritten in accordance with our underwriting policies which include a financial analysis of the developers, property owners, construction cost estimates, and independent appraisal valuations. These loans are underwritten after evaluating historical and projected profitability and cash flow to determine the borrower's ability to repay their obligation as agreed. Commercial and industrial loans are made primarily based will rely on the identified cash flowvalue associated with the project upon completion. These cost and valuation estimates may be inaccurate. Construction loans generally involve the disbursement of substantial funds over a short period of time with repayment substantially dependent upon the success of the completed project rather than the ability of the borrower or guarantor to repay principal and secondarilyinterest.  Additionally, land is underwritten according to our policies which include independent appraisal valuations as well as the estimated value associated with the land upon completion of development. These cost and valuation estimates may be inaccurate. These loans are considered to be of a higher risk than other real estate loans due to their ultimate repayment being sensitive to general economic conditions, availability of long-term financing, interest rate sensitivity, and governmental regulation of real property.

The sources of repayment of these loans is typically permanent financing expected to be obtained upon completion or sales of developed property. These loans are closely monitored by onsite inspections and are considered to be of a higher risk than other real estate loans due to their ultimate repayment being sensitive to general economic conditions, availability of long-term financing, interest rate sensitivity, and governmental regulation of real property.

If the Bank is forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that the underlying collateral supportingBank will be able to recover all of the unpaid balance of the loan facility. Accordingly,as well as related foreclosure and holding costs.  In addition, the repaymentBank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of a commercial and industrial loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.time.

Home equity loansequity/2nds are - subject to the underwriting standards and processes similar to residential mortgages and are secured by one to four family dwelling units. Home equityequity/2nds loans have greater risk than residential mortgages as a result of the Bank generally being in a second lien position in the event collateral is liquidated.position.

Consumer loans- consist of loans to individuals through the Bank'sBank’s retail network and are typically unsecured or secured by personal property. Consumer loans have a greater credit risk than residential loans because of the difference inlower value of the underlying collateral, if any. The application of various federal and state bankruptcy and insolvency laws may limit the amount that can be recovered on such loans.

The loan portfolio segments and loan classes disclosed above are the same because this is the level of detail management uses when the original loan is recorded and is the level of detail used by management to assess and monitor the risk and performance of the portfolio.  Management has determined that this level of detail is adequate to understand and manage the inherent risks within each portfolio segment and loan class.

Allowance for Loan Losses- An allowance for loan losses is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based on evaluations of the collectability of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.  Determining the amount of the allowance for loan losses requires the use of estimates and assumptions, which is permitted under GAAP. Actual results could differ significantly from those estimates.  Management believes the allowance for losses on loans is adequate. While management uses available information to estimate losses on loans, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the state of Maryland.  In addition, various regulatory agencies periodically review the Bank's allowance for losses on loans as an integral part of their examination process.  Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

The allowance consists of specific and general components.  The specific component relates to loans that are classified as impaired.  When a real estate secured loan becomes impaired, a decision is made as to whether an updated certified appraisal of the real estate is necessary.  This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property.  Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value.  The discounts also include estimated costs to sell the property.
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 – Loans Receivable - Continued

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

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

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

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

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

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

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The accrual of interest on loans is discontinued at the time the loan is 90 days past due.  Past due status is based on contractual terms of the loan.  In all cases, loans are placed in nonaccrual status or charged off at an earlier date if collection of principal or interest is considered a troubled debt restructuringdoubtful.

All interest accrued but not collected for loans that are placed in nonaccrual status or charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when for economic or legal reasons relatingall the principal and interest amounts contractually due are brought current and future payments are reasonably assured, generally after nine months of consecutive current payments and completion of an updated analysis of the borrower’s ability to service the borrowers financial difficulties Bancorp grants a concession to the borrower that it would not otherwise consider.  Loan modifications made with terms consistent with current market conditions that the borrower could obtain in the open market are not considered troubled debt restructurings.loan.

Loans that experience insignificant payment delays and payment shortfalls generally aremay not be placed in nonaccrual status or classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

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

Note 10 – Loans Receivable - ContinuedThe Allowance consists of specific and general components.  The specific component relates to loans that are classified as impaired.  The general component relates to loans that are classified as doubtful, substandard, or special mention that are not considered impaired, as well as loans that are not classified.

A loan is considered impaired if it meets any of the following three criteria:

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

If a loan is considered to be impaired, it is then determined to be either cash flow or collateral dependent for purposes of Allowance determination.

With respect to all loan segments, management doeswe do not charge off a loan, or a portion of a loan, until one of the following conditions have been met:

●·The loan has been foreclosed on. Onceforeclosed. At the loan has been transferred from the Loans Receivable to Foreclosed Real Estate,time of foreclosure, a charge off is recorded for the difference between the recorded amount of the loan and the netfair value of the underlying collateral.

●·An agreement to accept less than the recorded balance of the loan has been made with the borrower. Once an agreement has been finalized, and any proceeds from the borrower are received, a charge offcharge-off is recorded for the difference between the recorded amount of the loan and the net value of the underlying collateral.agreed upon proceeds amount.

●·The loan is considered to be impaireda collateral dependent andimpaired loan when its collateral valuation is less than the recorded balance. The loan is written down for accounting purposes by the amount of the difference between the recorded balance and collateral value.

Prior to the above conditions,Specific Allowance Component

Impaired loans secured by real estate - when a loan is assessed for impairment when: (i) asecured real estate loan becomes 90 days or more in arrears or (ii)impaired, a decision is made as to whether an updated certified appraisal of the real estate is necessary.  This decision is based on current information and events, it is probable thatvarious considerations, including the borrower will be unable to pay all amounts due according to the contractual termsage of the loan agreement.  If a loanmost recent appraisal, the LTV ratio based on the original appraisal, and the condition of the property. Appraised values are discounted, if appropriate, to arrive at the estimated selling price of the collateral, which is considered to be impaired, it is then determinedthe estimated fair value.  The discounts also include estimated costs to be either cash flow or collateral dependent. For a cash flow dependent loan, if based on management’s calculation of discounted cash flows, a reserve is needed, a specific reserve is recorded.  That reserve is included insell the Allowance for Loan Losses in the Consolidated Statement of Financial Condition.property.

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

Bancorp evaluates the financial condition of guarantorsdetermined based on the most currentborrower’s financial statements, inventory reports, accounts receivable aging, or equipment appraisals or invoices.  Indications of value from these sources are generally discounted based on the age of the financial information available. Most often, such information takesor the form of (i) personal financial statements of net worth, cash flow statements and tax returns (for individual guarantors) and (ii) financial and operating statements, tax returns and financial projections (for legal entity guarantors). Bancorp’s evaluation is primarily focused on various key financial metrics, including net worth, global cash flow, leverage ratios, and liquidity. It is Bancorp's policy to update such information annually, or more frequently as warranted, over the lifequality of the loan.assets.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIESFor such loans that are classified as impaired, an Allowance is established when the current fair value of the underlying collateral less its estimated disposal costs is lower than the carrying value of the loan.  For loans that are not solely collateral dependent, an Allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of the loan.

Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUEDGeneral Allowance Component

Note 10 – The general component of the Allowance is based on historical loss experience adjusted for qualitative factors. Loans Receivable – Continuedare pooled by portfolio class and an historical loss percentage, based upon a four-year net charge-off history, is applied to each class.  The result of that calculation for each loan class is then applied to the current loan portfolio balances to determine the required general component of the Allowance per loan class.  We then apply additional loss multipliers to the different classes of loans to reflect various qualitative factors. These qualitative factors include, but are not limited to:

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

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

·Effects of any change in lending policies and procedures;
Construction loans are reviewed for extensions upon expiration of the loan term, if necessary. Provided the loan is performing in accordance with contractual terms, extensions may be granted to allow for the completion of the project, marketing or sales of completed units, or to provide for permanent financing. Extension terms generally do not exceed 12 to 18 months.
·Experience, ability, and depth of management;

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

Bancorp recognized $202,000 and $312,000 of interest income from its loan portfolio from interest reserves during the nine months ended September 30, 2016 and 2015, respectively.  None of the loans where interest reserves were recorded as capitalized interest were non-performing.
·Industry conditions.
 
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Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following is a summary oftables present, by portfolio segment, the allowance for loan losses forchanges in the nineAllowance and three month periods ended September 30, 2016 (dollarsthe recorded investment in thousands):loans:
  Three Months Ended September 30, 2017 
  
Residential
Mortgage
  Commercial  
Commercial
Real Estate
  ADC  
Home Equity/
2nds
  Consumer  Total 
  (dollars in thousands) 
Beginning Balance $3,403  $389  $2,571  $984  $367  $4  $7,718 
Charge-offs  -   -   -   -   -   -   - 
Recoveries  156   -   40   -   22   -   218 
Net recoveries  156   -   40   -   22   -   218 
(Reversal of) provision for loan losses  (137)  53   (44)  158   (28)  (2)  - 
Ending Balance $3,422  $442  $2,567  $1,142  $361  $2  $7,936 

 
Total
  
Residential
Mortgage
  
Construction
Acquisition
Development
  
Land
  
Lines of
Credit
  
Commercial
Real Estate
  
Commercial
Non-Real
Estate
  
Home
Equity
  
Consumer
  Nine Months Ended September 30, 2017 
Nine months ended September 30, 2016
                           
 (dollars in thousands) 
Beginning Balance $8,758  $4,188  $446  $510  $57  $2,792  $234  $528  $3  $3,833  $478  $2,535  $1,390  $728  $5  $8,969 
Provision  150   (491)  (133)  349   (27)  (226)  409   317   (48)
Charge-offs  (446)  (151)  (13)  (59)  -   (178)  (17)  (28)  -   (707)  -   -   -   (98)  -   (805)
Recoveries  523   322   97   3   10   4   33   4   50   295   -   100   -   27   -   422 
Net (charge-offs) recoveries  (412)  -   100   -   (71)  -   (383)
Provision for (reversal of) loan losses  1   (36)  (68)  (248)  (296)  (3)  (650)
Ending Balance $8,985  $3,868  $397  $803  $40  $2,392  $659  $821  $5  $3,422  $442  $2,567  $1,142  $361  $2  $7,936 
Ending balance related to:                                    
Loans individually evaluated for impairment $2,259  $1,583  $-  $55  $15  $200  $-  $402  $4 
Loans collectively evaluated for impairment $6,726  $2,285  $397  $748  $25  $2,192  $659  $419  $1 
                                                                
Three months ended September 30, 2016                                    
Ending balance - individually evaluated for impairment $1,544  $-  $186  $50  $-  $2  $1,782 
Ending balance - collectively evaluated for impairment  1,878   442   2,381   1,092   361   -   6,154 
                                     $3,422  $442  $2,567  $1,142  $361  $2  $7,936 
Beginning Balance $8,804  $3,892  $297  $686  $49  $2,577  $703  $593  $7 
Provision  50   (161)  113   176   (9)  (189)  (54)  226   (52)
Charge-offs  (72)  -   (13)  (59)  -   -   -   -   - 
Recoveries  203   137   -   -   -   4   10   2   50 
Ending Balance $8,985  $3,868  $397  $803  $40  $2,392  $659  $821  $5 
                            
Ending loan balance - individually evaluated for impairment $20,379  $-  $3,419  $1,003  $-  $87  $24,888 
Ending loan balance - collectively evaluated for impairment  268,790   37,485   219,748   83,161   15,861   1,031   626,076 
 $289,169  $37,485  $223,167  $84,164  $15,861  $1,118  $650,964 

  December 31, 2016 
  
Residential
Mortgage
  Commercial  
Commercial
Real Estate
  ADC  
Home Equity/
2nds
  Consumer  Total 
  (dollars in thousands) 
Ending Allowance balance - individually evaluated for impairment $1,703  $15  $196  $53  $402  $4  $2,373 
Ending Allowance balance - collectively evaluated for impairment  2,130   463   2,339   1,337   326   1   6,596 
  $3,833  $478  $2,535  $1,390  $728  $5  $8,969 
                             
Ending loan balance - individually evaluated for impairment $20,403  $148  $5,656  $858  $3,137  $96  $30,298 
Ending loan balance - collectively evaluated for impairment  237,256   46,320   190,054   89,244   15,992   1,114   579,980 
  $257,659  $46,468  $195,710  $90,102  $19,129  $1,210  $610,278 
 
1913
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED
  Three Months Ended September 30, 2016 
  
Residential
Mortgage
  Commercial  
Commercial
Real Estate
  ADC  
Home Equity/
2nds
  Consumer  Total 
  (dollars in thousands) 
Beginning Balance $3,892  $752  $2,577  $983  $593  $7  $8,804 
Charge-offs  -   -   -   (72)  -   -   (72)
Recoveries  137   10   4   -   2   50   203 
Net recoveries (charge-offs)  137   10   4   (72)  2   50   131 
(Reversal of) provision for loan losses  (161)  (63)  (189)  289   226   (52)  50 
Ending Balance $3,868  $699  $2,392  $1,200  $821  $5  $8,985 

  Nine Months Ended September 30, 2016 
  (dollars in thousands) 
Beginning Balance $4,188  $291  $2,792  $956  $528  $3  $8,758 
Charge-offs  (151)  (17)  (178)  (72)  (28)  -   (446)
Recoveries  322   43   4   100   4   50   523 
Net recoveries (charge-offs)  171   26   (174)  28   (24)  50   77 
(Reversal of) provision for loan losses  (491)  382   (226)  216   317   (48)  150 
Ending Balance $3,868  $699  $2,392  $1,200  $821  $5  $8,985 
                             
Ending balance - individually evaluated for impairment $1,583  $15  $200  $55  $402  $4  $2,259 
Ending balance - collectively evaluated for impairment  2,285   684   2,192   1,145   419   1   6,726 
  $3,868  $699  $2,392  $1,200  $821  $5  $8,985 
                             
Ending loan balance -  individually evaluated for impairment $22,521  $495  $5,696  $1,446  $3,519  $100  $33,777 
Ending loan balance - collectively evaluated for impairment  246,375   41,864   193,219   79,894   16,220   1,109   578,681 
  $268,896  $42,359  $198,915  $81,340  $19,739  $1,209  $612,458 
Note 10 - Loans Receivable - Continued

The following is a summarytables present the credit quality breakdown of the allowance forour loan losses for the year ended December 31, 2015 (dollars in thousands):portfolio by class:

 
2015
 
Total
  
Residential
Mortgage
  
Construction
Acquisition
Development
  
Land
  
Lines of
Credit
  
Commercial
Real Estate
  
Commercial
Non-Real
Estate
  
Home
 Equity
  Consumer 
 
Beginning Balance
 $9,435  $4,664  $362  $646  $12  $2,504  $280  $963  $4 
Provision  (280)  (651)  84   (185)  (190)  368   59   236   (1)
Charge-offs  (1,522)  (454)  -   -   -   (80)  (154)  (834)  - 
Recoveries  1,125   629   -   49   235   -   49   163   - 
Ending Balance $8,758  $4,188  $446  $510  $57  $2,792  $234  $528  $3 
                                     
Allowance on loans individually evaluated for impairment $2,282  $1,838  $-  $78  $30  $328  $5  $2  $1 
 
Allowance on loans collectively evaluated for impairment
 $6,476  $2,350  $446  $432  $27  $2,464  $229  $526  $2 
  September 30, 2017 
  Pass  
Special
Mention
  Substandard  Total 
  (dollars in thousands) 
Residential mortgage $281,954  $1,397  $5,818  $289,169 
Commercial  37,299   50   136   37,485 
Commercial real estate  216,373   4,668   2,126   223,167 
ADC  82,958   -   1,206   84,164 
Home equity/2nds  14,531   471   859   15,861 
Consumer  1,118   -   -   1,118 
  $634,233  $6,586  $10,145  $650,964 
 
2014
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable – Continued

The following is a summary of the allowance for loan losses for the nine and three month periods ended September 30, 2015 (dollars in thousands):

  
Total
  
Residential
 Mortgage
  
Construction
Acquisition
Development
  
Land
  
Lines of
Credit
  
Commercial
Real Estate
  
Commercial
Non-Real
Estate
  
Home
Equity
  
Consumer
 
Nine months ended September 30, 2015
 
                           
Beginning Balance $9,435  $4,664  $362  $646  $12  $2,504  $280  $963  $4 
Provision  200   (311)  (60)  (216)  (30)  362   223   233   (1)
Charge-offs  (1,357)  (383)  -   -   -   (50)  (155)  (769)  - 
Recoveries  411   208   -   -   40   -   29   134   - 
Ending Balance $8,689  $4,178  $302  $430  $22  $2,816  $377  $561  $3 
 
Ending balance related to:
                                    
Loans individually evaluated for impairment $2,290  $1,883  $1  $42  $-  $322  $6  $34  $2 
Loans collectively evaluated for impairment $6,399  $2,295  $301  $388  $22  $2,494  $371  $527  $1 
                                     
Three months ended September 30, 2015                                    
                                     
Beginning Balance $8,944  $4,396  $422  $458  $21  $2,732  $394  $518  $3 
Provision  -   (267)  (120)  (28)  (14)  84   135   210   - 
Charge-offs  (484)  (32)  -   -   -   -   (154)  (298)  - 
Recoveries  229   81   -   -   15   -   2   131   - 
Ending Balance $8,689  $4,178  $302  $430  $22  $2,816  $377  $561  $3 
21
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

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

All interest accrued but not collected for loans that are placed on non-accrual or charged-off is reversed against interest income.  The interest collected on these loans is applied to principal unless the loan meets the criteria for recognizing interest income on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
22
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize impaired loans at September 30, 2016 and December 31, 2015 (dollars in thousands):

  
Impaired Loans with
Specific Allowance
  
Impaired
Loans with
No Specific
Allowance
  
Total Impaired Loans
 
  
Recorded
Investment
  
Related
Allowance
  
Recorded
Investment
  
Recorded
Investment
  
Unpaid
Principal
Balance
 
September 30, 2016               
Residential mortgage $9,812  $1,583  $12,709  $22,521  $23,138 
Construction, acquisition and development  -   -   71   71   71 
Land  424   55   951   1,375   1,488 
Lines of credit  149   15   346   495   495 
Commercial real estate  1,973   200   3,723   5,696   5,898 
Commercial non-real estate  -   -   -   -   - 
Home equity  1,609   402   1,910   3,519   4,105 
Consumer  100   4   -   100   100 
Total impaired loans $14,067  $2,259  $19,710  $33,777  $35,295 

  
Impaired Loans with
Specific Allowance
  
Impaired
Loans with
 No Specific
Allowance
  
Total Impaired Loans
 
  
Recorded
Investment
  
Related
Allowance
  
Recorded
Investment
  
Recorded
Investment
  
Unpaid
Principal
Balance
 
December 31, 2015               
Residential mortgage $11,885  $1,838  $14,202  $26,087  $26,656 
Construction, acquisition and development  -   -   309   309   309 
Land  639   78   969   1,608   1,723 
Lines of credit  299   30   -   299   299 
Commercial real estate  3,214   328   3,107   6,321   6,469 
Commercial non-real estate  103   5   19   122   123 
Home equity  16   2   2,269   2,285   3,251 
Consumer  10   1   -   10   10 
Total impaired loans $16,166  $2,282  $20,875  $37,041  $38,840 
23
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize average impaired loans for the nine month and three month periods ended September 30, 2016 (dollars in thousands):

  
Impaired Loans with
Specific Allowance
  
Impaired Loans with No
Specific Allowance
  
Total Impaired Loans
 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
 
Nine months ended September 30, 2016                  
Residential mortgage $10,684  $356  $13,774  $417  $24,458  $773 
Construction, acquisition and development  -   -   269   9   269   9 
Land  513   20   1,162   27   1,675   47 
Lines of credit  149   6   144   3   293   9 
Commercial real estate  2,040   77   4,655   134   6,695   211 
Commercial non-real estate  33   1   6   -   39   1 
Home equity  370   7   1,991   59   2,361   66 
Consumer  73   2   23   -   96   2 
Total impaired loans $13,862  $469  $22,024  $649  $35,886  $1,118 

  
Impaired Loans with
Specific Allowance
  
Impaired Loans with No
Specific Allowance
  
Total Impaired Loans
 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
 
                   
Three months ended September 30, 2016                  
Residential mortgage $9,831  $106  $12,734  $132  $22,565  $238 
Construction, acquisition and development  -   -   71   1   71   1 
Land  426   6   960   8   1,386   14 
Lines of credit  149   2   274   2   423   4 
Commercial real estate  1,977   25   3,730   57   5,707   82 
Commercial non-real estate  -   -   -   -   -   - 
Home equity  1,078   6   1,911   18   2,989   24 
Consumer  102   1   -   -   102   1 
Total impaired loans $13,563  $146  $19,680  $218  $33,243  $364 
24
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following tables summarize average impaired loans for the nine and three month periods ended September 30, 2015 (dollars in thousands):

  
Impaired Loans with
Specific Allowance
  
Impaired Loans with No
Specific Allowance
  
Total Impaired Loans
 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
 
Nine months ended September 30, 2015                  
Residential mortgage $12,438  $402  $14,101  $422  $26,539  $824 
Construction, acquisition and development  125   1   623   23   748   24 
Land  843   14   1,118   60   1,961   74 
Lines of credit  -   -   395   17   395   17 
Commercial real estate  2,754   94   1,942   121   4,696   215 
Commercial non-real estate  249   4   7   13   256   17 
Home equity  448   -   2,627   90   3,075   90 
Consumer  11   -   551   3   562   3 
Total impaired loans $16,868  $515  $21,364  $749  $38,232  $1,264 

  
Impaired Loans with
Specific Allowance
  
Impaired Loans with No
Specific Allowance
  
Total Impaired Loans
 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
 
                   
Three months ended September 30, 2015                  
Residential mortgage $12,848  $137  $12,512  $125  $25,360  $262 
Construction, acquisition and development  125   1   413   6   538   7 
Land  821   8   1,075   16   1,896   24 
Lines of credit  -   -   278   2   278   2 
Commercial real estate  3,241   37   1,866   39   5,107   76 
Commercial non-real estate  210   1   20   -   230   1 
Home equity  12   -   2,663   25   2,675   25 
Consumer  11   -   2   -   13   - 
Total impaired loans $17,268  $184  $18,829  $213  $36,097  $397 
25
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Bancorp recognized $364,000 and $1,118,000 of interest income on impaired loans using a cash-basis method of accounting for the three months and nine months ended September 30, 2016, respectively, and $397,000 and $1,264,000 for the three months and nine months ended September 30, 2015, respectively. Bancorp did not record any interest income attributable to the change in present value attributable to the passage of time.  Bancorp evaluates its impaired loans and assesses them based on either discounted cash flows or if it deems its loans to be collateral dependent, assesses impairment based on the value of the underlying collateral, less disposal costs.

Included in the above impaired loans amount at September 30, 2016 was $25,571,000 of loans that are not in non-accrual status.  In addition, there was a total of $22,521,000 of residential real estate loans included in impaired loans at September 30, 2016, of which $17,631,000 were to consumers and $4,890,000 to builders. The collateral supporting impaired collateral dependent loans is individually reviewed by management to determine its estimated fair market value, less estimated disposal cost and a charge off is taken, if necessary, for the difference between the carrying amount of any loan and the estimated fair value of the collateral less estimated disposal cost.
26
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

The following table presents the classes of the loan portfolio summarized by the aggregate Pass and the criticized categories of Special Mention, Substandard and Doubtful within the internal risk rating system as of September 30, 2016 and December 31, 2015.  Included in the Pass column were $17,400,000 and $21,101,000 in unfunded commitments at September 30, 2016 and December 31, 2015, respectively (dollars in thousands):

  
Pass
  
Special
Mention
  
Substandard
  
Doubtful
  
Total
 
                
September 30, 2016               
Residential mortgage $261,922  $6,868  $3,134  $-  $271,924 
Construction, acquisition and development  63,533   346   -   -   63,879 
Land  33,683   372   806   -   34,861 
Lines of credit  25,813   189   252   -   26,254 
Commercial real estate  187,060   8,534   3,321   -   198,915 
Commercial non-real estate  15,782   98   225   -   16,105 
Home equity  16,289   586   2,864   -   19,739 
Consumer  1,209   -   -   -   1,209 
Total loans $605,291  $16,993  $10,602  $-  $632,886 

  
Pass
  
Special
Mention
  
Substandard
  
Doubtful
  
Total
 
                
December 31, 2015               
Residential mortgage $268,583  $12,457  $4,890  $-  $285,930 
Construction, acquisition and development  77,168   71   239   -   77,478 
Land  26,845   1,268   564   -   28,677 
Lines of credit  19,521   368   299   -   20,188 
Commercial real estate  155,766   13,208   5,938   -   174,912 
Commercial non-real estate  9,151   125   20   -   9,296 
Home equity  22,018   588   1,923   -   24,529 
Consumer  1,224   -   -   -   1,224 
Total loans $580,276  $28,085  $13,873  $-  $622,234 
27
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
  December 31, 2016 
  Pass  
Special
Mention
  Substandard  Total 
  (dollars in thousands) 
Residential mortgage $248,819  $4,316  $4,524  $257,659 
Commercial  46,011   204   253   46,468 
Commercial real estate  184,820   7,420   3,470   195,710 
ADC  89,324   -   778   90,102 
Home equity/2nds  16,056   472   2,601   19,129 
Consumer  1,210   -   -   1,210 
  $586,240  $12,412  $11,626  $610,278 

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due.  Included in the Current column were $17,400,000 and $21,101,000 in unfunded commitments at September 30, 2016 and December 31, 2015, respectively. The following table presentstables present the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans:
  September 30, 2017 
   
30-59
Days
Past Due
  
60-89
Days
Past Due
  
90+
Days
Past Due
  
Total
Past Due
  Current  Total  
Non-
Accrual
 
   (dollars in thousands) 
Residential mortgage $1,173  $1,216  $2,364  $4,753  $284,416  $289,169  $4,531 
Commercial  -   -   -   -   37,485   37,485   84 
Commercial real estate  -   478   -   478   222,689   223,167   160 
ADC  -   -   239   239   83,925   84,164   318 
Home equity/2nds  -   -   458   458   15,403   15,861   1,284 
Consumer  -   -   -   -   1,118   1,118   - 
   $1,173  $1,694  $3,061  $5,928  $645,036  $650,964  $6,377 
  December 31, 2016 
  
30-59
Days
Past Due
  
60-89
Days
Past Due
  
90+
Days
Past Due
  
Total
Past Due
  Current  Total  
Non-
Accrual
 
  (dollars in thousands) 
Residential mortgage $1,472  $2,074  $964  $4,510  $253,149  $257,659  $3,580 
Commercial  -   -   -   -   46,468   46,468   151 
Commercial real estate  -   171   515   686   195,024   195,710   2,938 
ADC  106   -   6   112   89,990   90,102   269 
Home equity/2nds  34   -   2,174   2,208   16,921   19,129   2,914 
Consumer  4   -   -   4   1,206   1,210   - 
  $1,616  $2,245  $3,659  $7,520  $602,758  $610,278  $9,852 

We do not have any greater than 90 days and still accruing loans as of September 30, 2016 and2017 or December 31, 2015 (dollars in thousands):2016.

  
30-59
Days
Past Due
  
60-89
Days
Past Due
  
90+
Days
Past Due
  
Total
Past Due
  
Current
  
Total
Loans
  
Non-
Accrual
 
September 30, 2016                     
Residential mortgage $1,158  $-  $1,100  $2,258  $269,666  $271,924  $1,615 
Construction, acquisition and development  -   -   -   -   63,879   63,879   - 
Land  45   -   6   51   34,810   34,861   149 
Lines of credit  -   -   -   -   26,254   26,254   149 
Commercial real estate  -   -   515   515   198,400   198,915   2,908 
Commercial non-real estate  -   240   -   240   15,865   16,105   - 
Home equity  -   1,593   603   2,196   17,543   19,739   3,179 
Consumer  -   -   205   205   1,004   1,209   206 
Total loans $1,203  $1,833  $2,429  $5,465  $627,421  $632,886  $8,206 

  
30-59
Days
Past Due
  
60-89
Days
Past Due
  
90+
Days
Past Due
  
Total
Past Due
  
Current
  
Total
Loans
  
Non-
Accrual
 
December 31, 2015                     
Residential mortgage $1,593  $65  $2,461  $4,119  $281,811  $285,930  $3,191 
Construction, acquisition and development  -   -   -   -   77,478   77,478   244 
Land  137   -   156   293   28,384   28,677   277 
Lines of credit  149   -   -   149   20,039   20,188   483 
Commercial real estate  253   -   292   545   174,367   174,912   2,681 
Commercial non-real estate  -   -   -   -   9,296   9,296   - 
Home equity  -   -   625   625   23,904   24,529   2,098 
Consumer  3   -   -   3   1,221   1,224   - 
Total loans $2,135  $65  $3,534  $5,734  $616,500  $622,234  $8,974 

Bancorp did notThe interest which would have anybeen recorded on the above nonaccrual loans that were  90 or more past dueif those loans had been performing in accordance with their contractual terms was approximately $1.2 million and still accruing interest as of$338,000 for the nine months ended September 30, 2017 and 2016, respectively.  The actual interest income recorded on those loans was approximately $403,000 and December 31, 2015.$130,000 for the nine months ended September 30, 2017 and 2016, respectively.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUEDThe following tables summarize impaired loans:

  September 30, 2017  December 31, 2016 
  
Unpaid
Principal
Balance
  
Recorded
Investment
  
Related
Allowance
  
Unpaid
Principal
Balance
  
Recorded
Investment
  
Related
Allowance
 
With no related Allowance: (dollars in thousands) 
Residential mortgage $12,856  $11,306  $-  $9,854  $9,338  $- 
Commercial  -   -   -   -   -   - 
Commercial real estate  1,576   1,527   -   3,900   3,698   - 
ADC  636   636   -   441   441   - 
Home equity/2nds  -   -   -   2,139   1,529   - 
Consumer  -   -   -   -   -   - 
With a related Allowance:                        
Residential mortgage  9,306   9,073   1,544   11,176   11,065   1,703 
Commercial  -   -   -   148   148   15 
Commercial real estate  1,892   1,892   186   1,958   1,958   196 
ADC  402   367   50   417   417   53 
Home equity/2nds  -   -   -   1,608   1,608   402 
Consumer  87   87   2   96   96   4 
Totals:                        
Residential mortgage  22,162   20,379   1,544   21,030   20,403   1,703 
Commercial  -   -   -   148   148   15 
Commercial real estate  3,468   3,419   186   5,858   5,656   196 
ADC  1,038   1,003   50   858   858   53 
Home equity/2nds  -   -   -   3,747   3,137   402 
Consumer  87   87   2   96   96   4 
Note 10 - Loans Receivable - Continued
  Three Months Ended September 30,  Nine Months Ended September 30, 
  2017  2016  2017  2016 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Average
Recorded
Investment
  
Interest
Income
Recognized
 
With no related Allowance: (dollars in thousands) 
Residential mortgage $10,423  $138  $12,734  $132  $9,696  $353  $13,774  $417 
Commercial  -   -   274   2   -   -   150   3 
Commercial real estate  1,531   22   3,730   57   2,652   69   4,655   134 
ADC  637   9   1,031   9   487   21   1,431   36 
Home equity/2nds  918   15   1,911   18   679   40   1,991   59 
Consumer  -   -   -   -   -   -   23   - 
With a related Allowance:                                
Residential mortgage  8,910   116   9,831   106   9,231   286   10,684   356 
Commercial  -   -   149   2   37   -   182   7 
Commercial real estate  1,896   23   1,977   25   1,919   73   2,040   77 
ADC  369   6   426   6   385   16   513   20 
Home equity/2nds  180   -   1,078   6   715   -   370   7 
Consumer  88   1   102   1   91   2   73   2 
Totals:                                
Residential mortgage  19,333   254   22,565   238   18,927   639   24,458   773 
Commercial  -   -   423   4   37   -   332   10 
Commercial real estate  3,427   45   5,707   82   4,571   142   6,695   211 
ADC  1,006   15   1,457   15   872   37   1,944   56 
Home equity/2nds  1,098   15   2,989   24   1,394   40   2,361   66 
Consumer  88   1   102   1   91   2   96   2 

Bancorp offers a varietyResidential mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process according to local requirements of modifications to borrowers.  The modification categories offered can generally be described in the following categories:

●Rate Modification – A modification in which the interest rate is changed.
●Term Modification – A modification in which the maturity date, timingapplicable jurisdiction totaled $3.1 million as of payments or frequency of payments is changed.
●Interest Only Modification – A modification in which the loan is converted to interest only payments for a period of time.
●Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification above.
●Loan Balance Modification – A modification in which a portion of the outstanding loan balance is forgiven.
●Combination Modification – Any other type of modification, including the use of multiple categories above.

Bancorp has not purchased, sold or reclassified any loans to held for sale during the periods discussed.  Only loans originated specifically for sale are recorded as held for sale at the period ended September 30, 20162017. Residential mortgage loans in real estate acquired through foreclosure amounted to $287,000 and $393,000 at September 30, 2017 and December 31, 2015.2016, respectively.

Bancorp considers a modification of a loan term a troubled debt restructuring or “TDR” if BancorpTDRs

In situations where, for economic or legal reasons related to thea borrower’s financial difficulties, grantsmanagement may grant a concession for other than an insignificant period of time to the debtorborrower that it would not otherwise consider.  Prior to entering intobe considered, the related loan is classified as a TDR.  Such concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions.  At the time that a loan modification, Bancorp assessesis modified, management evaluates any possible impairment based on the borrower’s financial condition to determine ifpresent value of expected future cash flows, discounted at the borrower has the means to meet the termscontractual interest rate of the modification.  This includes obtainingoriginal loan agreement, except when the sole remaining source of repayment for the loan is the liquidation of the collateral.  In these cases, we use the current fair value of the collateral, less selling costs, instead of discounted cash flows.  Any impairment amount is then set up as a credit report onspecific reserve in the borrower as well as the borrower’s tax returns and financial statements.

There were 71 restructured loans at September 30, 2016 totaling $22,795,000, of which 67 loans totaling $22,431,000 were performing as agreed.  Of those performing loans, 53 loans totaling $18,422,000 have not been late on a payment during the last 2 years.

There were 77 restructured loans at December 31, 2015 totaling $25,715,000, of which 71 loans totaling $24,386,000 were performing as agreed.Allowance.
 
In
16
Table of Contents
The following table presents loans that were modified during the nine months ended September 30:
  2017  2016 
  
Number of
Modifications
  
Recorded
Investment
Prior to
Modification
  
Recorded
Investment
After
Modification
  
Number of
Modifications
  
Recorded
Investment
Prior to
Modification
  
Recorded
Investment
After
Modification
 
  (dollars in thousands) 
Residential Mortgage           3  $624  $624 
   -  $-  $-   3  $624  $624 

We did not modify any loans during the three months ended September 30, 20162017 or 2016.

Interest on our portfolio of TDRs was accounted for under the following methods:
  September 30, 2017 
  
Number of
Modifications
  
Accrual
Status
  
Number of
Modifications
  
Nonaccrual
Status
  
Total
Number of
Modifications
  
Total
Balance of
Modifications
 
  (dollars in thousands) 
Residential mortgage  43  $13,086   4  $2,285   47  $15,371 
Commercial real estate  3   1,875   1   84   4   1,959 
ADC  1   138   1   6   2   144 
Home equity/2nds  1   230   -   -   1   230 
Consumer  4   87   -   -   4   87 
   52  $15,416   6  $2,375   58  $17,791 
  December 31, 2016 
  
Number of
Modifications
  
Accrual
Status
  
Number of
Modifications
  
Nonaccrual
Status
  
Total
Number of
Modifications
  
Total
Balance of
Modifications
 
  (dollars in thousands) 
Residential mortgage  48  $15,886   4  $2,137   52  $18,023 
Commercial real estate  3   1,914   2   249   5   2,163 
ADC  2   170   1   6   3   176 
Consumer  5   96   -   -   5   96 
   58  $18,066   7  $2,392   65  $20,458 

During the three and 2015,nine months ended September 30, 2017 and 2016, there were no TDRs that subsequently defaulted during the 12 month period ended September 30, 20162017 and 2015.2016.

Off-Balance Sheet Instruments

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

Our exposure to credit loss from nonperformance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with off-balancesheet credit risk.
 
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SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable – Continued

The following tables present newly restructured loans that occurred duringtable shows the nine and three months ended September 30, 2016 (dollars in thousands):

  Nine months ended September 30, 2016 
  
Rate
 Modification
  
Contracts
  
Combination
Modifications
  
Contracts
  
Total
  
Total
Contracts
 
Pre-Modification Outstanding Recorded Investment:             
                   
Residential mortgage  -   -  $624   3  $624   3 
Construction, acquisition and development  -   -   -   -   -   - 
Land  -   -   -   -   -   - 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  -   -   -   -   -   - 
Commercial non-real estate  -   -   -   -   -   - 
Home equity  -   -   -   -   -   - 
Consumer  -   -   -   -   -   - 
Total loans  -   -  $624   3  $624   3 
                  
Post-Modification Outstanding Recorded Investment:                 
                         
Residential mortgage  -   -  $624   3  $624   3 
Construction, acquisition and development  -   -   -   -   -   - 
Land  -   -   -   -   -   - 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  -   -   -   -   -   - 
Commercial non-real estate  -   -   -   -   -   - 
Home equity  -   -   -   -   -   - 
Consumer  -   -   -   -   -   - 
Total loans  -   -  $624   3  $624   3 
30
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable – Continued

Three months ended September 30, 2016
Rate
Modification
Contracts
Combination
Modifications
Contracts
Total
Total
Contracts
Pre-Modification Outstanding Recorded Investment:
Residential mortgage--$--$--
Construction, acquisition and development------
Land------
Lines of credit------
Commercial real estate------
Commercial non-real estate------
Home equity------
Consumer------
Total loans--$--$--
Post-Modification Outstanding Recorded Investment:
Residential mortgage--$--$--
Construction, acquisition and development------
Land------
Lines of credit------
Commercial real estate------
Commercial non-real estate------
Home equity------
Consumer------
Total loans--$--$--

In addition, the TDR is evaluatedcontract amounts for impairment loss.  A determination is made as to whether an impaired TDR is cash flow or collateral dependent.  If the TDR is cash flow dependent, an allowance for loan losses specific reserve is calculated based on the difference in net present value of future cash flows between the original and modified loan terms.  If the TDR is collateral dependent, the collateral securing the TDR, which is always real estate, is evaluated for impairment based on either an appraisal or broker price opinion.  If a TDR’s collateral valuation is less than its current loan balance, the TDR is written down for accounting purposes by the amount of the difference between the current loan balance and the collateral value.  If the borrower performs under the terms of the modification, generally six consecutive months, and the ultimate collectability of all amounts contractually due under the modified terms is not in doubt, the loan is returned to accrual status.  There are no loans that have been modified due to the financial difficulties of the borrower that are not considered a TDR.  There were no TDR defaults during the nine months ended September 30, 2016 and 2015.our off-balance sheet instruments:
 
31
Table of Contents
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
The following tables present newly restructured loans that occurred during the nine and three months ended September 30, 2015 (dollars in thousands):
  Nine months ended September 30, 2015 
  
Rate
Modification
  
Contracts
  
Combination
Modifications
  
Contracts
  
Total
  
Total
Contracts
 
Pre-Modification Outstanding Recorded Investment:
             
                   
Residential mortgage  -   -  $91   2  $91   2 
Construction, acquisition and development  -   -   -   -   -   - 
Land  -   -   -   -   -   - 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  -   -   -   -   -   - 
Commercial non-real estate  -   -   -   -   -   - 
Home equity  -   -   -   -   -   - 
Consumer  -   -   -   -   -   - 
Total loans  -   -  $91   2  $91   2 
                  
Post-Modification Outstanding Recorded Investment:                 
                         
Residential mortgage  -   -  $200   2  $200   2 
Construction, acquisition and development  -   -   -   -   -   - 
Land  -   -   -   -   -   - 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  -   -   -   -   -   - 
Commercial non-real estate  -   -   -   -   -   - 
Home equity  -   -   -   -   -   - 
Consumer  -   -   -   -   -   - 
Total loans  -   -  $200   2  $200   2 
32
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Three months ended September 30, 2015
Rate
Modification
Contracts
Combination
Modifications
Contracts
Total
Total
Contracts
Pre-Modification Outstanding Recorded Investment:
Residential mortgage--$--$--
Construction, acquisition and development------
Land------
Lines of credit------
Commercial real estate------
Commercial non-real estate------
Home equity------
Consumer------
Total loans--$--$--
Post-Modification Outstanding Recorded Investment:
Residential mortgage--$--$--
Construction, acquisition and development------
Land------
Lines of credit------
Commercial real estate------
Commercial non-real estate------
Home equity------
Consumer------
Total loans--$--$--
33
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued

Interest on TDRs was accounted for under the following methods as of September 30, 2016 and December 31, 2015 (dollars in thousands):
  
Number
of
Contracts
  
Accrual
Status
  
Number
of
Contracts
  
Non-
Accrual
Status
  
Total
Number
of
Contracts
  
Total
Modifications
 
September 30, 2016                  
Residential mortgage  52  $19,185   1  $109   53  $19,294 
Construction, acquisition and Development  1   70   -   -   1   70 
Land  5   661   1   6   6   667 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  4   2,414   2   249   6   2,663 
Commercial non-real estate  4   92   -   -   4   92 
Home equity  -   -   -   -   -   - 
Consumer  1   9   -   -   1   9 
Total loans  67  $22,431   4  $364   71  $22,795 
December 31, 2015                        
Residential mortgage  55  $20,831   3  $1,071   58  $21,902 
Construction, acquisition and development  1   71   -   -   1   71 
Land  6   907   1   6   7   913 
Lines of credit  -   -   -   -   -   - 
Commercial real estate  4   2,464   2   252   6   2,716 
Commercial non-real estate  4   103   -   -   4   103 
Home equity  -   -   -   -   -   - 
Consumer  1   10   -   -   1   10 
Total loans  71  $24,386   6  $1,329   77  $25,715 

Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk (dollars in thousands).
Financial Instruments Whose Contract
Amounts Represent Credit Risk
  Contract Amount At  
September 30, 2016  December 31, 2015
Standby letters of credit $4,316  $5,937 
Home equity lines of credit  7,804   7,467 
Unadvanced construction commitments  17,400   21,101 
Mortgage loan commitments  7,665   3,233 
Lines of credit  34,716   27,189 
Loans sold with limited repurchase provisions  55,017   65,107 
34
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 10 - Loans Receivable - Continued
  
September 30,
2017
  
December 31,
2016
 
  (dollars in thousands) 
Standby letters of credit $3,854  $4,022 
Home equity lines of credit  12,425   7,736 
Unadvanced construction commitments  72,045   15,728 
Mortgage loan commitments  -   574 
Lines of credit  13,092   34,125 
Loans sold and serviced with limited repurchase provisions  19,979   70,773 

Standby letters of credit are conditional commitments issued by the Bank guaranteeing performance by a customer to various municipalities. These guarantees are issued primarily to support performance arrangements and are limited to real estate transactions.  The majority of these standby letters of credit expire within the next twelve months.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments.  The Bank requires collateral supporting these letters of credit as deemed necessary.  Management believes, except for certain standby letters of credit, that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees.  The current amount of the liability as of September 30, 20162017 and December 31, 20152016 for guarantees under standby letters of credit issued was $98,000$79,000 and $115,000,$94,000, respectively.

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

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

Mortgage loan commitments not reflected in the accompanying statements of financial condition at September 30,December 31, 2016 included seventeen loan commitments totaling $7,665,000two loans at a fixed interest rate range of 3.25% to 4.63% and none4.25% totaling $574,000. There were no such commitments at floating interest rates, and at December 31, 2015 included seven loan commitments totaling $3,233,000 at a fixed interest rate range of 3.75% to 8.00% and none at floating interest rates.September 30, 2017.

Lines of credit are loan commitments to individuals and companies as long as there is no violation of any condition established in the contract. Lines of credit have a fixed expiration date. The Bank evaluates each customer'scustomer’s credit worthiness on a case-by-case basis.

The Bank has entered into several agreements to sell mortgage loans to third parties. The loans sold under these agreements for the nine month period ended September 30, 2016 and year ended December 31, 2015 were $43,960,000 and $157,309,000, respectively. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within a period ranging generally from 120 to 180 days after the terms specified bysale date depending on the investor’s agreement. The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers.

Only  We established a reserve for potential repurchases for these loans, originated specifically for sale are recorded as held for salewhich amounted to $59,000 at September 30, 20162017 and December 31, 2015.

No amount was recognized in the consolidated statement of financial condition at September 30, 2016 and December 31, 2015 as a liability for credit loss related to these loans.

Except for the liability recorded for standby letters of credit of $98,000 at September 30, 2016 and $115,000$48,000 at December 31, 2016.  We did not repurchase any loans during the nine months ended September 30, 2017 or 2016.

Note 4 -  Regulatory Matters

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

In July 2015, liabilitiesfederal bank regulatory agencies issued final results to revise their risk-based capital requirements and the method for credit losses associatedcalculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act (“Basel III”).  On January 1, 2015, the Basel III rules became effective and include transition provisions which implement certain portions of the rules through January 1, 2019.  Under the final rules, the effects of certain accumulated other comprehensive items are not excluded, however, banking organizations like us that are not considered “advanced approaches” banking organizations may make a one-time permanent election to continue to exclude these commitments were not material.items.  With the submission of the Call Report for the first quarter of 2015, we made this election in order to avoid significant variations in the level of capital that can be caused by interest rate fluctuations on the fair value of the Bank’s AFS securities portfolio.
 
3518
SEVERN BANCORP, INC. AND SUBSIDIARIESThe Basel III rules also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital.  The new capital conservation buffer requirements began to phase in effective January 2016 at 0.625% of risk-weighted assets and increase by that amount each year until fully implemented in January 2019 (1.25% at September 30, 2017).  An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses to executive officers if its capital level falls below the buffer amount.  These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUEDAs of the date of the last regulatory exam, the Bank was considered “well capitalized” and as of September 30, 2017, the Bank continued to meet the requirements to be considered “well capitalized” based on applicable U.S. regulatory capital ratio requirements.

The Bank’s regulatory capital amounts and ratios were as follows:
  Actual     
Minimum
Requirements
for Capital Adequacy
Purposes
  
Minimum
Requirements
with Capital
Conservation Buffer
  
To be Well
Capitalized Under
Prompt Corrective
Action Provision
 
  Amount  Ratio  Amount  Ratio  Amount  Ratio  Amount  Ratio 
September 30, 2017 (dollars in thousands) 
Common Equity Tier 1 Capital (to risk-weighted assets) $104,318   16.8% $27,907   4.5% $35,658   5.8% $40,309   6.5%
                                 
Total capital (to risk-weighted assets)  112,086   18.1%  49,612   8.0%  57,363   9.3%  62,015   10.0%
                                 
Tier 1 capital (to risk-weighted assets)  104,318   16.8%  37,209   6.0%  44,961   7.3%  49,612   8.0%
                                 
Tier 1 capital (to average quarterly assets)  104,318   13.3%  31,313   4.0%  41,099   5.3%  39,142   5.0%
                                 
December 31, 2016   
Common Equity Tier 1 Capital (to risk-weighted assets) $98,970   16.5% $26,983   4.5% $30,730   5.1% $38,975   6.5%
                                 
Total capital (to risk-weighted assets)  106,517   17.8%  47,969   8.0%  51,717   8.6%  59,962   10.0%
                                 
Tier 1 capital (to risk-weighted assets)  98,970   16.5%  35,977   6.0%  39,725   6.6%  47,969   8.0%
                                 
Tier 1 capital (to average quarterly assets)  98,970   12.9%  30,634   4.0%  35,420   4.6%  38,292   5.0%
Note 5 -  Earnings Per Share

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for each period.  Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Potential common shares that may be issued by the Company relate to outstanding stock options, warrants, and convertible preferred stock, and are determined using the treasury stock method.

Not included in the diluted earnings per share calculation for 2017 and 2016 because they were anti-dilutive, were 20,000 and 126,600 shares, respectively, of common stock issuable upon exercise of outstanding stock options, 437,500 shares of common stock issuable upon conversion of the Company’s Series A Preferred Stock, and, in 2016, 556,976 shares of common stock issuable upon the exercise of a warrant were also anti-dilutive and excluded from the calculation.

Information relating to the calculations of our income per common share is summarized as follows:
  Three Months Ended September 30,  Nine Months Ended September 30, 
  2017  2016  2017  2016 
  (dollars in thousands, except for per share data) 
Weighted-average shares outstanding - basic  12,172,586   12,104,379   12,140,689   11,324,660 
Dilution  150,986   79,360   107,525   51,193 
Weighted-average share outstanding - diluted  12,323,572   12,183,739   12,248,214   11,375,853 
                 
Net income available to common stockholders $1,121  $539  $2,753  $12,864 
                 
Net income per share - basic $0.09  $0.04  $0.23  $1.14 
Net income per share - diluted $0.09  $0.04  $0.22  $1.13 
19
Note 6 - Stock-Based Compensation

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

We account for stock-based compensation in accordance with FASB Accounting Standards Codification Topic 718, Compensation – Stock Compensation, which requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the statement of operations at fair value.  Additionally, we are required to recognize the expense of employee services received in share-based payment transactions and measure the expense based on the grant date fair value of the award.  The expense is recognized over the period during which an employee is required to provide service in exchange for the award. Stock-based compensation expense included in the consolidated statements of operations for the three months ended September 30, 2017 and 2016 totaled $44,000 and $48,000, respectively. Stock-based compensation expense included in the consolidated statements of operations for the nine months ended September 30, 2017 and 2016 totaled $146,000 and $143,000, respectively.

The weighted average fair value of the options issued during the three and nine months ended September 30, 2017 was $2.56.  There were no options granted during the three or nine months ended September 30, 2016.  The fair value of the options was calculated using the Black-Scholes-Merton option-pricing model with the following weighted average assumptions for the three and nine months ended September 30, 2017:
Dividend yield0.00%
Expected volatility36.02%
Risk-free interest rate1.76%
Expected lives5.5 years
Information regarding our stock-based compensation plan is as follows as of and for the nine months ended September 30:
  2017  2016 
  
Number
of Shares
  
Weighted-
Average
Exercise
Price
  
Weighted-
Average
Remaining
Contractual
Term (in years)
  
Aggregate
Intrinsic
Value
(in thousands)
  
Number
of Shares
  
Weighted-
Average
Exercise
Price
  
Weighted-
Average
Remaining
Contractual
Term (in years)
  
Aggregate
Intrinsic
Value
(in thousands)
 
Outstanding at beginning of period  339,500  $5.31         339,800  $4.83       
Granted  20,000   7.10         -   -       
Exercised  (5,025)  3.37         -   -       
Forfeited  (16,000)  4.59         (54,500)  5.07       
Outstanding at end of period  338,475   5.48   7.2  $526   285,300   4.79   8.2  $491 
Exercisable at end of period  173,702   4.78   6.5  $398   136,125   4.37   7.0  $292 

As of September 30, 2017, there was $520,000 of total unrecognized stock-based compensation expense related to nonvested stock options, which is expected to be recognized over the next 59 months.
20
Note 7 - Other Comprehensive Income

The following table presents the changes in the components of accumulated other comprehensive loss for the three and nine months ended September 30, 2017:

  Three Months  Nine Months 
  (dollars in thousands) 
Balance at beginning of period $6  $- 
Other comprehensive loss before reclassification  (9)  (3)
Amounts reclassified from accumulated other comprehensive loss  (1)  (1)
Net other comprehensive loss during period  (10)  (4)
Balance at end of period $(4) $(4)
We did not have any accumulated other comprehensive income or loss for the three or nine months ended September 30, 2016.

Note 118 - Fair ValuesValue of Financial Instruments

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

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

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

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

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

The following information should not be interpreted as an estimateWe record transfers between levels at the end of the fair value of Bancorp since a fair value calculation is only provided for a limited portion of Bancorp’s assets and liabilities.  Due to a wide range of valuation techniques andreporting period in which the degree of subjectivity usedchange in making the estimates, comparisons between Bancorp’s disclosures and those of other companies may not be meaningful.  The following methods and assumptions were used to estimate the fair values of Bancorp’s financial instruments at September 30, 2016 and December 31, 2015.significant inputs occurs.

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

For such loans that are classified as impaired, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  For such loans that are classified as collateral dependent impaired loans, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan.  Once the net collateral value has been determined, a charge-off is taken for the difference between the net collateral value and the carrying value of the loan.

Impaired loans are those for which Bancorp has measured impairment based on the present value of expected future cash flows or on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements. The fair value consisted of the loan balances of $14,067,000 and $16,166,000 at September 30, 2016 and December 31, 2015, respectively, less their valuation allowances of $2,259,000 and $2,282,000 at September 30, 2016 and December 31, 2015, respectively. The fair value of three impaired collateral-dependent loans that were partially charged off during the nine months ended September 30, 2016 totaled $1,990,000 net of charge-offs of $67,000 that were recorded in the nine months ended September 30, 2016.  The fair value of seven impaired collateral-dependent loans that were partially charged off during the year ended December 31, 2015 totaled $3,219,000 net of charge-offs of $622,000 that were recorded in the twelve months ended December 31, 2016.2017:

  
Carrying
Value
  
Quoted
Prices
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
  
Total Changes
In Fair Values
Included In
Period Income
 
  (dollars in thousands) 
AFS Securities - U.S. government agency notes $3,129  $-  $3,129  $-  $- 
Loans held for sale (“LHFS”)  4,871   -   4,871   -   139 
Mortgage servicing rights (“MSRs”)  473   -   -   473   (84)
Interest-rate lock commitments (“IRLCs”)  42   -   42   -   (120)
Mandatory forward contracts  7   -   7   -   (146)
Best efforts forward contracts  6   -   6   -   6 
 
3621
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments - Continued

Foreclosed Real Estate:
Real estate acquired through foreclosure is recordedThe following tables present fair value measurements for assets that are measured at fair value less estimated disposal costs. Management periodically evaluateson a recurring basis as of and for the recoverability of the carrying value of the real estate acquired through foreclosure using current estimates of fair value. In the event of a subsequent decline, management provides a specific allowance to reduce real estate acquired through foreclosure to fair value less estimated disposal cost. Expenses incurred on foreclosed real estate prior to disposition are charged to expense. Gains or losses on the sale of foreclosed real estate are recognized upon disposition of the property.year ended December 31, 2016:

Foreclosed real estate totaled $1,343,000 and $1,744,000 as of September 30, 2016 and December 31, 2015, respectively.  The carrying value of foreclosed residential real estate included within foreclosed real estate totaled $552,000 and $543,000 as of September 30, 2016 and December 31, 2015, respectively.

Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process according to local requirements of the applicable jurisdiction totaled $3,252,000 and $1,487,000 as of September 30, 2016 and December 31, 2015, respectively.
37
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued
  
Carrying
Value
  
Quoted
Prices
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
  
Total Changes
In Fair Values
Included In
Period Income
 
  (dollars in thousands) 
MSRs $557  $-  $-  $557  $66 
IRLCs  162   -   162   -   (21)
Mandatory forward contracts  153   -   153   -   42 

The following table sets forth financial assets that were accounted for at fair value on a nonrecurring and recurring basis by level within the fair value hierarchy as of September 30, 2016 and December 31, 2015:

     
September 30, 2016
Fair Value Measurement Using:
 
  
September 30,
2016
  
Quoted Prices in
Active Markets
For Identical
Assets
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
  (dollars in thousands) 
Nonrecurring fair value measurements
            
Impaired loans $13,798  $-  $-  $13,798 
Foreclosed real estate  1,343   -   -   1,343 
Total nonrecurring fair value measurements $15,141  $-  $-  $15,141 
Recurring fair value measurements
                
Mortgage servicing rights $484  $-  $-  $484 
Rate lock commitments  480   -   480   - 
Mandatory forward contracts  14   -   14   - 
Total recurring fair value measurements $978  $-  $494  $484 
      
December 31, 2015
Fair Value Measurement Using:
 
  
December 31,
2015
  
Quoted Prices in
Active Markets
For Identical
Assets
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
  (dollars in thousands) 
Nonrecurring fair value measurements
                
Impaired loans $17,103  $-  $-  $17,103 
Foreclosed real estate  543   -   -   543 
Total nonrecurring fair value measurements $17,646  $-  $-  $17,646 
Recurring fair value measurements
                
Mortgage servicing rights $623  $-  $-  $623 
Rate lock commitments  141   -   141   - 
Mandatory forward contracts  111   -   111   - 
Total recurring fair value measurements $875  $-  $252  $623 

There were no liabilities that were required to be re-measured on a nonrecurring basis at September 30, 2016 or December 31, 2015.
38
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments - Continued

The following table presentsprovides additional quantitative information about assets measured at fair value on a recurring basis and for which Bancorp haswe have utilized Level 3 inputs to determine fair value:
 
  Quantitative Information about Level 3 Fair Value Measurements 
  
Fair Value
Estimate
 
Valuation
Techniques
 Unobservable Input 
Range (Weighted
Average)
 
September 30, 2016
         
Mortgage servicing rights $484 Market approach Weighted average prepayment speed  7.83%
            
December 31, 2015
           
Mortgage servicing rights $623 Market approach Weighted average prepayment speed  9.91%
  
Fair Value
Estimate
 
Valuation
Technique
 
Unobservable
Input
 
Range
(Weighted-Average)
 
  (dollars in thousands)     
September 30, 2017:         
MSRs $473 Market Approach Weighted average prepayment speed  3.95%
            
December 31, 2016:           
MSRs $557 Market Approach Weighted average prepayment speed  3.95%

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

  Quantitative Information about Level 3 Fair Value Measurements 
  
Fair Value
Estimate
 
Valuation
Techniques
 Unobservable Input 
Range (Weighted
Average)
 
September 30, 2016
         
Impaired loans $11,808 PV of future cash flows (1) Discount rate  -10.00% 
   1,990 Appraisal of collateral (2) Liquidation expenses (3)  -10.00% 
Foreclosed real estate $1,343 Appraisal of  collateral (2),(4) Appraisal adjustments (3) 
-10.00% to -15.11%
(-12.76%)
 
            
December 31, 2015
           
Impaired loans $13,884 PV of future cash flows (1) Discount rate  -6.00 % 
  $3,219 Appraisal of collateral (2) Liquidation expenses (3)  -6.00% 
            
Foreclosed real estate $543 Appraisal of  collateral (2),(4) Appraisal adjustments (3) 
-6.12% to -7.31%
(-6.24%)
 
(1)Cash flow which generally includes various level 3 inputs which are not identifiable.
(2)Fair value is generally determined through independent appraisals for the underlying collateral, which generally include various level 3 inputs which are not identifiable.
(3)Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.
(4)Includes qualitative adjustments by management and estimated liquidation expenses.
39
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – Continued
    
Fair Value Measurement at
September 30, 2016
 
  
Carrying
Amount
  
Fair
Value
  
Quoted Prices in
Active Markets
For Identical
Assets
(Level 1)
  
Significant Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
Financial Assets
 (dollars in thousands) 
Cash and cash equivalents $44,493  $44,493  $44,493  $-  $- 
Investment securities (HTM)  67,677   68,975   -   68,975     
Loans held for sale  12,961   13,348   -   13,124   - 
Loans receivable, net  603,473   611,051   -   -   611,051 
FHLB stock  5,230   5,230   -   5,230   - 
Accrued interest receivable  2,262   2,262   -   2,262   - 
Mortgage servicing rights  484   484   -   -   484 
Rate lock commitments  480   480   -   480   - 
Mandatory forward contracts  14   14   -   14   - 
                     
Financial Liabilities
                    
Deposits $556,610  $557,547   -  $557,547   - 
FHLB advances/Other Borrowings  110,500   107,626   -   107,626   - 
Subordinated debentures  20,619   20,619   -   -   20,619 
Accrued interest payable  528   528   -   528   - 
                     
Off Balance Sheet Commitments
 $-  $-  $-  $-  $- 

     
Fair Value Measurement at
December 31, 2015
 
  
Carrying
Amount
  
Fair
Value
  
Quoted Prices in
Active Markets
For Identical
Assets
(Level 1)
  
Significant Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
 
Financial Assets
 (dollars in thousands) 
Cash and cash equivalents $43,591  $43,591  $43,591  $-  $- 
Investment securities (HTM)  76,133   76,310   -   76,310   - 
Loans held for sale  13,203   13,295   -   13,295   - 
Loans receivable, net  589,656   593,742   -   -   593,742 
FHLB stock  5,626   5,626   -   5,626   - 
Accrued interest receivable  2,218   2,218   -   2,218   - 
Mortgage servicing rights  623   623   -   -   623 
Rate lock commitments  141   141   -   141   - 
Mandatory forward contracts  111   111   -   111   - 
Financial Liabilities
                    
Deposits $523,771  $524,458   -   524,458   - 
FHLB advances  115,000   110,759   -   110,759   - 
Subordinated debentures  24,119   24,119   -   -   24,119 
Accrued interest payable  3,137   3,137   -   3,137   - 
Off Balance Sheet Commitments
 $-  $-  $-  $-  $- 
40
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 11 - Fair Values of Financial Instruments – ContinuedAFS Securities

The following methodsestimated fair values of AFS debt securities are obtained from a nationally-recognized pricing service. This pricing service develops estimated fair values by analyzing like securities and assumptions wereapplying available market information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare valuations. Matrix pricing is a mathematical technique widely used in the industry to measurevalue debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities. The fair value of financial instruments recorded at costmeasurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things, and are based on Bancorp’s consolidated balance sheet:market data obtained from sources independent from the Bank. The Level 2 investments in the Bank’s portfolio are priced using those inputs that, based on the analysis prepared by the pricing service, reflect the assumptions that market participants would use to price the assets. The Bank has determined that the Level 2 designation is appropriate for these securities because, as with most fixed-income securities, those in the Bank’s portfolio are not exchange-traded, and such nonexchange-traded fixed income securities are typically priced by correlation to observed market data.

Cash and cash equivalents:LHFS
The carrying amount reported
At September 30, 2017, LHFS were carried at fair value, which is determined based on outstanding investor commitments or, in the consolidated statementsabsence of financial condition for cash and cash equivalents approximate those assets’ fair values.such commitments, on current investor yield requirements or third party pricing models. At December 31, 2016, LHFS were carried at the lower-of-cost or market value (“LCM”) utilizing the same method.

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

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

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

FHLB stock:
The carrying amount of FHLB stock approximates fair value based on the redemption provisions of the FHLB.  There have been no identified events or changes in circumstances that may have a significant adverse effect on the FHLB stock.  Based on our evaluation, we have concluded that our FHLB stock was not impaired at September 30, 2016 and December 31, 2015.

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

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

Mortgage servicing rights:
The fair value of mortgage servicing rightsMSRs is determined using a valuation model administered by a third party that calculates the present value of estimated future net servicing income.  The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service (including delinquency and foreclosure costs), escrow account earnings, contractual servicing fee income, and other ancillary income such as late fees.  Management reviews all significant assumptions on a monthly basis.  Mortgage loan prepayment speed, a key assumption in the model, is the annual rate at which borrowers are forecasted to repay their mortgage loan principal.  The discount rate used to determine the present value of estimated future net servicing income, another key assumption in the model, is an estimate of the required rate of return investors in the market would require for an asset with similar risk.  Both assumptions can, and generally will, change as market conditions and interest rates change.
 
4122
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUEDIRLCs

Note 11 - We utilize a third party specialist model to estimate the fair value of our IRLCs, which are valued based upon mandatory pricing quotes from correspondent lenders less estimated costs to process and settle the loan.  Fair Valuesvalue is adjusted for the estimated probability of Financial Instruments – Continuedthe loan closing with the borrower.

Deposit liabilities:Forward Contracts

To avoid interest rate risk, we enter into best efforts forward sales commitments with investors at the time we make an IRLC to a borrower. Once a loan has been closed and funded, the best efforts commitments convert to mandatory forward sales commitments. The mandatory commitments are derivatives, and the bank measures and reports them at fair value. Fair value is based on the gain or loss that would occur if we were to pair-off the transaction with the investor at the measurement date.  This is a level 2 input. We have elected to measure and report best efforts commitments at fair value using a valuation methodology similar to that used for our mandatory commitments.

Assets Measured on a Nonrecurring Basis

We may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis.  These adjustments to fair value usually result from application of LCM accounting or write-downs of individual assets.  For assets measured at fair value on a nonrecurring basis, the following tables provide the level of valuation assumptions used to determine each adjustment and the carrying value of assets:
  September 30, 2017 
  
Carrying
Value
  
Quoted
Prices
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
  
Range of
Discount
  
Weighted
Average
 
  (dollars in thousands)       
Impaired loans $1,597  $-  $-  $1,597   0% - 33%  25.5%
Real estate acquired through foreclosure  691   -   -   691   0% - 26%  20.9%
  December 31, 2016 
  
Carrying
Value
  
Quoted
Prices
(Level 1)
  
Significant
Other
Observable
Inputs
(Level 2)
  
Significant
Unobservable
Inputs
(Level 3)
  
Range of
Discount
  
Weighted
Average
 
  (dollars in thousands)       
Impaired loans $2,136  $-  $-  $2,136   0% - 2%  2.0%
Real estate acquired through foreclosure  767   -   -   767   0% - 10%  10.0%

Impaired Loans

Impaired loans are those for which we have measured impairment based on the present value of expected future cash flows or on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds.  If it is determined that the repayment of the loan will be provided solely by the underlying collateral, and there are no other available and reliable sources of repayment, the loan is considered collateral dependent.  Impaired loans that are considered collateral dependent are carried at the LCM.  Collateral may be in the form of real estate or business assets including equipment, inventory, and/or accounts receivable.  The use of independent appraisals and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and impaired loans are therefore classified within level 3 of the fair value hierarchy.

For such loans that are classified as impaired, an Allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  For such impaired loans that are classified as collateral dependent, an Allowance is established when the current market value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan.  Once the net collateral value has been determined, a charge-off is taken for the difference between the net collateral value and the carrying value of the loan.
23
Real Estate Acquired Through Foreclosure

We record foreclosed real estate assets at the fair value less estimated selling costs on their acquisition dates and at the lower of such initial amount or estimated fair value less estimated selling costs thereafter.  We generally obtain certified external appraisals of real estate acquired through foreclosure and estimate fair value using those appraisals. Other valuation sources may be used, including broker price opinions, letters of intent, and executed sale agreements.

Fair Value of All Financial Instruments

The carrying value and estimated fair value of all financial instruments are summarized in the following tables.  The descriptions of the fair value calculations for AFS securities, LHFS, MSRs, IRLCs, best efforts forward contracts, mandatory forward contracts, impaired loans, and real estate acquired through foreclosure are included in the discussions above.
  September 30, 2017 
  Carrying  Fair Value 
  Value  Level 1  Level 2  Level 3  Total 
Assets: (dollars in thousands) 
Cash and cash equivalents $41,635  $41,635  $-  $-  $41,635 
AFS securities  3,129   -   3,129   -   3,129 
HTM securities  58,764   8,102   50,857   -   58,959 
LHFS  4,871   -   4,871   -   4,871 
Loans receivable  643,028   -   -   653,381   653,381 
Restricted stock investments  4,699   -   4,699   -   4,699 
Accrued interest receivable  2,503   -   2,503   -   2,503 
MSRs  473   -   -   473   473 
IRLCs  42   -   42   -   42 
Mandatory forward contracts  7   -   7   -   7 
Best effort forward contracts  6   -   6   -   6 
Liabilities:                    
Deposits  593,492   -   586,594   -   586,594 
Borrowings  93,450   -   87,909   -   87,909 
Subordinated debentures  20,619   -   -   20,619   20,619 
Accrued interest payable  478   -   478   -   478 

  December 31, 2016 
  Carrying  Fair Value 
  Value  Level 1  Level 2  Level 3  Total 
Assets: (dollars in thousands) 
Cash and cash equivalents $67,114  $67,114  $-  $-  $67,114 
HTM securities  62,757   13,165   49,662   -   62,827 
LHFS  10,307   -   10,313   -   10,313 
Loans receivable  601,309   -   -   602,953   602,953 
Restricted stock investments  5,103   -   5,103   -   5,103 
Accrued interest receivable  2,249   -   2,249   -   2,249 
MSRs  557   -   -   557   557 
IRLCs  162   -   162   -   162 
Mandatory forward contracts  153   -   153   -   153 
Liabilities:                    
Deposits  571,946   -   572,556   -   572,556 
Borrowings  103,500   -   97,961   -   97,961 
Subordinated debentures  20,619   -   -   20,619   20,619 
Accrued interest payable  538   -   538   -   538 
24
At September 30, 2017 and December 31, 2016, the Bank had loan funding commitments of $97.6 million and $58.2 million, respectively, and standby letters of credit outstanding of $3.9 million and $4.0 million, respectively.  The fair value of these commitments is nominal.

Cash and Cash Equivalents

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

HTM securities

The Company utilizes a third party source to determine the fair value of its securities.  The methodology consists of pricing models based on asset class and includes available trade, bid, other market information, broker quotes, proprietary models, various databases, and trading desk quotes.  U.S Treasury Securities are considered Level 1 and all of our other securities are considered Level 2.

Loans Receivable

The fair values of loans receivable were estimated using discounted cash flow analyses, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. These rates were used for each aggregated category of loans.

Restricted Stock Investments

The carrying value of restricted stock investments is a reasonable estimate of fair value as these investments do not have a readily available market.

Deposits

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

FHLB advancesBorrowings

Long-term and Other Borrowings:
Fairshort-term borrowings were segmented into categories with similar financial characteristics. Carrying values of long-term debt are estimatedwere discounted using discounteda cash flow analysis, based on rates currently available for advances from the FHLB with similar terms and remaining maturities.  Fair values of long-term debt are estimated using discounted cash flow analysis,approach based on market rates currently available for notes with similar terms.rates.

Subordinated debentures:debentures

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

Off-balance sheet financial instruments:Limitations

Fair valuesvalue estimates are made at a specific point in time, based on relevant market information and information about financial instruments. These estimates do not reflect any premium or discount that could result from a one-time sale of our total holdings of a particular financial instrument. Because no market exists for Bancorp’s off-balance sheeta significant portion of our financial instruments, (lending commitments and letters of credit) are not significant andfair value estimates are based on fees currently charged to enter into similar agreements, taking into account the remaining termsjudgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect estimates.  The above information should not be interpreted as an estimate of the agreementsfair value of the Company since a fair value calculation is only provided for a limited portion of our assets and liabilities.  Due to a wide range of valuation techniques and the counterparties’ credit standing.degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful.

Note 12 - Income Taxes

Tax expense was $378,000There were no transfers between any of Levels 1, 2, and 3 for the third quarter of 2016 compared to a $52,000 for the third quarter of 2015.  For the nine months ended September 30, 2017 or 2016 the Bancorp recorded an income tax benefit of $10,816,000 compared to income tax expense of $88,000or for the same period of 2015. The income tax benefit in 2016 was primarily due to the reversal of an $11,837,000 valuation allowance during the second quarter ofyear ended December 31, 2016. The valuation allowance was first recorded in the third quarter of 2013 due to the uncertainty of whether or not the Bancorp would be able to realize the asset.

In assessing Bancorp’s ability to realize its net deferred tax asset, Management considers whether it is more likely than not that some portion or all of the net deferred tax asset will or will not be realized.  Bancorp’s ultimate realization of the net deferred tax asset is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible.  Management considers the nature and amount of historical and projected future taxable income, the scheduled reversal of deferred tax assets and liabilities, and available tax planning strategies in making this assessment.  The amount of net deferred taxes recognized could be impacted by changes to any of these variables.

Each quarter, Bancorp weighs both the positive and negative information and analyzes its position of whether or not a valuation allowance is required. Over the past several quarters, the positive information has been increasing while the negative information has been decreasing. Over the last eight quarters, the Bancorp has demonstrated consistent earnings while its level of non-performing assets has steadily decreased. Additionally, the Federal Reserve Bank and The Office of the Comptroller of the Currency have terminated their formal agreements with Bancorp, reducing regulatory risk.
 
4225
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Note 12 - Income Taxes - Continued

Given the consistent earnings and improving asset quality, Bancorp’s analysis has now concluded that, as of September 30, 2016, it is more likely than not that it will generate sufficient taxable income within the applicable carry-forward periods to realize its net deferred tax asset. As such, the full valuation allowance of $11,837,000 was reversed to income tax expense at June 30, 2016. Bancorp’s net deferred tax asset was $10,916,000 as of September 30, 2016.

Note 13 - Recent Accounting Pronouncements

Under ASU 2014-09, Revenue from Contracts with Customers, establishes a comprehensive revenue recognition standard for virtually all industries under U.S. GAAP, including those that previously followed industry-specific guidance.  The revenue standard’s core principal is built on the contract between a vendor and a customer for the provision of goods and services.  It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled.  The new standard applies to all public entities for annual periods beginning after December 15, 2017.  Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim periods within that year.  Bancorp is currently evaluating the impact this update will have on its consolidated financial position and results of operations.

Under ASU 2016-08, Revenue from Contracts with Customers, the new revenue standard clarifies the principal versus agent implementation guidance, but does not change the core principle of the new standard. The updates to the principal versus agent guidance:

require an entity to determine whether it is a principal or an agent for each distinct good or service (or a distinct bundle of goods or services) to be provided to the customer;
illustrate how an entity that is a principal might apply the control principle to goods, services, or rights to services, when another party is involved in providing goods or services to a customer;
clarify that the purpose of certain specific control indicators is to support or assist in the assessment of whether an entity controls a good or service before it is transferred to the customer, provide more specific guidance on how the indicators should be considered, and clarify that their relevance will vary depending on the facts and circumstances; and
revise existing examples and add two new ones to more clearly depict how the guidance should be applied.

Bancorp is currently evaluating the impact this update will have on its consolidated financial position and results of operations.

Under ASU 2016-01, Amendment to the Recognition and Measurement Guidance for Financial Instruments, an entity is required to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in Other Comprehensive Income the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of Available For Sale debt securities in combination with other deferred tax assets. The Amendment provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes.
43
SEVERN BANCORP, INC. AND SUBSIDIARIES
Annapolis, Maryland
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CONTINUED

Note 13 - Recent Accounting Pronouncements – Continued

The Amendment also requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements. The new standard takes effect in 2018 for public companies. Early adoption is only permitted for the provision related to instrument-specific credit risk and the fair value disclosure exemption provided to nonpublic entities. Bancorp has evaluated the effect of ASU 2016-01 and believes adoption will not have a material effect on the Consolidated Financial Statements.

Under ASU 2016-09 Stock Compensation, introduces targeted amendments intended to simplify the accounting for stock compensation. Specifically, the ASU requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity also should recognize excess tax benefits, and assess the need for a valuation allowance, regardless of whether the benefit reduces taxes payable in the current period. That is, off balance sheet accounting for net operating losses stemming from excess tax benefits would no longer be required and instead such net operating losses would be recognized when they arise. Existing net operating losses that are currently tracked off balance sheet would be recognized, net of a valuation allowance if required, through an adjustment to opening retained earnings in the period of adoption. Entities will no longer need to maintain and track an “APIC pool.” The ASU also requires excess tax benefits to be classified along with other income tax cash flows as an operating activity in the statement of cash flows.

In addition, the ASU elevates the statutory tax withholding threshold to qualify for equity classification up to the maximum statutory tax rates in the applicable jurisdiction(s). The ASU also clarifies that cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity.

The ASU provides an optional accounting policy election (with limited exceptions), to be applied on an entity-wide basis, to either estimate the number of awards that are expected to vest (consistent with existing U.S. GAAP) or account for forfeitures when they occur.

Bancorp is currently evaluating the impact this update will have on its consolidated financial position and results of operations.

In February 2016, the FASB issued ASU 2016-02, “Leases.” The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months.  Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.  Bancorp is currently evaluating the impact this update will have on its consolidated financial position and results of operations.

Under ASU 2016-13, Financial Instruments – Credit Losses the ASU sets forth a “current expected credit loss” (CECL) model which requires Bancorp to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Bancorp is currently assessing the impact of the adoption of this ASU on its consolidated financial statements.
44
Under ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments clarifications of how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are intended to reduce diversity in practice.

·Cash payments for debt prepayment or extinguishment costs will be classified in financing activities.
·Upon settlement of zero-coupon bonds and bonds with insignificant cash coupons, the portion of the payment attributable to imputed interest will be classified as an operating activity, while the portion of the payment attributable to principal will be classified as a financing activity.
·Cash paid by an acquirer that isn’t soon after a business combination for the settlement of a contingent consideration liability will be separated between financing activities and operating activities. Cash payments up to the amount of the contingent consideration liability recognized at the acquisition date will be classified in financing activities; any excess will be classified in operating activities. Cash paid soon after the business combination will be classified in investing activities.
·Cash proceeds received from the settlement of insurance claims will be classified on the basis of the related insurance coverage (that is, the nature of the loss). Cash proceeds from lump-sum settlements will be classified based on the nature of each loss included in the settlement.
·Cash proceeds received from the settlement of corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) policies will be classified as cash inflows from investing activities. Cash payments for premiums on COLI and BOLI may be classified as cash outflows for investing, operating, or a combination of both.
·A transferor’s beneficial interest obtained in a securitization of financial assets will be disclosed as a noncash activity, and cash received from beneficial interests will be classified in investing activities.
·Distributions received from equity method investees will be classified using either a cumulative earnings approach or a look-through approach as an accounting policy election.

The ASU contains additional guidance clarifying when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) versus when an entity should classify the aggregate amount into one class of cash flows on the basis of predominance.  Bancorp is currently assessing the impact of the adoption of this ASU on its consolidated financial statements.

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

When used in this report, the terms “the Company,” “we,” “us,” and “our” refer to Severn Bancorp and, unless the context requires otherwise, its consolidated subsidiaries.  The following discussion should be read and reviewed in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in Severn Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2016.

The Company

BancorpThe Company is a savings and loan holding company chartered as a corporation in the state of Maryland in 1990.  It conducts business primarily through twothree subsidiaries, Severn Savings Bank, FSB (“Bank”(the “Bank”), Mid-Maryland Title Company, Inc. (the “Title Company”), and SBI Mortgage Company (“SBI”).  The Bank’s principal subsidiary Louis Hyatt, Inc. (“Hyatt Commercial”), conducts business as Hyatt Commercial, a commercial real estate brokerage and property management company.  SBI holds mortgages that do not meet the underwriting criteria of the Bank, and is the parent company of Crownsville Development Corporation (“Crownsville”), which is doing business as Annapolis Equity Group, whichand acquires real estate for syndication and investment purposes.  The Title Company is a real estate settlement company that handles commercial and residential real estate settlements in Maryland. The Bank’s principal subsidiary Louis Hyatt, Inc. (“Hyatt Commercial”), conducts business as Hyatt Commercial, a commercial real estate brokerage and property management company.  The Bank has five branches in Anne Arundel County, Maryland, which offer a full range of deposit products, and originate mortgages in its primary market of Anne Arundel County, Maryland and, to a lesser extent, in other parts of Maryland, Delaware, and Virginia.  As of September 30, 2017, we had 132 full-time equivalent employees.

Bank CompetitionOverview

The Annapolis, Maryland area hasCompany provides a wide range of personal and commercial banking services. Personal services include mortgage lending and various other lending services as well as deposit products such as personal Internet banking and online bill pay, checking accounts, individual retirement accounts, money market accounts, and savings and time deposit accounts. Commercial services include commercial secured and unsecured lending services as well as business Internet banking, corporate cash management services, and deposit services.  The Company also provides ATMs, credit cards, debit cards, safe deposit boxes, and telephone banking, among other products and services.

We have experienced a slightly improved level of profitability for the three and nine months ended September 30, 2017, primarily due to the payoff of high densitycosting Federal Home Loan Bank of financial institutions, many of which are significantly largerAtlanta (“FHLB”) advances and have greater financial resources than the Bank, and all of which are competitorsreversals of the Bankprovision for loan losses. Management believes that, while conditions continue to varying degrees.improve and real estate values in the Company’s market area continue to stabilize, certain detrimental factors still exist in the market. The Bank’s competitioninterest rate spread between our cost of funds and what we earn on loans has grown somewhat from 2016 levels due primarily to the aforementioned payoff of FHLB advances and a change in the mix from higher costing time deposits to lower costing transaction accounts. During the second quarter of 2016, we reversed the valuation allowance maintained on the net deferred tax asset, which resulted in an $11.2 million tax benefit. With the reversal of the valuation allowance, we are now recording a provision for income taxes.

The Company expects to experience similar market conditions during the remainder of 2017, as the national and local economies continue to improve and as the employment environment in our market improves. If interest rates increase, demand for loans comes primarily from savingsmay decrease and our interest rate spread could decrease. Interest rates are outside of our control, so we must attempt to balance the pricing and duration of the loan associations, savings banks,portfolio against the risks of rising costs of our deposits and borrowings. The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to our ability to originate and grow mortgage banking companies, insurance companiesloans and commercial banks.  Its most direct competition for deposits, has historically come from savingsas will our continued focus on maintaining a low overhead. If the volatility in the market and loan associations, savings banks, commercial banks and credit unions.  The Bank faces additional competition for deposits from money market mutualthe economy continues or worsens, our business, financial condition, results of operations, access to funds, and corporatethe price of our stock could be materially and government securities funds and investments.  The Bank also faces increased competition for deposits from other financial institutions such as brokerage firms and insurance companies.  The Bank is a community-oriented financial institution serving its market area with a wide selection of mortgage loan products.  Management considers the Bank’s reputation and customer service to be a major competitive advantage in attracting and retaining customers in its market area.  The Bank also believes it benefits from its community orientation.adversely impacted.
 
45Acquisition
Table of Contents
Forward Looking Statements

In addition toOn September 1, 2017, we acquired the historical information contained herein, the discussionTitle Company by issuing stock in this report contains forward-looking statements that involve risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from thosea business combination. We issued 108,084 shares in the forward-looking statements.transaction valued at $775,000.  We recorded $759,000 in goodwill in the transaction.  The forward-looking statements contained herein include, but are not limited to, those with respect toacquisition continues our growth strategy and focus on being a full-service provider and complements the Bank’s strategy; management’s determinationmortgage services, commercial banking services, and commercial real estate services we provide. The acquisition of the amountTitle Company has not had a material effect on the Company’s financial condition or results of the loan loss allowance; the effect of changes in interest rates;  changes in deposit insurance premiums; ability to meet obligations; and legal proceedings.  The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “will,” “would,” “could,” “should,” “guidance,” “potential,” “continue,” “project,” “forecast,” “confident,” and similar expressions are typically used to identify forward-looking statements.  Bancorp’s operations and actual results could differ significantly from those discussed in the forward-looking statements.  Some of the factors that could cause or contribute to such differences include, but are not limited to: changes in general economic conditions and political conditions and by governmental monetary and fiscal policies; changes in the economic conditions of the geographic areas in which Bancorp conducts business; changes in interest rates; a downturn in the real estate markets in which Bancorp conducts business; the high degree of risk exhibited by Bancorp’s loan portfolio; environmental liabilities with respect to properties Bancorp has title; changes in federal and state regulation; Bancorp’s ability to estimate loan losses; competition; breaches in security or interruptions in Bancorp’s information systems; Bancorp’s ability to timely develop and implement technology; Bancorp’s ability to retain its management team; perception of Bancorp in the market place; Bancorp’s ability to maintain effective internal controls over financial reporting and disclosure controls and procedures; and terrorist attacks and threat of actual war; and other factors detailed from time to time in Bancorp’s filings with the Securities and Exchange Commission (the “SEC”), including “Item 1A. Risk Factors” contained in Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.operations.

Critical Accounting Policies

Bancorp’sOur significant accounting policies are set forth in Note 1 of the audited consolidated financial statements as offor the year ended December 31, 20152016 which were included in Bancorp’sour Annual Report on Form 10-K. Of these significant accounting policies, Bancorp considers itswe consider our policies regarding the allowancevaluation of  investment securities, the Allowance for loan losses (“Allowance”), the valuation of foreclosed real estate the evaluation of other than temporary impairment of investment securitiesacquired through foreclosure, and the valuation of the net deferred tax asset to be itsour most critical accounting policies, givendue to the uncertainty in evaluatingfact that these policies inherently have a greater reliance on the leveluse of the allowanceestimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to cover credit losses inherentbe recorded at fair value, when a decline in the loan portfolio and the material effect that such judgments can have on the resultsvalue of operations and future taxable income.  In addition, changesan asset not carried in economic conditions can have a significant impact on real estate values of underlying collateral affecting the allowance for loan losses and therefore the provision for loan losses and results of operations as well as the valuation of foreclosed real estate.  Bancorp has developed policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio.  Bancorp’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers that is not known to management at the time of the issuance of the consolidated financial statements.statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility.  When applying accounting policies in such areas that are subjective in nature, management must use its best judgment to arrive at the carrying value of certain assets and liabilities.  Below is a discussion of our critical accounting policies.
 
4626
Table of Contents
OverviewSecurities

Bancorp providesWe designate securities into one of three categories at the time of purchase. Debt securities that we have the intent and ability to hold to maturity are classified as held to maturity (“HTM”) and recorded at amortized cost. Debt and equity securities are classified as trading if bought and held principally for the purpose of sale in the near term. Trading securities are reported at estimated fair value, with unrealized gains and losses included in earnings. Debt securities not classified as HTM and debt and equity securities not classified as trading securities are considered available for sale (“AFS”) and are reported at estimated fair value, with unrealized gains and losses reported as a wide rangeseparate component of personalstockholders’ equity, net of tax effects, in accumulated other comprehensive loss.

AFS and commercial banking services. Personal servicesHTM securities are evaluated periodically to determine whether a decline in their value is other than temporary. The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near-term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the security.

The initial indications of other-than-temporary impairment (“OTTI”) for both debt and equity securities are a decline in the market value below the amount recorded for a security and the severity and duration of the decline. In determining whether an impairment is other than temporary, we consider the length of time and the extent to which the market value has been below cost, recent events specific to the issuer, including investment downgrades by rating agencies and economic conditions of its industry, our intent to sell the security, and if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. We also consider the cause of the price decline (general level of interest rates and industry- and issuer-specific factors), the issuer’s financial condition, near-term prospects and current ability to make future payments in a timely manner, the issuer’s ability to service debt, and any change in agencies’ ratings at evaluation date from acquisition date and any likely imminent action. Once a decline in value is determined to be other than temporary, the security is segmented into credit- and noncredit-related components.  Any impairment adjustment due to identified credit-related components is recorded as an adjustment to current period earnings, while noncredit-related fair value adjustments are recorded through accumulated other comprehensive loss.  In situations where we intend to sell or it is more likely than not that we will be required to sell the security, the entire OTTI loss is recognized in earnings.

Allowance for Loan Losses

The Allowance is maintained at an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based on evaluations of the collectability of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay.  Determining the amount of the Allowance requires the use of estimates and assumptions.  Actual results could differ significantly from those estimates.

Future additions or reductions in the Allowance may be necessary based on changes in economic conditions, particularly in Anne Arundel County and the State of Maryland.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s Allowance.  Such agencies may require the Bank to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination.

The Allowance consists of specific and general components. The specific component relates to loans that are classified as impaired.  When a real estate secured loan becomes impaired, a decision is made as to whether an updated certified appraisal of the real estate is necessary.  This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value (“LTV”) ratio based on the original appraisal and the condition of the property.  Appraised values are discounted, if appropriate, to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value.  The discounts also include various lending servicesestimated costs to sell the property.  For loans secured by collateral other than real estate, such as accounts receivable, inventory, and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging, or equipment appraisals or invoices.  Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

For such loans that are classified as impaired, an Allowance is established when the current fair value of the underlying collateral less its estimated disposal costs has not been finalized, but management determines that it is likely that the value is lower than the carrying value of that loan.  Once the fair collateral value has been determined, a charge off is taken for the difference between the fair value and the carrying value of the loan.  For loans that are not solely collateral dependent, an Allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.
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Table of Contents
The general component relates to loans that are classified as doubtful, substandard, or special mention that are not considered impaired, as well as checking, individual retirement accounts, money market, savings and time deposit accounts. Commercial servicesnonclassified loans.  The general reserve is based on historical loss experience adjusted for qualitative factors.  These qualitative factors include, commercial secured and unsecured lending services as well as business internet banking, corporate cash management services and deposit services. Bancorp also provides ATMs, debit cards, internet banking including on-line bill pay, mortgage lending, safe deposit boxes, and telephone banking, among other products and services.but are not limited to:

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

A loan is considered impaired if it meets any of $14,437,000the following three criteria:

·Loans that are 90 days or more in arrears (nonaccrual loans);
·Loans where, based on current information and events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement; or
·Loans that are modified and qualify as troubled debt restructured loans (“TDR” or “TDRs”).
Loans that experience insignificant payment delays and payment shortfalls may not be classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the nine months ended September 30, 2016, compareddelay, the borrower’s prior payment record, and the amount of the shortfall in relation to $3,457,000the principal and interest owed.
We assign risk ratings to the loans in our portfolio.  These credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful, and loss.  Loans classified special mention have potential weaknesses that deserve management’s close attention.  If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects.  Loans classified substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable.  Loans classified as a loss are considered uncollectible and are charged to the Allowance.  Loans not classified are rated pass.
Real Estate Acquired Through Foreclosure

Real estate acquired through or in the process of foreclosure is recorded at fair value less estimated disposal costs.  Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using estimates as described under “Allowance for Loan Losses” above. In the nine months ended September 30, 2015.event of a subsequent change in fair value, the carrying amount is adjusted to the lesser of the new fair value, less disposal costs, or the carrying value recorded at acquisition. The increaseamount of the change is primarily duecharged or credited to an $11,194,000noninterest expense.  Expenses on real estate acquired through foreclosure incurred prior to the disposition of the property, such as maintenance, insurance and taxes, and physical security, are charged to expense.  Material expenses that improve the property to its best use are capitalized to the property. If a foreclosed property is sold for more or less than the carrying value, a gain or loss is recognized upon the sale of the property.

Deferred Income Taxes

Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax benefit recordedbasis of assets and liabilities based on enacted tax rates expected to be in the second quarter of 2016 dueeffect when such amounts are realized or settled. Deferred tax assets are recognized only to the reversal of the valuation allowance recorded against the deferred tax asset.  The reversal resulted in the recognition of a one-time tax benefit in the second quarter of 2016 of approximately $11,837,000.  Bancorp has now concludedextent that it is more likely than not that itsuch amount will generate sufficient taxable income within the applicable carry-forward periods to realize its net deferred tax assets.

Our resultsbe realized based on consideration of operations depend primarily on net interest income, which is the difference between the interest income from earning assets, such as loans and investments, and the interest expense incurred on interest bearing liabilities, such as deposits, borrowings and subordinated debentures.  We also generate non-interest income, including, among other sources, mortgage banking activities, real estate commissions and management fees, and service charges on deposit accounts.  Our non-interest expense consists primarily of employee compensation and benefits, net occupancy expense and other operating expenses.

If interest rates increase, demand for borrowing may decrease and Bancorp’s interest rate spread could decrease.  Bancorp will continue to manage loan and deposit pricing against the risks of rising costs of its deposits and borrowings.  Interest rates are outside the control of Bancorp, so it must attempt to balance its pricing and duration of its loan portfolio against the risks of rising costs of its deposits and borrowings.available evidence.

The continued successeffect on deferred tax assets and attractionliabilities of Anne Arundel County, Maryland, and vicinity, will also be important to Bancorp’s ability to originate and grow mortgage loans and deposits, as will Bancorp’s continued focus on maintaining a low overhead.

If the volatilitychange in tax rates is recognized in income in the marketperiod that includes the enactment date.  To the extent that current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. We recognizes a tax position as a benefit only if it “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination presumed to occur.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.  The judgment about the level of future taxable income is inherently subjective and the economy worsens, ouris reviewed on a continual basis as regulatory and business financial condition, resultsfactors change.
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Table of operations, access to funds and the price of our stock could be materially and adversely impacted.Contents

Results of Operations

Net income decreased by $172,000 to net income of $1,055,000 for the third quarter of 2016, compared to net income of $1,227,000 for the third quarter of 2015.  This was primarily due to increases in non-interest expenses and income taxes. Basic and diluted earnings per share were $0.04 for the third quarter of 2016 compared to $0.06 for the third quarter of 2015. Income

Three months ended September 30

Net income increased by $10,980,000$204,000, or 19.3%, to $1.3 million for the three months ended September 30, 2017, compared to $1.1 million for the three months ended September 30, 2016.  Basic and diluted income per share were $0.09 for the three months ended September 30, 2017 compared to $0.04 for the three months ended September 30, 2016.  The increase in net income of $14,437,000reflected improved net interest income, decreased noninterest expenses, and a reduced loan loss provision, partially offset by decreased noninterest income.

Nine months ended September 30

Net income decreased by $11.3 million, or 78.1%, to $3.2 million for the nine months ended September 30, 2016,2017, compared to net income of $3,457,000$14.4 million for the nine months ended September 30, 2015.  The increase was due to the reversal of the valuation allowance recorded against the deferred tax asset in the second quarter of 2016.  Basic and diluted earningsincome per share were $1.14$0.23 and $1.13,$0.22, respectively, for the nine months ended September 30, 20162017, compared to $0.17$1.14 (basic) and $1.13 (diluted) for the nine months ended September 30, 2015.2016.  During 2016, we recorded a one-time reversal of the valuation allowance held against the net deferred tax asset in the amount of $11.2 million.  Income before taxes amounted to $5.3 million for the nine months ended September 30, 2017, compared to $3.6 million for the nine months ended September 30, 2016. The increase in pre-tax income reflected improved net interest income, a reversal of loan loss provision, and decreased noninterest expense, partially offset by decreased noninterest income.

Net Interest Income

Three months ended September 30

Net interest income, which is interest earned net of interest expense, increased by $69,000,$614,000, or 1.2%10.7%, to $5,717,000$6.3 million for the three months ended September 30, 2017, compared to $5.7 million for the three months ended September 30, 2016. Our net interest margin increased from 3.19% for the third quarter of 2016 compared to $5,648,0003.38% for the third quarter of 2015.2017.  Our net interest spread increased from 3.04% for the third quarter of 2016 to 3.16% for the third quarter of 2017.

Interest Income

Interest income increased by $397,000, or 5.1%, to $8.2 million for the three months ended September 30, 2017, compared to $7.8 million for the three months ended September 30, 2016.  Average interest-earning assets increased from $713.4 million for the third quarter of 2016 to $743.9 million for the third quarter of 2017.  Average loans outstanding increased by $12.1 million due to increased originations. The average yield on loans increased from 4.80% for the three months ended September 30, 2016 to 4.92% for the three months ended September 30, 2017 as a result of a slightly increased rate environment.  Average HTM securities decreased by $11.6 million due to security maturities and repayments from mortgage-backed securities.  The proceeds were used to fund the purchase of AFS securities and, along with other available funds, the purchase of certificates of deposit from other banks, which contributed to the increase in average other interest-earning assets.

Interest Expense

Interest expense decreased by $217,000, or 10.2%, to $1.9 million for the three months ended September 30, 2017, compared to $2.1 million for the three months ended September 30, 2016.  The decrease was primarily due to a decrease in the average rate paid on transaction accounts from 0.23% for the third quarter of 2016 to 0.12% for the third quarter of 2017, due to a change in the mix from higher costing time deposits to lower costcosting transaction accounts. Additionally, average interest-bearing liabilities decreased by $19.0 million to $615.3 million for the three months ended September 30, 2017 compared to $634.3 million for the same period of borrowings. 2016.

Nine months ended September 30

Net interest income decreased $350,000,increased by $1.4 million, or 2.1%8.7%, to $16,493,000$17.9 million for the nine months ended September 30, 2017, compared to $16.5 million for the nine months ended September 30, 2016. Our net interest margin increased from 3.07% for the nine months ended September 30, 2016 compared to $16,843,0003.25% for the nine months ended September 30, 2015. The primary reason2017.  Our net interest spread increased from 2.94% for this decrease was a decrease in the average yield onnine months ended September 30, 2016 to 3.04% for the average balance of the loan portfolio.nine months ended September 30, 2017.
 
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Bancorp’sInterest Income

Interest income increased by $704,000, or 3.1%, to $23.7 million for the nine months ended September 30, 2017, compared to $23.0 million for the comparable period of 2016.  Average interest-earning assets increased from $718.0 million for the nine months ended September 30, 2016 to $738.4 million for the nine months ended September 30, 2017.  Average loans outstanding increased by $6.7 million due to increased originations. The average yield on loans increased from 4.74% for the nine months ended September 30, 2016 to 4.81% for the nine months ended September 30, 2017.  Average HTM securities decreased by $9.5 million due to security maturities and repayments from mortgage-backed securities.  As mentioned above, the purchase of AFS securities and certificates of deposit from other banks contributed to the increase in average other interest-earning assets.

Interest Expense

Interest expense decreased by $727,000, or 11.2%, to $5.8 million for the nine months ended September 30, 2017, compared to $6.5 million for the comparable period of 2016.  The decrease was primarily due to the decreased average rate of our borrowings.  Average borrowings decreased $18.0 million and the average rate paid on borrowings decreased from 3.47% for the nine months ended September 30, 2016 to 3.26% for the nine months ended September 30, 2017. Additionally, average interest-bearing liabilities decreased by $30.7 million to $614.7 million for the nine months ended September 30, 2017 compared to $645.4 million for the same period of 2016.

The following table sets forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities and the resulting yields on average interest-earning assets and average rates paid on average interest-bearing liabilities.  Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.
  Three Months Ended September 30, 
  2017  2016 
  
Average
Balance (1)
  
Interest (2)
  
Yield/
Rate (4)
  
Average
Balance (1)
  
Interest (2)
  
Yield/
Rate (4)
 
ASSETS (dollars in thousands) 
Loans $621,177  $7,702   4.92% $609,096  $7,346   4.80%
Loans held for sale (“LHFS”)  3,117   40   5.09%  10,384   133   5.10%
AFS securities  5,853   26   1.76%  -   -   - 
HTM securities  62,249   304   1.94%  73,872   280   1.51%
Other interest-earning assets (3)  46,825   106   0.90%  14,134   16   0.45%
Restricted stock investments, at cost  4,676   61   5.18%  5,885   67   4.53%
Total interest-earning assets  743,897   8,239   4.39%  713,371   7,842   4.37%
Allowance  (8,383)          (8,808)        
Cash and other noninterest-earning assets  56,589           71,805         
Total assets $792,103   8,239      $776,368   7,842     
                         
LIABILITIES AND STOCKHOLDERS’ EQUITY                     
Interest-bearing deposits:                        
Checking and savings $287,299   89   0.12% $271,003   154   0.23%
Certificates of deposit  214,282   922   1.71%  221,778   865   1.55%
Total interest-bearing deposits  501,581   1,011   0.80%  492,781   1,019   0.82%
Borrowings  113,719   897   3.13%  141,537   1,106   3.11%
Total interest-bearing liabilities  615,300   1,908   1.23%  634,318   2,125   1.33%
Noninterest-bearing deposits  86,437           39,685         
Other noninterest-bearing liabilities  2,665           4,530         
Stockholders’ equity  87,701           97,835         
Total liabilities and stockholders’ equity $792,103   1,908      $776,368   2,125     
Net interest income/net interest spread  $6,331   3.16%     $5,717   3.04%
Net interest margin          3.38%          3.19%
(1)Nonaccrual loans are included in average loans.
(2)There are no tax equivalency adjustments.
(3)Other interest-earning assets include interest-earning deposits and federal funds sold
(4)Annualized
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  Nine Months Ended September 30, 
  2017  2016 
  
Average
Balance (1)
  
Interest (2)
  
Yield/
Rate (4)
  
Average
Balance (1)
  
Interest (2)
  
Yield/
Rate (4)
 
ASSETS (dollars in thousands) 
Loans $613,833  $22,105   4.81% $607,113  $21,561   4.74%
LHFS  3,690   162   5.87%  7,570   286   5.05%
AFS securities  4,984   71   1.90%  -   -   - 
HTM securities  61,705   856   1.85%  71,253   890   1.67%
Other interest-earning assets (3)  49,353   317   0.86%  26,479   50   0.25%
Restricted stock investments, at cost  4,791   181   5.05%  5,573   201   4.82%
Total interest-earning assets  738,356   23,692   4.29%  717,988   22,988   4.28%
Allowance  (8,687)          (8,857)        
Cash and other noninterest-earning assets  61,758           69,151         
Total assets $791,427   23,692      $778,282   22,988     
                         
LIABILITIES AND STOCKHOLDERS’ EQUITY                     
Interest-bearing deposits:                        
Checking and savings $282,649   618   0.29% $290,518   481   0.22%
Certificates of deposit  215,499   2,306   1.43%  220,337   2,521   1.53%
Total interest-bearing deposits  498,148   2,924   0.78%  510,855   3,002   0.78%
Borrowings  116,539   2,844   3.26%  134,546   3,493   3.47%
Total interest-bearing liabilities  614,687   5,768   1.25%  645,401   6,495   1.34%
Noninterest-bearing deposits  85,928           36,725         
Other noninterest-bearing liabilities  2,624           4,559         
Stockholders’ equity  88,188           91,597         
Total liabilities and stockholders’ equity $791,427   5,768      $778,282   6,495     
Net interest income/net interest spread  $17,924   3.04%     $16,493   2.94%
Net interest margin          3.25%          3.07%

(1)Nonaccrual loans are included in average loans.
(2)There are no tax equivalency adjustments.
(3)Other interest-earning assets include interest-earning deposits and federal funds sold
(4)Annualized

The “Rate/Volume Analysis” below indicates the changes in our net interest income as a result of changes in volume and rates. We maintain an asset and liability management policy designed to provide a proper balance between rate-sensitive assets and rate-sensitive liabilities to attempt to optimize interest margins while providing adequate liquidity for our anticipated needs.  Changes in interest income and interest expense that result from variances in both volume and rates have been allocated to rate and volume changes in proportion to the absolute dollar amounts of the change in each.
  Three Months Ended September 30, 2017 vs. 2016  Nine Months Ended September 30, 2017 vs. 2016 
  Due to Variances in  Due to Variances in 
  Rate  Volume  Total  Rate  Volume  Total 
Interest earned on: (dollars in thousands) 
Loans $169  $187  $356  $312  $232  $544 
LHFS  -   (93)  (93)  65   (189)  (124)
AFS securities  -   26   26   -   71   71 
HTM Securities  240   (216)  24   109   (143)  (34)
Other interest-earning assets  28   62   90   196   71   267 
Restricted stock investments, at cost  39   (45)  (6)  14   (34)  (20)
Total interest income  476   (79)  397   696   8   704 
                         
Interest paid on:                        
Interest-bearing deposits:                        
Checking and savings  (123)  58   (65)  158   (21)  137 
Certificates of deposit  217   (160)  57   (160)  (55)  (215)
Total interest-bearing deposits  94   (102)  (8)  (2)  (76)  (78)
Borrowings  53   (262)  (209)  (199)  (450)  (649)
Total interest expense  147   (364)  (217)  (201)  (526)  (727)
Net interest income $329  $285  $614  $897  $534  $1,431 
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Provision for Loan Losses

Our loan portfolio is subject to varying degrees of credit risk and an allowance for loan lossesAllowance is maintained to absorb losses inherent in itsour loan portfolio.  Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what Bancorpwe determined it was worth at the time of the granting of the loan.  Bancorp monitors itsWe monitor loan delinquencies at least monthly.  All loans that are delinquent and all loans within the various categories of Bancorp’sour portfolio as a group are evaluated.  Bancorp’s Board,Management, with the advice and recommendation of Bancorp’s management,the Company’s Board of Directors, estimates an allowanceAllowance to be set aside for loan losses.  Included in determining the calculation are such factors as historical losses for each loan portfolio, current market value of the loan’s underlying collateral, inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectability.  As a result of our Allowance analysis, during the nine months ended September 30, 2017, we determined that a provision reversal of  $650,000 was appropriate.

TheSee additional information about the provision for loan losses increasedunder “Credit Risk Management and the Allowance” later in this Item.

Noninterest Income

Three months ended September 30

Total noninterest income decreased by $497,000, or 26.2%, to $50,000$1.4 million for the three months ended September 30, 2017, compared to $1.9 million for the three months ended September 30, 2016, primarily due to decreased mortgage-banking revenue. Mortgage-banking revenue decreased $708,000, or 67.9%, due to a decreased volume of loans originated through our Internet mortgage platform (“E-Home Finance”) in the third quarter of 20162017 compared to $0 for the third quarter of 2015. The provision for loan losses2016. In 2017, the decision was made to move away from the E-Home Finance purchased lead model and instead focus on internally generated leads.  We have experienced a temporary reduction in volume during this transition. Deposit service charges increased $158,000 due primarily to onboarding fees received on a new deposit product during the three months ended September 30, 2017.  Other noninterest income includes $48,000 in revenue generated by the Title Company after the acquisition on September 1, 2017.

Nine months ended September 30

Total noninterest income decreased by $50,000,$1.8 million, or 25.0%32.6%, to $150,000$3.8 million for the nine months ended September 30, 2017, compared to $5.6 million for the comparable period in 2016, primarily due to decreased real estate commissions and mortgage-banking revenue. Real estate commissions by Hyatt Commercial decreased by $287,000, or 23.0%, to $959,000 for the nine months ended September 30, 2017, compared to $1.2 million for the same period of 2016.  The decrease was due to a decreased volume of commercial sales in the nine months ended September 30, 2017 compared to the same period in 2016.  Mortgage-banking revenue decreased $1.5 million, or 57.3%, to $1.2 million for the nine months ended September 30, 2017, compared to $2.7 million for the comparable period of 2016.  This decrease in activity was the result of a decrease in the volume of loans originated through E-Home Finance in the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 due to the transition from the E-Home Finance purchased lead model to internally generated leads. Deposit service charges increased $160,000 due primarily to onboarding fees received on a new deposit product during the nine months ended September 30, 2017.  Other noninterest income includes $48,000 in revenue generated by the Title Company after the acquisition on September 1, 2017.

Noninterest Expense

Three months ended September 30

Total noninterest expenses decreased $609,000, or 9.9%, to $5.5 million for the three months ended September 30, 2017, compared to $6.1 million for the three months ended September 30, 2016, primarily due to decreases in compensation and related expenses, Federal Deposit Insurance Corporation (“FDIC”) assessments, mortgage leads purchased, and professional fees. Compensation and related expenses decreased by $640,000, or 16.3%, to $3.3 million for the three months ended September 30, 2017, compared to $3.9 million for the three months ended September 30, 2016. This decrease was primarily due to staff reductions. Our FDIC insurance premiums decreased during the third quarter of 2017 as a result of the termination of the formal agreements with the Office of the Comptroller of the Currency (“OCC”) and the Federal Reserve Board (“FRB”) in 2016.  Professional fees decreased by $65,000, or 34.4%, to $124,000 for the three months ended September 30, 2017, compared to $189,000 for the three months ended September 30, 2016, primarily due to decreased fees incurred for consulting. Mortgage leads purchased decreased $157,000 due to the transition away from the E-Home Finance purchased lead model. Partially offsetting the decreases in noninterest expense, on-line charges increased $120,000, credit reports and appraisal fees increased $55,000, and we recorded increased write-downs and incurred increased costs on real estate acquired through foreclosure during the three months ended September 30, 2017 compared to the same period in 2016.

Nine months ended September 30

Total noninterest expenses decreased $1.3 million, or 7.0%, to $17.0 million for the nine months ended September 30, 2017, compared to $18.3 million for the nine months ended September 30, 2016, with decreases in the majority of expense categories.  Compensation and related expenses decreased by $499,000, or 4.4%, to $10.7 million for the nine months ended September 30, 2017, compared to $200,000$11.2 million for the nine months ended September 30, 2016 due to staff reductions. During the nine months ended September 30, 2017, we reversed an over accrual of FDIC assessment expense due to a lower 2017 rate assessment that arose from the termination of the OCC and FRB agreements in 2016. Professional fees decreased by $151,000, or 28.6%, to $377,000 for the nine months ended September 30, 2017, compared to $528,000 for the same period of 2016, primarily due to a decrease in 2015.fees incurred for consulting. Mortgage leads purchased decreased $325,000 due to the transition away from the E-Home Finance purchased lead model.
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Income Tax Provision

We recorded $950,000 and $2.2 million in income tax provisions during the three and nine months ended September 30, 2017, respectively, compared to a tax provision of $378,000 for the three months ended September 30, 2016 and a $10.8 million income tax benefit for the nine months ended September 30, 2016.  We fully released our net deferred tax asset valuation allowance in the first half of 2016.

Financial Condition

Total assets increased $13.8 million to $801.3 million at September 30, 2017, compared to $787.5 million at December 31, 2016.  LHFS decreased $5.4 million, or 52.7%, to $4.9 million at September 30, 2017, compared to $10.3 million at December 31, 2016.  This decrease was due to a lower volume of loan originations, and to a lesser extent, the timing of loans pending sale.  Loans increased $40.7 million, or 6.7%, to $651.0 million at September 30, 2017 from $610.3 million at December 31, 2016 due to increased residential mortgage and commercial real estate originations during 2017.  Total deposits increased $21.5 million, or 3.8%, to $593.5 million at September 30, 2017 compared to $571.9 million at December 31, 2016.  Total borrowings decreased by $10.1 million, or 9.7%, to $93.5 million at September 30, 2017 compared to $103.5 million at December 31, 2016.  The borrowings held at December 31, 2016 began to mature in February of 2017.  To facilitate the funding of the loan growth and the repayment of FHLB advances, cash and cash equivalents decreased by $25.5 million, or 38.0%, to $41.6 million at September 30, 2017, compared to $67.1 million at December 31, 2016.

Securities

We utilize the securities portfolio as part of our overall asset/liability management practices to enhance interest revenue while providing necessary liquidity for the funding of loan growth or deposit withdrawals.  We continually monitor the credit risk associated with investments and diversify the risk in the securities portfolios.  We held $3.1 million in securities classified as AFS as of September 30, 2017.  We held $58.8 million and $62.8 million, respectively, in securities classified as HTM as of September 30, 2017 and December 31, 2016.

Changes in current market conditions, such as interest rates and the economic uncertainties in the mortgage, housing, and banking industries impact the securities market. Quarterly, we review each security in our portfolio to determine the nature of any decline in value and evaluate if any impairment should be classified as OTTI.  For the three and nine months ended September 30, 2017, we determined that no OTTI charges were required.

All of the AFS and HTM securities that are impaired as of September 30, 2017 are so due to declines in fair values resulting from changes in interest rates or decreased credit/liquidity spreads compared to the time they were purchased.  We have the intent to hold these securities to maturity (including those designated as AFS) and it is more likely than not that we will not be required to sell the securities before recovery of value. As such, management considers the impairments to be temporary.

Our AFS securities portfolio consists of United States of America (“U.S.”) government agency notes in the amount of $3.1 million at September 30, 2017, all of which were purchased in 2017.

Our HTM securities portfolio composition is as follows:
  September 30, 2017  December 31, 2016 
  (dollars in thousands) 
U.S. Treasury securities $7,996  $12,998 
U.S. government agency notes  19,008   20,027 
Mortgage-backed securities  31,760   29,732 
  $58,764  $62,757 
LHFS

We originate residential mortgage loans for sale on the secondary market.  At September 30, 2017, such LHFS, which are carried at fair value, amounted to $4.9 million, the majority of which are subject to purchase commitments from investors. The LHFS balance at December 31, 2016 was $10.3 million and was recorded at lower-of-cost or market value (“LCM”).  LHFS decreased by $5.4 million, or 52.7%, compared to December 31, 2016.  This decrease was primarily due to a lower origination volume and the timing of loans pending sale on the secondary market.
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Loans

Our loan portfolio is expected to produce higher yields than investment securities and other interest-earning assets; the absolute volume and mix of loans and the volume and mix of loans as a percentage of total interest-earning assets is an improvementimportant determinant of our net interest margin.

The following table sets forth the composition of our loan portfolio:
  September 30, 2017  December 31, 2016 
  Amount  
Percent
of Total
  Amount  
Percent
of Total
 
  (dollars in thousands) 
Residential Mortgage $289,169   44.4% $257,659   42.2%
Commercial  37,485   5.8%  46,468   7.6%
Commercial real estate  223,167   34.3%  195,710   32.1%
Construction, land acquisition, and development (“ADC”)  84,164   12.9%  90,102   14.8%
Home equity/2nds  15,861   2.4%  19,129   3.1%
Consumer  1,118   0.2%  1,210   0.2%
  $650,964   100.0% $610,278   100.0%
Loans increased by $40.7 million, or 6.7%, to $651.0 million at September 30, 2017, compared to $610.3 million at December 31, 2016.  This increase was due to increased demand and originations of residential mortgages and commercial real estate loans.

Credit Risk Management and the Allowance

Credit risk is the risk of loss arising from the inability of a borrower to meet his or her obligations and entails both general risks, which are inherent in the process of lending, and risks specific to individual borrowers.  Our credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry, or collateral type.

We manage credit risk by evaluating the risk profile of the borrower, repayment sources, the nature of the underlying collateral, and other support given current events, conditions, and expectations.  We attempt to manage the risk characteristics of our loan portfolio through various control processes, such as credit evaluation of borrowers, establishment of lending limits, and application of lending procedures, including the holding of adequate collateral and the maintenance of compensating balances. However, we seek to rely primarily on the cash flow of our borrowers as the principal source of repayment. Although credit policies and evaluation processes are designed to minimize our risk, management recognizes that loan losses will occur and the amount of these losses will fluctuate depending on the risk characteristics of our loan portfolio, as well as general and regional economic conditions.

Management has an established methodology to determine the adequacy of the Allowance that assesses the risks and losses inherent in the loan portfolio quality, a lowerportfolio.  Our Allowance methodology employs management’s assessment as to the level of net charge-offsfuture losses on existing loans based on our internal review of the loan portfolio, including an analysis of the borrowers’ current financial position, and lowerthe consideration of current and anticipated economic conditions and their potential effects on specific borrowers and/or lines of business. In determining our ability to collect certain loans, we also consider the fair value of any underlying collateral. In addition, we evaluate credit risk concentrations, including trends in large dollar exposures to related borrowers, industry and geographic concentrations, and economic and environmental factors.  Our risk management practices are designed to ensure timely identification of changes in loan delinquenciesrisk profiles; however, undetected losses may inherently exist within the loan portfolio. The assessment aspects involved in analyzing the quality of individual loans and assessing collateral values can also contribute to undetected, but probable, losses. For more detailed information about our Allowance methodology and risk rating system, see Note 3 to the Consolidated Financial Statements.
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The following table summarizes the activity in our Allowance by portfolio segment:
  Three Months Ended September 30,  Nine Months Ended September 30, 
  2017  2016  2017  2016 
  (dollars in thousands) 
Allowance, beginning of period $7,718  $8,804  $8,969  $8,758 
Charge-offs:                
Residential mortgage  -   -   (707)  (151)
Commercial  -   -   -   (17)
Commercial real estate  -   -   -   (178)
ADC  -   (72)  -   (72)
Home equity/2nds  -   -   (98)  (28)
Consumer  -   -   -   - 
Total charge-offs  -   (72)  (805)  (446)
Recoveries:                
Residential mortgage  156   137   295   322 
Commercial  -   10   -   43 
Commercial real estate  40   4   100   4 
ADC  -   -   -   100 
Home equity/2nds  22   2   27   4 
Consumer  -   50   -   50 
Total recoveries  218   203   422   523 
Net recoveries (charge offs)  218   131   (383)  77 
Provision for (reversal of) loan losses  -   50   (650)  150 
Allowance, end of period $7,936  $8,985  $7,936  $8,985 
Loans:                
Period-end balance $650,964  $612,458  $650,964  $612,458 
Average balance during period  621,177   609,096   613,833   607,113 
Allowance as a percentage of period-end loan balance  1.22%  1.47%  1.22%  1.47%
Percent of average loans (annualized):                
Provision for (reversal of) loan losses  -   0.03%  (0.14)%  0.03%
Net recoveries (charge offs)  0.14%  0.09%  (0.08)%  0.02%

The following table summarizes our allocation of the Allowance by loan segment:
  September 30, 2017  December 31, 2016 
  Amount  
Percent
of Total
  
Percent
of Loans
to Total
Loans
  Amount  
Percent
of Total
  
Percent
of Loans
to Total
Loans
 
  (dollars in thousands) 
Residential mortgage $3,422   43.1%  44.4% $3,833   42.7%  42.2%
Commercial  442   5.6%  5.8%  478   5.3%  7.6%
Commercial real estate  2,567   32.3%  34.3%  2,535   28.3%  32.1%
ADC  1,142   14.4%  12.9%  1,390   15.5%  14.8%
Home equity/2nds  361   4.6%  2.4%  728   8.1%  3.1%
Consumer  2   -   0.2%  5   0.1%  0.2%
Total $7,936   100.0%  100.0% $8,969   100.0%  100.0%

Based upon management’s evaluation, provisions are made to maintain the Allowance as a best estimate of inherent losses within the portfolio. The Allowance totaled $7.9 million at September 30, 2017 and $9.0 million at December 31, 2016.  Any changes in the Allowance from period to period reflect management’s ongoing application of its methodologies to establish the Allowance, which, for the nine months ended September 30, 2017, resulted in decreased allocated Allowances for most loan segments.  The allocated Allowance for commercial real estate increased over the December 31, 2016 compared to 2015. Additionally, Bancorp experiencedlevel. The changes in the Allowances for the respective loan segments were a higher amountfunction of recoveriesthe changes in 2016 compared to 2015.  Additionally, Bancorp experiencedthe corresponding loan balances and asset quality.
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As a higher amountresult of recoveriesour Allowance analysis, and overall improved asset quality, we released $650,000 from the Allowance during the nine months ended September 30, 2017.  We did not record a provision, nor did we release any Allowance during the three months ended September 30, 2017.  We recorded $50,000 and $150,000, respectively, in 2016 compared to 2015. Recoveries were $203,000 and $523,000provision for losses for the three and nine months ended September 30, 2016, respectively. Comparatively, the2016.  We recorded net recoveries were $229,000of $218,000 and $411,000 fornet charge-offs $383,000, respectively, during the three and nine months ended September 30, 2015. The higher recoveries in 2016 increased the allowance for loan losses and thus lowered the need for additional provisions.
Total non-interest income increased by $246,000, or 16.7%, to $1,715,000 for the third quarter of 2016,2017 compared to $1,469,000 fornet recoveries of $131,000 and $77,000, respectively, during the third quarter of 2015.  Total non-interest income increased by $78,000, or 1.7%, to $4,779,000 forthree months and nine months ended September 30, 2016.  During the nine months ended September 30, 2016,2017, annualized net (charge-offs) recoveries as compared to $4,701,000average loans outstanding amounted to (0.08)%, compared to 0.02% during the first nine months of 2016.  The Allowance as a percentage of outstanding loans decreased from 1.47% as of December 31, 2016 to 1.22% as of September 30, 2017, reflecting the improvement in our overall asset quality.

Although management uses available information to establish the appropriate level of the Allowance, future additions or reductions to the Allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions, and other factors. As a result, our Allowance may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect our operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our Allowance and related methodology. Such agencies may require us to recognize adjustments to the same periodAllowance based on their judgments about information available to them at the time of their examination.  Management believes the Allowance is adequate as of September 30, 2017 and is sufficient to address the credit losses inherent in 2015.the current loan portfolio.

Nonperforming Assets (“NPAs”)

Given the volatility of the real estate market, it is very important for us to have current appraisals on our NPAs. Generally, we obtain appraisals on NPAs annually.  In addition, as part of our asset monitoring activities, we maintain a Loss Mitigation Committee that meets monthly. During these Loss Mitigation Committee meetings, all NPAs and loan delinquencies are reviewed. We also produce an NPA report which is distributed monthly to senior management and is also discussed and reviewed at the Loss Mitigation Committee meetings. This report contains all relevant data on the NPAs, including the latest appraised value and valuation date.  Accordingly, these reports identify which assets will require an updated appraisal. As a result, we have not experienced any internal delays in identifying which loans/credits require appraisals. With respect to the ordering process of the appraisals, we have not experienced any delays in turnaround time nor has this been an issue over the past three years. Furthermore, we have not had any delays in turnaround time or variances thereof in our specific loan operating markets.

NPAs, expressed as a percentage of total assets, totaled 0.93% at September 30, 2017 and 1.37% at December 31, 2016.  The primary reasons for these increasesratio of the Allowance to nonperforming loans was 124.4% at September 30, 2017 and 91.0% at December 31, 2016.  The increase in non-interest income werethis ratio from December 31, 2016 to September 30, 2017 was a reflection of the decrease in nonperforming loans, as well as an increase in total assets.

The distribution of our NPAs is illustrated in the following table.  We did not have any loans greater than 90 days past due and still accruing at September 30, 2017 and December 31, 2016.
  September 30, 2017  December 31, 2016 
Nonaccrual Loans: (dollars in thousands) 
Residential mortgage $4,531  $3,580 
Commercial  84   151 
Commercial real estate  160   2,938 
ADC  318   269 
Home equity/2nds  1,284   2,914 
Consumer  -   - 
   6,377   9,852 
         
Real Estate Acquired Through Foreclosure:        
Residential mortgage  287   393 
Commercial  -   - 
Commercial real estate  601   341 
ADC  216   239 
Home equity/2nds  -   - 
Consumer  -   - 
   1,104   973 
Total Nonperforming Assets $7,481  $10,825 
Nonaccrual loans amounted to $6.4 million, or 1.0% of total loans, at September 30, 2017 and $9.9 million, or 1.6% of total loans, at December 31, 2016.  We added six loans in the amount of $2.6 million to nonaccrual status during 2017.  Of the balance of nonaccrual loans at December 31, 2016, $2.6 million were returned to accrual status, $422,000 were charged off, $515,000 were transferred to real estate commissionsacquired through foreclosure, and management fees, partially offset by a decrease in mortgage banking activities ,  and decreases in the fair values of interest rate lock commitments and mandatory forward contracts entered into by the Bank.  Mortgage banking activities increased $2,000, or 0.2%, to $861,000 for the third quarter of 2016, compared to $859,000 for the third quarter of 2015.  Mortgage banking activities decreased $385,000, or 16.9%, to $1,893,000 for the nine months ended September 30, 2016, compared to $2,278,000 for the same period in 2015.  This decrease was the result of lower mortgage origination production and a decrease in the fair value of mortgage servicing rights.  Real estate commissions increased by $157,000, or 52.7%, to $455,000 for the third quarter of 2016, compared to $298,000 for the third quarter of 2015.  Real estate commissions increased $350,000, or 39.1%, to $1,246,000 for the nine months ended September 30, 2016, compared to $896,000 for the same period in 2015.  The increase in real estate commissions was due to increased commercial sales and leasing activity in 2016 compared to 2015. Real estate management fees increased by $48,000, or 29.0%, to $214,000 for the third quarter of 2016, compared to $166,000 for the third quarter of 2015. Real estate management fees increased $73,000, or 14.9%, to $564,000 for the nine months ended September 30, 2016, compared to $491,000 for the same period in 2015.  These increases$1.7 million were due to a higher level of commercial property under management in 2016 compared to 2015.  Other non-interest income increased $39,000, or 26.7%, to $185,000 for the third quarter of 2016, compared to $146,000 for the third quarter of 2015.  Other non-interest income increased $40,000, or 3.9%, to $1,076,000 for the nine months ended September 30, 2016, compared to $1,036,000 for the same period in 2015.  The primary reason for the third quarter increase was due to the initial reception of income from the investment in the Bancorp’s real estate subsidiary.paid off.
 
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Total non-interest expensesReal estate acquired through foreclosure increased $111,000, or 1.9%, to $5,949,000 for the third quarter of 2016,$131,000 compared to $5,838,000December 31, 2016. The increase in commercial real estate was primarily from one foreclosure in the amount of $515,000.

The activity in our real estate acquired through foreclosure was as follows:
  Three Months Ended September 30,  Nine Months Ended September 30, 
  2017  2016  2017  2016 
  (dollars in thousands) 
Balance at beginning of period $1,015  $1,112  $973  $1,744 
Real estate acquired in satisfaction of loans  188   293   703   1,370 
Write-downs and losses  (99)  (62)  (139)  (149)
Proceeds from sales  -   -   (433)  (1,622)
Balance at end of period $1,104  $1,343  $1,104  $1,343 
TDRs

In situations where, for economic or legal reasons related to a borrower’s financial difficulties, management may grant a concession for other than an insignificant period of time to the third quarterborrower that would not otherwise be considered, the related loan is classified as a TDR.

The composition of 2015.  Total non-interest expenses decreased $298,000, or 1.7%,our TDRs is illustrated in the following table:
  September 30, 2017  December 31, 2016 
Residential mortgage: (dollars in thousands) 
Nonaccrual $2,285  $2,137 
<90 days past due/current  13,086   15,886 
Commercial real estate:        
Nonaccrual  84   249 
<90 days past due/current  1,875   1,914 
ADC:        
Nonaccrual  6   6 
<90 days past due/current  138   170 
Home equity/2nds:        
Nonaccrual  -   - 
<90 days past due/current  230   - 
Consumer        
Nonaccrual  -   - 
<90 days past due/current  87   96 
Totals        
Nonaccrual  2,375   2,392 
<90 days past due/current  15,416   18,066 
  $17,791  $20,458 

See additional information on TDRs in Note 3 to $17,501,000 forthe Consolidated Financial Statements.

Deposits

Deposits were $593.5 million at September 30, 2017 and $571.9 million at December 31, 2016.  During the nine months ended September 30, 2016, compared2017, we obtained significant new noninterest-bearing deposits and interest-bearing checking accounts through a campaign designed to $17,799,000 for the same periodattract deposits in 2015.  Compensation and related expenses increased by $270,000, or 7.2%, to $4,028,000 for the third quartercertain local emerging markets. The decrease in certificates of 2016, compared to $3,758,000 for the third quarter of 2015. The third quarter increasedeposit (“CDs”) was primarily due to an increase in commissions and also, compensation and accrued time off payouts to executive officers who retired or resigned. Compensation and related expenses decreased by $181,000, or 1.6%, to $11,478,000 for the nine months ended September 30, 2016, compared to $11,659,000 for the same period in 2015. This was primarily due to lower commissions paid on lower mortgage banking activities in 2016 compared to 2015. Net occupancy costs increased by $109,000, or 28.9%, to $486,000 for the third quarter of 2016, compared to $377,000 for the third quarter of 2015.  Net occupancy costs increased by $132,000, or 10.5%, to $1,387,000 for the nine months ended September 30, 2016, compared to $1,255,000 for the same period in 2015.  These increases were the result of the timing of maintenance costs in 2016 compared to 2015, partially offset by an increase in rents collected from tenants and the beginning of rent payments for the Severna Park branch.  Legal fees increased by $11,000, or 15.7%, to $81,000 for the third quarter of 2016, compared to $70,000 for the third quarter of 2015.  Legal fees increased $18,000, or 9.0%, to $217,000 for the nine months ended September 30, 2016, compared to $199,000 for the same period in 2015. These variances were primarily due to the timingpayoff of services needed from outside legal firms in 2016 compared to 2015. Expenses on foreclosed real estate decreased by $91,000, or 68.9%, to $41,000 for the third quarter of 2016 compared to $132,000 for the third quarter of 2015. This decrease was due to a recovery of expenses from a former REO property. Expenses on foreclosed real estate increased by $65,000 to $184,000 for the nine months ended September 30, 2016, compared to $119,000 for the same period in 2015.  These increases were primarily due to higher losses and expenses on properties in 2016, compared to 2015. FDIC assessments and regulatory expense decreased by $132,000, or 43.0% to $175,000 for the third quarter of 2016, compared to $307,000 for the third quarter of 2015.  FDIC assessments and regulatory expense decreased by $448,000, or 48.9% to $469,000 for the nine months ended September 30, 2016, compared to $917,000 for the same period in 2015.  These decreases were primarily due to a decrease in the risk-based assessment percentage charged by the FDIC due to Bancorp’s release from its regulatory agreements.  Professional fees increased by $73,000, or 40.8% to $252,000 for the third quarter of 2016 compared to $179,000 for the third quarter of 2015. This increase was primarily due to higher fees in accounting and consulting expenses in 2016 compared to 2015. Professional fees decreased by $21,000, or 3.1% to $659,000 for the nine months ended September 30, 2016, compared to $680,000 for the same period in 2015.  This decrease was primarily due to a decrease in consulting related fees during the first quarter of 2016.  Advertising increased $46,000, to $134,000 for the third quarter of 2016, compared to $88,000 for the third quarter of 2015.  Advertising increased by $254,000, or 114.9% to $475,000 for the nine months ended September 30, 2016, compared to $221,000 for the same period in 2015.  These increases were primarily due to the advertising campaign associated with the opening of the new branch in Severna Park. Online charges decreased $116,000, or 49.8%, to $117,000 for the third quarter of 2016, compared to $233,000 for the third quarter of 2015.  Online charges decreased by $23,000, or 3.6% to $617,000 for the nine months ended September 30, 2016, compared to $640,000 for the same period in 2015.  These decreases were primarily due to a decrease in the yearly charges from the Bank’s computer processor in 2016 compared to 2015.  Credit report and appraisal fees decreased $22,000, or 12.9%, to $148,000 for the third quarter of 2016, compared to $170,000 for the third quarter of 2015.  Credit report and appraisal fees decreased $166,000, or 25.7% to $480,000 for the nine months ended September 30, 2016, compared to $646,000 for the same period in 2015.  These decreases were primarily due to a lower volume of mortgage banking activity in 2016 versus 2015.  Other non-interest expenses decreased by $37,000, or 7.1%, to $487,000 for the third quarter of 2016 compared to $524,000 for the third quarter of 2015.  Other non-interest expenses increased by $72,000, or 4.9% to $1,535,000 for the nine months ended September 30, 2016, compared to $1,463,000 for the same period in 2015.  The decrease was primarily due to a decrease in the provision for contingent liabilities and the fair value of mandatory contracts for the quarter.  The increase was primarily due to an overall increase in the provision for contingent liabilities and the fair value of mandatory contracts for the nine months ended September 30, 2016.
Income Taxes

There was a $378,000 income tax expense recorded for the third quarter of 2016 compared to a $52,000 tax expense for the third quarter of 2015.  For the nine months ended September 30, 2016, the income tax benefit was $10,816,000 compared to income tax expense of $88,000 for the same period in 2015. The income tax benefit in 2016 was primarily due to the reversal of an $11,837,000 valuation allowance during the second quarter of 2016. The valuation allowance was first recorded against the deferred tax asset in the third quarter of 2013.

In assessing the Bancorp’s ability to realize its net deferred tax asset, Management considers whether it is more likely than not that some portion or all of the net deferred tax asset will or will not be realized.  Bancorp’s ultimate realization of the net deferred tax asset is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible.  Management considers the nature and amount of historical and projected future taxable income, the scheduled reversal of deferred tax assets and liabilities, and available tax planning strategies in making this assessment.  The amount of net deferred taxes recognized could be impacted by changes to any of these variables.
Bancorp has now concluded that, as of September 30, 2016, it is more likely than not that it will generate sufficient taxable income within the applicable carry-forward periods to realize its net deferred tax asset. The Bancorp’s net deferred tax asset was $10,916,000 as of September 30, 2016 and is included in the other assets category within the financial statements.regularly maturing CDs.
 
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Analysis of Financial ConditionThe deposit breakdown is as follows:
  September 30, 2017  December 31, 2016 
  Balance  
Percent
of Total
  Balance  
Percent
of Total
 
  (dollars in thousands) 
Checking and savings $261,581   44.1% $239,985   41.9%
Certificates of deposit  260,396   43.9%  273,816   47.9%
Total interest-bearing deposits  521,977   88.0%  513,801   89.8%
Noninterest-bearing deposits  71,515   12.0%  58,145   10.2%
Total deposits $593,492   100.0% $571,946   100.0%

Borrowings

Total assets increased $15,677,000, or 2.1%, to $777,756,000 at September 30, 2016, compared to $762,079,000 at December 31, 2015.  Cash and cash equivalents increased by $902,000, or 2.1%, to $44,493,000 at September 30, 2016, compared to $43,591,000 at December 31, 2015.  This increase was primarily due to a higher levelOur borrowings consist of cash and due from banks as a result of a increase in deposits at September 30, 2016 compared to December 31, 2015.  Investment securities decreased 11.1%, or $8,456.000 to $67,677,000 as of September 30, 2016 compared to $76,133,000 as of December 31, 2015. The decrease was due to matured securities not being reinvested and allowed to convert to cash. Loans receivable, net increased $13,817,000, or 2.3%, to $603,473,000 at September 30, 2016, compared to $589,656,000 at December 31, 2015.  This increase was due to a continued higher demand for commercial loans during 2016 compared to 2015.  Loans held for sale decreased $242,000, or 1.8%, to $12,961,000 at September 30, 2016, compared to $13,203,000 at December 31, 2015.  This decrease was primarily due to the timing of loans sold through September 30, 2016 compared to December 31, 2015.  Foreclosed real estate decreased $401,000, or 23.0%, to $1,343,000 at September 30, 2016 compared to $1,744,000 at December 31, 2015. This decrease was the result of additional properties sold and less properties foreclosed on during 2016 compared to 2015.

Total liabilities increased $15,350,000 or 2.3%, to $690,973,000 at September 30, 2016 from $675,623,000 at December 31, 2015.  Total deposits increased $32,839,000, or 6.3%, to $556,610,000 at September 30, 2016 compared to $523,771,000 at December 31, 2015.  This increase was primarily due to an increase in deposits from commercial relationships.  Long-term and short-term borrowings decreased by $4,500,000, or 3.9%, to $110,500,000 at September 30, 2016 compared to $115,000,000 at December 31, 2015.  The decrease was due to the payoff of a $15,000,000 advance net of a $3,500,000 loan and an additional $7,000,000 in short-term borrowings.  Accrued interest payable and other liabilities decreased $9,489,000, or 74.5%, to $3,244,000 at September 30, 2016 compared to $12,733,000 at December 31, 2015.  This decrease was due to the payment of the TARP and Trust Preferred accruals for dividends and interest.

Stockholders’ Equity

Total stockholders’ equity increased $327,000 to $86,783,000 at September 30, 2016 compared to $86,456,000 as of December 31, 2015.  This increase was primarily a result of Bancorp raising $10,510,000 of new common equity by entering into subscription agreements with various purchasers under which it issued a total of 2,015,500 shares of its common stock at a price of $5.50 per share, and net income for the nine months ended September 30, 2016, which was offset by the redemption of $23,400,000 of Series B Preferred Stock.

Liquidity and Capital Resources

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

In assessing its liquidity, the management of Bancorp considers operating requirements, anticipated deposit flows, expected funding of loans, deposit maturities and borrowing availability, so that sufficient funds may be available on short notice to meet obligations as they arise or to permit Bancorp to take advantage of business opportunities.

Management believes Bancorp has sufficient cash flow and liquidity to meet its current commitments through the next 12 months.  Certificates of deposit, which are scheduled to mature in less than one year, totaled $177,473,000 at September 30, 2016.  Based on past experience, management believes that a significant portion of such deposits will remain with Bancorp. At September 30, 2016, Bancorp had commitments to originate mortgage loans of $7,665,000, unadvanced home equity lines of credit of $7,804,000, unadvanced construction commitments of $17,400,000, unused lines of credit of $34,716,000 and commitments under standby letters of credit of $4,316,000.  Bancorp has the ability to reduce its commitments for new loan originations, adjust other cash outflows, and borrow from FHLB Atlanta should the need arise.  As of September 30, 2016, outstanding FHLB Atlanta borrowings totaled $107,000,000, and Bancorp had available to it an additional $130,043,000 in borrowing availability from FHLB Atlanta.
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Net cash provided by operating activities was $1,900,000 for the nine months ended September 30, 2016, compared to net cash provided by operating activities in the amount of $294,000 for the same period in 2015, an increase in cash provided by operating activities of $1,606,000. This change was primarily the result of an increase in net income and lower origination volume of loans held for sale into the secondary market. Net cash used in investing activities was $5,033,000 for the nine months ended September 30, 2016, compared to $28,864,000 of net cash provided by investing activities for the same period in 2015, a decrease in cash provided by investing of $33,897,000.  This change was primarily due to a net increase in loans receivable of $58,864,000 offset by a decrease in the purchase of investment securities that totaled $20,637,000.  Net cash provided by financing activities increased $11,107,000 to $4,035,000 for the nine months ended September 30, 2016, compared to $7,072,000 net cash used in financing activities for the same period in 2015.  This increase was primarily due to net proceeds receivedadvances from the issuance of common stock in 2016FHLB and an increase in customer deposits, partially offset by the redemption of $23,393,000 of Series B Preferred Stock and dividends paid on Preferred Stock in the amount of $7,472,000.

Federal Home Loan Bank of Atlanta Line of Credita term loan from a commercial bank.

The Bank has anFHLB advances are available lineunder a specific collateral pledge and security agreement, which requires that we maintain collateral for all of credit, secured by various loans in its portfolio, in the amountour borrowings equal to 30% of twenty five percent of its total assets, withassets.  Our advances from the FHLB Atlanta.  As of September 30, 2016, the total available line of credit with the FHLB Atlanta was approximately $237,043,000, of which $107,000,000 was outstandingmay be in the form of short-term or long-term obligations. Short-term advances have maturities for one year or less and short-term borrowings.may contain prepayment penalties. Long-term borrowings through the FHLB have original maturities up to 15 years and generally contain prepayment penalties.

At September 30, 2017, our total credit line with the FHLB was $231.7 million. The Bank, from time to time, utilizes the line of credit when interest rates are more favorable than obtaining deposits from the public.

The following table sets forth information concerning the interest rates and maturity dates of the advances from the  Our outstanding FHLB Atlanta as ofadvance balance at September 30, 2017 and December 31, 2016 (dollars in thousands):was $90.0 million and $100.0 million, respectively.
Principal Amount  Rate  Maturity 
$7,000   0.36%  2016 
 70,000  2.43% to 4.05%   2017 
 15,000  2.58% to 3.43%   2018 
 15,000   4.00%   2019 
$107,000         

Notes Payable
On September 30, 2016, the Bancorpwe entered into a loan agreement with a commercial bank whereby the Bancorpwe borrowed $3,500,000 for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Bancorp,Company, converts to either (1) floating rate of the Wall Street Journal Prime plus .50%50 basis points or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing Federal Home Loan BankFHLB rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If the Bancorp electswe elect the 5 year fixed rate of 275 basis points over the Federal Home Loan BankFHLB rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth, and fifth years of the FHLB Rate Period. The BancorpWe may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period.
The following table sets forth information concerning the interest rates and maturity dates of the advances from the FHLB as of September 30, 2017:
 
Principal
Amount (in thousands)
  Rate  Maturity 
$24,950  1.21% to 4.05%  2017 
 15,000  2.58% to 3.43%  2018 
 35,000  1.55% to 4.00%  2019 
 15,000  1.75%  2020 
$89,950        

Subordinated Debentures

As of both September 30, 2017 and December 31, 2016, Bancorpthe Company had outstanding $20,619,000$20.6 million in principal amount of Junior Subordinated Debt Securities, Duedue in 2035 (the “2035 Debentures”).  The 2035 Debentures were issued pursuant to an Indenture dated as of December 17, 2004 (the “2035 Indenture”) between Bancorpthe Company and Wells Fargo Bank, National Association as Trustee.  The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.63% as of September 30, 2016) plus 200 basis points, and mature on January 7, 2035.  Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of Bancorp,the Company, as defined in the 2035 Indenture.  The 2035 Debentures became redeemable, in whole or in part, by Bancorpthe Company on January 7, 2010.
 
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The 2035 Debentures were issued and sold to Severn Capital Trust I (the “Trust”), of which 100% of the common equity is owned by Bancorp.the Company.  The Trust was formed for the purpose of issuing corporation-obligated mandatorily redeemable Capital Securities (“Capital Securities”) to third-party investors and using the proceeds from the sale of such Capital Securities to purchase the 2035 Debentures.  The 2035 Debentures held by the Trust are the sole assets of the Trust.  Distributions on the Capital Securities issued by the Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Trust on the 2035 Debentures.  The Capital Securities are subject to mandatory redemption, in whole or in part, upon repayment of the 2035 Debentures.   Bancorp hasWe have entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee.

Under the terms of the 2035 Indenture, Bancorp isDebenture, we are permitted to defer the payment of interest on the 2035 Debentures for up to 20 consecutive quarterly periods, provided that no event of default has occurred and is continuing.  AtAs of December 31, 2015, the 2035 Debenturewe had deferred the payment of fifteen quarters of interest and the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $1,863,000.  During the secondthird quarter of 2016, the Bancorpwe paid all of the deferred interest and as of September 30, 2016, Bancorp is2017, we were current on all interest due on the 2035 Debenture.

UnderCapital Resources

Total stockholders’ equity increased $4.1 million to $92.0 million at September 30, 2017 compared to $87.9 million as of December 31, 2016.  The increase was principally the termsresult of Bancorp’s 2035 Indenture, if Bancorp defers payments2017 net income and stock issuance related to the purchase of interest on the 2035 Debentures, Bancorp may not, among other things, declare or pay any dividends or distributions on, or redeem, purchase, acquire, or make a liquidation payment with respect to, any of its capital stock, including common stock until all such deferred interest has been paid.Title Company.

Series A Preferred Stock

On November 15, 2008, Bancorpthe Company completed a private placement offering consisting of a total of 70 units, at an offering price of $100,000 per unit, for gross proceeds of $7.0 million.$7,000,000. Each unit consists of 6,250 shares of Bancorp'sthe Company’s Series A 8.0% Non-Cumulative Convertible Preferred Stock and Bancorp's Subordinated Note in the original principal amount of $50,000. In the aggregate, the Series A Preferred Stock totaled $3.5 million and the Subordinated Note totaled $3.5 million.

On September 30, 2016 the aggregate principal amount of Subordinated Notes outstanding at was $3,500,000 was paid in full.  The Subordinated Notes earned interest at an annual rate of 8.0%, payable quarterly in arrears on the last day of March, June, September and December which commenced December 31, 2008.  The Subordinated Notes were redeemable in whole or in part at the option of Bancorp at any time beginning on December 31, 2009 until maturity, which is December 31, 2018.  Debt issuance costs totaled $245,000 and were taken back into income.  Interest payments on the Subordinated Notes were current as of September 30, 2016. On September 30, 2016, the Bancorp exercised its option to redeem the full amount of the Subordinated Note.

Common Stock
In April 2016, Bancorp issued a total of 2,015,500 shares of its common stock at a price of $5.50 per share to various purchasers in a private placement exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and Regulation D of the rules and regulations promulgated thereunder.  The offering resulted in gross proceeds of approximately $11,085,000.  Costs related to the issuance of the common stock totaled approximately $575,000 and were netted against the proceeds.  Proceeds from the private placement were used in part to pay all accrued and unpaid interest on 2035 Debentures and Series B Preferred Stock, and dividends on Bancorp’s Series B Preferred Stock, partially redeem its Series B Preferred Stock, and for general corporate and working capital purposes.
Preferred Stock
Bancorp issued a total of 437,500 shares of its Series A 8.0% Non-Cumulative Convertible Preferred Stock (“Series A Preferred Stock”) as part of the private placement offering completed on November 15, 2008.  The liquidation preference is $8.00 per share.  Each share of Series A Preferred Stock is convertible at the option of the holder into one share of Bancorp’s common stock, subject to adjustment upon certain corporate events. The initial conversion rate is equivalent to an initial conversion price of $8.00 per share of Bancorp’s common stock. At the option of Bancorp, on and after December 31, 2013, at any time and from time to time, some or all of the Series A Preferred Stock may be converted into shares of Bancorp’s common stock at the then-applicable conversion rate.  Costs related to the issuance of the preferred stock totaled $247,000 and were netted against the proceeds.
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If declared by Bancorp's board of directors, cash dividends at an annual rate of 8.0% will be paid quarterly in arrears on the last day of March, June, September and December commencing December 31, 2008.Stock. Dividends will not be paid on Bancorp’sour common stock in any quarter until the dividend on the Series A Preferred Stock has been paid for such quarter; however, there is no requirement that Bancorp's boardour Board of directorsDirectors declare any dividends on the Series A Preferred Stock and any unpaid dividends shallare not be cumulative.  On June 30, 2016 and September 30, 2016, the Bancorp declared and paid dividends on the

Series AB Preferred Stock in the amount of $70,000 each.  Prior to that, Bancorp had not paid a dividend on the Series A Preferred Stock since the first quarter of 2012.

On November 21, 2008, Bancorpwe entered into an agreement with the United States Department of the Treasury (“Treasury”), pursuant to which Bancorpwe issued and sold (i) 23,393 shares of itsour Series B Fixed Rate Cumulative Perpetual Preferred Stock par value $0.01 per share and liquidation preference $1,000 per share, (the “Series B (“Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 556,976 shares of Bancorp’sthe Company’s common stock, par value $0.01 per share, for an aggregate purchase priceshare.  As of $23,393,000.  Costs related toDecember 31, 2016, the issuanceCompany had redeemed all outstanding shares of the preferred stock and warrants totaled $45,000 and were netted againstPreferred Stock. At September 30, 2017 the proceeds.  On September 25, 2013, the Treasury sold all of its 23,393 shares of Series B Preferred Stock to outside investors as part of their ongoing efforts to wind down and recover its remaining investments under the Troubled Asset Relief Program (“TARP’).  The terms of the Series B Preferred Stock remain the same.  The Treasury continues to hold a warrant to purchase 556,976 shares of Bancorp’s common stock.the Warrant.

The Series B Preferred Stock qualified as Tier 1 capital and paid cumulative compounding dividends at a rate of 9% per annum. The Series B Preferred Stock may be redeemed by Bancorp. On May 11, 2016, Bancorp redeemed 10,000 shares of the Series B Preferred Stock for a payment of $10,000,000 and on September 8, 2016, the Bancorp redeemed the remaining 13,393 shares for $13,393,000.

On April 15, 2016, Bancorp paid all unpaid cumulative dividends and interest in arrears on the Series B Preferred Stock totaling $7,590,000.  On May 11, 2016, Bancorp declared and paid a dividend of $326,000 on the Series B Preferred Stock, on August 11, 2016 it declared and paid a dividend of $326,000 and on September 8, 2016 a final dividend of $77,000 was paid.

The Series B Preferred Stock had no maturity date and ranked pari passu with Bancorp’s existing Series A Preferred Stock, in terms of dividend payments and distributions upon liquidation, dissolution and winding up of Bancorp.

The Series B Preferred Stock was non-voting, other than class voting rights on certain matters that could adversely affect the Series B Preferred Stock. If dividends on the Series B Preferred Stock were not paid for an aggregate of six quarterly dividend periods or more, whether consecutive or not, Bancorp’s authorized number of directors would be automatically increased by two and the holders of the Series B Preferred Stock, voting together with holders of any then outstanding voting parity stock, would have the right to elect those directors at Bancorp’s next annual meeting of stockholders or at a special meeting of stockholders called for that purpose. These preferred share directors would be elected annually and serve until all accrued and unpaid dividends on the Series B Preferred Stock have been paid.  In connection with the sale by the Treasury of the Series B Preferred Stock, the Federal Reserve obtained waivers from the outside investors who purchased the Series B Preferred Stock in which such investors agreed not to exercise their right to elect directors, and certain other voting or control rights, without the prior approval of the Federal Reserve.
The Warrant has a 10-year term and is immediately exercisable at an exercise price of $6.30 per share of Common Stock.  The exercise price and number of shares subject to the Warrant are both subject to anti-dilution adjustments.  Pursuant to the Purchase Agreement, Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant. The warrant expires November 11, 2018.

Capital Adequacy

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. As of September 30, 2017 and December 31, 2016, the Bank exceeded all capital adequacy requirements to which it is subject and meets the qualifications to be considered “well capitalized.”  See details of our capital ratios in Note 4 of the Consolidated Financial Statements.

Liquidity

Liquidity describes our ability to meet financial obligations, including lending commitments and contingencies, which arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers, to fund the operations of our mortgage-banking business, as well as to meet current and planned expenditures. These cash requirements are met on a daily basis through the inflow of deposit funds, the maintenance of short-term overnight investments, maturities and calls in our securities portfolio, and available lines of credit with the FHLB, which requires pledged collateral. Fluctuations in deposit and short-term borrowing balances may be influenced by the interest rates paid, general consumer confidence, and the overall economic environment. There can be no assurances that deposit withdrawals and loan fundings will not exceed all available sources of liquidity on a short-term basis. Such a situation would have an adverse effect on our ability to originate new loans and maintain reasonable loan and deposit interest rates, which would negatively impact earnings.
 
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Bancorp’sOur principal sources of liquidity are loan repayments, maturing investments, deposits, borrowed funds, and proceeds from loans sold on the secondary market. The levels of such sources are dependent on the Bank’s operating, financing, and investing activities at any given time.  We consider core deposits stable funding sources and include all deposits, except time deposits of $100,000 or more.  The Bank’s experience has been that a substantial portion of certificates of deposit renew at time of maturity and remain on deposit with the Bank.  Additionally, loan payments, maturities, deposit growth, and earnings contribute to our flow of funds.

In addition to our ability to declaregenerate deposits, we have external sources of funds, which may be drawn upon when desired.  The primary source of external liquidity is an available line of credit with the FHLB.  The Bank’s total credit availability under the FHLB’s credit availability program was $231.7 million at September 30, 2017, of which $90.0 million was outstanding.

The borrowing requirements of customers include commitments to extend credit and the unused portion of lines of credit (collectively “commitments”), which totaled $101.4 million at September 30, 2017. Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements. As of September 30, 2017, we had $72.0 million in unadvanced construction commitments, which we expect to fund from the sources of liquidity described above.  These amounts do not include undisbursed lines of credit, home equity lines of credit, and standby letters of credit, in the aggregate amount of $29.2 million at September 30, 2017, which we anticipate we will be able to fund, if required, from these liquidity sources in the regular course of business.

Customer withdrawals are also a principal use of liquidity, but are generally mitigated by growth in customer funding sources, such as deposits and short-term borrowings.

In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on its common stock is limitedliquidity.  As of September 30, 2017, we had no material commitments for capital expenditures.

Our ability to acquire deposits or borrow could be impaired by factors that are not specific to us, such as a severe disruption of the terms of Bancorp’s Series A Preferred Stockfinancial markets or negative views and Series B Preferred Stock.  Bancorp may not declare or pay any dividend on, make any distributions relatingexpectations about the prospects for the financial services industry as a whole.  At September 30, 2017, management considered the Company’s liquidity level to or redeem, purchase, acquire or make a liquidation payment relating to, or make any guarantee payment with respect to its common stock in any quarter until the dividend on the Series A Preferred Stock has been declared and paid for such quarter, subject to certain minor exceptions.  Additionally Bancorp may not declare or pay any dividend or distribution on its common stock, and Bancorp may not purchase, redeem or otherwise acquire for consideration any of its common stock, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Series B Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sumbe sufficient for the payment thereof has been set aside), subjectpurposes of meeting our cash flow requirements.  We are not aware of any undisclosed known trends, demands, commitments, or uncertainties that are reasonably likely to certain minor exceptions.result in material changes in our liquidity.

We anticipate that our primary sources of liquidity over the next twelve months will be from loan repayments, maturing investments, deposit growth, and borrowed funds. We believe that these sources of liquidity will be sufficient for us to meet our liquidity needs over the next twelve months.

Off-Balance Sheet Arrangements and Derivatives

For information concerningWe enter into off-balance sheet arrangements see Note 10in the normal course of business. These arrangements consist primarily of commitments to extend credit, lines of credit, and letters of credit. In addition, we have certain operating lease obligations.

Credit Commitments

Credit commitments are agreements to lend to a customer as long as there is no violation of any condition to the unaudited Consolidated Financial Statementscontract. Loan commitments generally have interest rates fixed at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party.

EffectsOur exposure to credit loss in the event of nonperformance by the borrower is the contract amount of the commitment. Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. We are not aware of any accounting loss we would incur by funding our commitments.

See detailed information on credit commitments above under “Liquidity.”

Derivatives

We maintain and account for derivatives, in the form of interest-rate lock commitments (“IRLCs”) , mandatory forward contracts, and best effort forward contracts, in accordance with the Financial Accounting Standards Board guidance on accounting for derivative instruments and hedging activities.  We recognize gains and losses on IRLCs, mandatory forward contracts, and best effort forward contracts on the loan pipeline through mortgage-banking revenue in the Consolidated Statements of Operations.
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IRLCs on mortgage loans that we intend to sell in the secondary market are considered derivatives. We are exposed to price risk from the time a mortgage loan closes until the time the loan is sold.  The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 14 days to 60 days. For these IRLCs, we attempt to protect the Bank from changes in interest rates through the use of best efforts and mandatory forward contracts.

Information pertaining to the carrying amounts of our derivative financial instruments follows:
  September 30, 2017  December 31, 2016 
  
Notional
Amount
  
Estimated
Fair Value
  
Notional
Amount
  
Estimated
Fair Value
 
  (dollars in thousands) 
Asset - IRLCs $2,329  $42  $9,725  $162 
Asset - Mandatory forward contracts  4,731   7   10,302   153 
Asset - Best effort forward contracts  2,329   6   -   - 
Inflation

The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of AmericaU.S. and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation.  Unlike industrial companies,As a financial institution, virtually all of theour assets and liabilities of a financial institution are monetary in nature.  As a result,nature and interest rates have a more significant impact on a financial institution’sour performance than the effects of general levels of inflation.  A prolonged period of inflation could cause interest rates, wages, and other costs to increase and could adversely affect our results of operations unless mitigated by a corresponding increase in our revenues. However, we believe that the impact of inflation on our operations was not material in 2017 or 2016.

Average Balance Sheet
Item 3.
Quantitative and Qualitative Disclosures About Market Risk

The following table presents Bancorp’s distributionprincipal objective of the average consolidatedCompany’s interest rate risk management is to evaluate the interest rate risk included in balance sheetssheet accounts, determine the level of risks appropriate given our business strategy, operating environment, capital and liquidity requirements, and performance objectives, and manage the risk consistent with our interest rate risk management policy.  Through this management, we seek to reduce the vulnerability of our operations to changes in interest rates.  The Board of Directors of the Company is responsible for reviewing our asset/liability policy and interest rate risk position. The Board of Directors reviews the interest rate risk position on a quarterly basis and, in connection with this review, evaluates the Company’s business activities and strategies, the effect of those strategies on the Company’s net interest analysis formargin and the nine months endedeffect that changes in interest rates will have on the loan portfolio.  While continuous movement of interest rates is certain, the extent and timing of these movements is not always predictable.  Any movement in interest rates has an effect on our profitability.   We face the risk that rising interest rates could cause the cost of interest-bearing liabilities, such as deposits and borrowings, to rise faster than the yield on interest-earning assets, such as loans and investments. Our interest rate spread and interest rate margin also may be negatively impacted in a declining interest rate environment even though we generally borrow at short-term interest rates and lend 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. Our 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.

Our primary strategy to control interest rate risk is to strive to balance our loan origination activities with the interest rate market. We attempt to maintain a substantial portion of our 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. At September 30, 2016 and September 30, 2015:2017, we had a one-year cumulative negative gap of approximately $159.2 million.
 
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  Nine Months Ended September 30, 2016  Nine Months Ended September 30, 2015 
  
Average
Volume
  
Interest
  
Annualized
Yield/Cost
  
Average
Volume
  
Interest
  
Annualized
Yield/Cost
 
  (dollars in thousands) 
ASSETS                  
Loans (1) $612,220  $21,847   4.76% $624,301  $22,541   4.81%
Held to maturity securities (2)  73,429   890   1.62%  65,537   788   1.60%
Other interest-earning assets (3)  9,155   251   3.66%  11,234   242   2.87%
                         
Total interest-earning assets  694,804   22,988   4.41%  701,072   23,571   4.48%
                         
Non-interest earning assets  80,206           75,278         
                         
Total assets $775,010          $776,350         
                         
LIABILITIES AND STOCKHOLDERS' EQUITY                        
Savings and checking deposits $252,234   465   0.25% $244,449   483   0.26%
Certificates of deposit  282,055   2,537   1.20%  296,849   2,572   1.16%
Borrowings  141,909   3,493   3.32%  139,126   3,673   3.52%
                         
Total interest-bearing liabilities  676,198   6,495   1.28%  680,424   6,728   1.32%
                         
Non-interest bearing liabilities  9,345           13,113         
                         
Stockholders' equity  89,467           82,813         
                         
Total liabilities and stockholders’ equity $775,010          $776,350         
                         
Net interest income and interest rate spread     $16,493   3.13%     $16,843   3.16%
                         
Net interest margin          3.17%          3.20%
                        
Average interest-earning assets to average interest-bearing liabilities       102.75%          103.03%
(1)Non-accrual loans and loans held for sale are included in the average balances and in the computation of yields.
(2)Bancorp does not have any tax-exempt securities.
(3)Other interest-earning assets include interest-earning deposits in other banks, federal funds sold and FHLB stock investments.
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Recent Accounting PronouncementsExposure to interest rate risk is actively monitored by management.  The objective is to maintain a consistent level of profitability within acceptable risk tolerances across a broad range of potential interest rate environments. We use the PROFITstar® model to monitor our exposure to interest rate risk, which calculates changes in the economic value of equity (“EVE”).

For information concerning recent accounting pronouncements, see Note 12The following table represents our EVE as of September 30, 2017:
Change in Rates  Amount  $ Change  % Change 
   (dollars in thousands)    
+400bp $160,130  $(16,836)  -9.51%
+300bp  166,030   (10,936)  -6.18%
+200bp  170,894   (6,072)  -3.43%
+100bp  174,580   (2,386)  -1.35%
0bp  176,966         
-100bp  176,569   (397)  -0.22%
-200bp  169,398   (7,568)  -4.28%
The preceding income simulation analysis does not represent a forecast of actual results and should not be relied upon as being indicative of expected operating results.  These hypothetical estimates are based upon numerous assumptions, which are subject to change, including: the unaudited Consolidated Financial Statements.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Not required for smaller reporting companies.nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others.  Also, as market conditions vary, prepayment/refinancing levels, the varying impact of interest rate changes on caps and floors embedded in adjustable-rate loans, early withdrawal of deposits, changes in product preferences, and other internal/external variables will likely deviate from those assumed.

Item 4.
Controls and Procedures

Disclosure Controls and Procedures

UnderThe Company’s management, under the supervision and with the participation of Bancorp's management, including itsthe Company’s Chief Executive Officer and Chief Financial Officer, Bancorp has evaluated, as of the last day of the period covered by this report, the effectiveness of itsthe design and operation of the Company’s disclosure controls and procedures, as of September 30, 2016.  Disclosure controls and procedures are defined in Rule 13a-15(e)13a-15 under the Securities Exchange Act as those controls and other procedures of an issuer1934. Based on that are designed to ensure that the information required to be disclosed by the issuer in the reports it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.  Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, Bancorp’sCompany’s disclosure controls and procedures were effective.

Changes There were no changes in Internal Control Over Financial Reporting

Bancorp’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of Bancorp’sCompany’s internal controlcontrols over financial reporting as(as defined in ExchangeRule 13a-15 under the Securities Act Rule 13a-15(f), to determine whether any changes occurredof 1934) during the quarterthree months ended September 30, 2016,2017 that have materially affected, or are reasonably likely to materially affect, Bancorp’sthe Company’s internal control over financial reporting.  Based on that evaluation, there were no such changes during the quarter ended September 30, 2016.

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Bancorp have been detected.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II – OTHER INFORMATION

Item 1.
Legal Proceedings

As of September 30, 2016. there are various claims pending involving Bancorp, arising inIn the normal course of business.business, we are party to litigation arising from the banking, financial, and other activities we conduct.  Management, believes, based uponafter consultation with legal counsel, does not anticipate that liabilitiesthe ultimate liability, if any, arising from these proceedings, if any,matters will not behave a material to Bancorp’s consolidatedeffect on the Company’s financial condition, and consolidatedoperating results, or liquidity as of operations.September 30, 2017.
56

Item 1A1A.
Risk Factors

The risk factorsrisks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I “Item 1A. Risk Factors” in ourof the Annual Report on Form 10-K of Severn Bancorp for the fiscal year ended December 31, 2015 should be carefully considered by you. If any2016.  There has been no material change in our risk factors since the filing of the risks actually occur, Bancorp’s business, financial condition or results of operations could be materially and adversely affected.  The risks described in our December 31, 2016 Annual Report on Form 10-K are not the only risks facing Bancorp.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or results of operations.  This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties.  Bancorp’s actual results could differ materially from those anticipated in the forward-looking statements as a result of many factors, including the risks faced by Bancorp described in Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015. There has ben no material change in the risk factors as reported in the Bancorp’s Form 10-K filed with the SEC on March 18, 2016.10-K.

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

None.

Item 3.Defaults Upon Senior Securities

None.

Item 4.Mine Safety Disclosures

Not applicable.

42
Item 5.
Other Information

None.

Item 6.
Exhibits

Exhibit No.
Description
   
31.131.1Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
31.231.2Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
   
3232Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
101101The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10-Q as of September 30, 2016 and December 31, 20152017 and for the three and nine months ended September 30, 2016 and 2015,2017, formatted in XBRL (Extensible Business Reporting Language): (i) Thethe Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Accumulated Comprehensive Income; (iv) the Consolidated Statements of Changes in Stockholders’ Equity; (iv)(v) the Consolidated Statements of Cash Flows; and (v)(vi) the Notes to Consolidated Financial Statements.
 
5743
EXHIBIT INDEX
Exhibit No.
Description
31.1
Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101
The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10-Q as of September 30, 2017 and for the three and nine months ended September 30, 2017, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Accumulated Comprehensive Income; (iv) the Consolidated Statements of Changes in Stockholders’ Equity; (v) the Consolidated Statements of Cash Flows; and (vi) the Notes to Consolidated Financial Statements.
44
SIGNATURES

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

 SEVERN BANCORP, INC. 
   
November 14, 20162017
/s/ Alan J. Hyatt 
 Alan J. Hyatt, Chairman of the Board, President and Chief Executive Officer
 (Principal Executive Officer) 
   
November 14, 20162017
/s/ Paul B. Susie 
 
Paul B. Susie,
Executive Vice President, and Chief Financial Officer 
 (Principal Financial and Accounting Officer) 
 
5845
Table of Contents
Exhibit Index

Exhibit No.
Description
31.1
Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101
The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10-Q as of September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2016 and 2015; (iv) the Consolidated Statements of Cash Flows; and (v) the Notes to Consolidated Financial Statements.
59