Severn Bancorp (SVBI) 10-K 2011 FY Annual report

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Severn Bancorp, Inc.

We have audited the accompanying consolidated statements of financial condition of Severn Bancorp, Inc. and its subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Severn Bancorp, Inc. and its subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.

/s/

Lancaster, Pennsylvania

March 15, 2012

F-1

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in thousands, except per share data)

	December 31,
	2011		2010
ASSETS
Cash and due from banks	$	35,577	$	33,339
Interest bearing deposits in other banks		40,610		20,149
Federal funds sold		11,203		17,467
Cash and cash equivalents		87,390		70,955
Investment securities held to maturity		40,357		27,311
Loans held for sale		4,128		3,426
Loans receivable, net of allowance for loan losses of
$25,938 and $29,871 in 2011 and 2010, respectively		693,303		778,937
Premises and equipment, net		27,218		28,327
Foreclosed real estate		19,932		20,955
Federal Home Loan Bank stock at cost		6,943		7,692
Accrued interest receivable and other assets		21,357		24,940
Total assets	$	900,628	$	962,543
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits	$	652,757	$	714,776
Long-term borrowings		115,000		115,000
Subordinated debentures		24,119		24,119
Accrued interest payable and other liabilities		2,822		2,548
Total Liabilities		794,698		856,443
Stockholders’ Equity
Preferred stock, $0.01 par value, 1,000,000 shares authorized:
Preferred stock series “A”, 437,500 shares issued and outstanding		4		4
Preferred stock series “B”,  23,393 shares issued and outstanding		-		-
Common stock, $0.01 par value, 20,000,000 shares authorized;
10,066,679 shares issued and outstanding		101		101
Additional paid-in capital		74,683		74,352
Retained earnings		31,142		31,643
Total stockholders' equity		105,930		106,100
Total liabilities and stockholders' equity	$	900,628	$	962,543

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

F-2

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

CONSOLIDATED STATEMENTS OF OPERATIONS

(dollars in thousands, except per share data)

	Years Ended December 31,
Interest Income	2011			2010			2009
Loans, including fees	$	43,675		$	49,154		$	52,520
Securities, taxable		617			245			104
Other		209			134			34
Total interest income		44,501			49,533			52,658
Interest Expense
Deposits		10,405			13,735			19,782
Short-term borrowings		-			-			12
Long-term borrowings and subordinated debentures		5,182			5,594			6,257
Total interest expense		15,587			19,329			26,051
Net interest income		28,914			30,204			26,607
Provision for loan losses		4,612			5,744			31,402
Net interest income (loss) after provision for loan losses		24,302			24,460			(4,795	)
Other Income
Mortgage banking activities		576			843			316
Real estate commissions		657			594			690
Real estate management fees		625			573			677
Other		652			735			818
Total other income		2,510			2,745			2,501
Non-Interest Expenses
Compensation and related expenses		10,155			9,583			9,377
Occupancy		1,247			1,466			1,365
Foreclosed real estate expenses, net		5,409			5,518			4,883
Legal		905			1,258			1,003
FDIC assessments and regulatory expense		2,231			2,282			2,156
Other		4,664			4,901			4,078
Total non-interest expenses		24,611			25,008			22,862
Income (loss) before income tax provision (benefit)		2,201			2,197			(25,156	)
Income tax provision (benefit)		982			1,040			(9,928	)
Net income (loss)	$	1,219		$	1,157		$	(15,228	)
Amortization of discount on preferred stock		270			270			270
Dividends on preferred stock		1,450			1,450			1,430
Net loss available to common stockholders	$	(501	)	$	(563	)	$	(16,928	)
Basic loss per share	$	(0.05	)	$	(0.06	)	$	(1.68	)
Diluted loss per share	$	(0.05	)	$	(0.06	)	$	(1.68	)

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

F-3

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years Ended December 31, 2011, 2010, and 2009

(dollars in thousands, except per share data)

	Preferred Stock		Common Stock		Additional Paid-In Capital		Retained Earnings			Total Stockholders’ Equity
Balance - December 31, 2008	$	4	$	101	$	73,522	$	50,040		$	123,667
Comprehensive Loss
Net loss		-		-		-		(15,228	)		(15,228	)
Stock-based compensation		-		-		128		-			128
Dividends on common stock
($.09 per share)		-		-		-		(906	)		(906	)
Dividend declared on Series A
preferred stock ($.64 per share)		-		-		-		(280	)		(280	)
Dividend declared on Series B
preferred stock		-		-		-		(1,150	)		(1,150	)
Amortization of discount on preferred		-		-		-
stock		-		-		270		(270	)		-
Balance - December 31, 2009		4		101		73,920		32,206			106,231
Comprehensive Income
Net income		-		-		-		1,157			1,157
Stock-based compensation		-		-		162		-			162
Dividend declared on Series A
preferred stock ($.64 per share)		-		-		-		(280	)		(280	)
Dividend declared on Series B
preferred stock		-		-		-		(1,170	)		(1,170	)
Amortization of discount on preferred
stock		-		-		270		(270	)		-
Balance - December 31, 2010		4		101		74,352		31,643			106,100
Comprehensive Income
Net income		-		-		-		1,219			1,219
Stock-based compensation		-		-		61		-			61
Dividend declared on Series A
preferred stock ($.64 per share)		-		-		-		(280	)		(280	)
Dividend declared on Series B
preferred stock		-		-		-		(1,170	)		(1,170	)
Amortization of discount on preferred
stock		-		-		270		(270	)		-
Balance - December 31, 2011	$	4	$	101	$	74,683	$	31,142		$	105,930

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

F-4

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

	Years Ended December 31,
	2011			2010			2009
Cash Flows from Operating Activities
Net income (loss)	$	1,219		$	1,157		$	(15,228	)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Amortization of deferred loan fees		(1,344	)		(1,463	)		(2,048	)
Net amortization of premiums and
discounts		170			87			3
Provision for loan losses		4,612			5,744			31,402
Provision for depreciation		1,248			1,238			1,276
Provision for foreclosed real estate		3,562			3,451			3,911
Gain on sale of loans		(575	)		(843	)		(316	)
Loss on sale of foreclosed real estate		639			449			15
Proceeds from loans sold to others		43,276			64,916			29,616
Loans originated for sale		(43,403	)		(62,654	)		(33,692	)
Stock-based compensation expense		61			162			128
Deferred income tax expense (benefit)		931			2,160			(9,194	)
Decrease (increase) in accrued interest receivable and
other assets		2,652			2,890			(8,532	)
Increase (decrease) in accrued interest payable and
other liabilities		274			439			(890	)
Net cash provided by (used in) operating activities		13,322			17,733			(3,549	)
Cash Flows from Investing Activities
Purchase of investment securities held to maturity		(21,530	)		(21,394	)		(7,999	)
Proceeds from maturing investment securities		8,000			2,000			1,000
Principal collected on mortgage-backed securities		314			27			310
Net decrease in loans		66,071			6,879			23,940
Proceeds from sale of foreclosed real estate		13,619			21,286			9,708
Investment in foreclosed real estate		(502	)		(430	)		(413	)
Investment in premises and equipment		(139	)		(461	)		(137	)
Proceeds from disposal of premises and
equipment		-			-			24
Redemption of FHLB stock		749			917			85
Net cash provided by investing activities		66,582			8,824			26,518

F-5

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(dollars in thousands)

	Years Ended December 31,
	2011			2010			2009
Cash Flows from Financing Activities
Net (decrease) increase in deposits	$	(62,019	)	$	4,447		$	26,463
Repayment of borrowed funds, long-term		-			(10,000	)		(28,000	)
Common stock dividends paid		-			-			(906	)
Series “A” preferred stock dividend paid		(280	)		(280	)		(280	)
Series “B” preferred stock dividend paid		(1,170	)		(1,170	)		(1,150	)
Net cash used in financing activities		(63,469	)		(7,003	)		(3,873	)
Increase in cash and cash equivalents		16,435			19,554			19,096
Cash and cash equivalents at beginning of year		70,955			51,401			32,305
Cash and cash equivalents at end of year	$	87,390		$	70,955		$	51,401
Supplemental disclosure of cash flows information:
Cash paid during year for:
Interest	$	15,582		$	19,395		$	26,410
Income taxes	$	476		$	-		$	2,295
Transfer of loans to foreclosed real estate	$	16,295		$	24,137		$	28,478

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

F-6

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies

A.	Principles of Consolidation - The consolidated financial statements include the accounts of Severn Bancorp, Inc. ("Bancorp"), and its wholly-owned subsidiaries, 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. Amounts in the prior year’s consolidated financial statements have been reclassified whenever necessary to conform to the current year’s presentation.  Such reclassifications had no impact on net income.
B.	Business - The Bank's primary business activity is the acceptance of deposits from the general public and the use of the proceeds for investments and loan originations. The Bank is subject to competition from other financial institutions.  In addition, the Bank is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities.
	Bancorp has no reportable segments. Management does not separately allocate expenses, including the cost of funding loan demand, between the retail and real estate operations of Bancorp.  As such, discrete financial information is not available and segment reporting would not be meaningful.
C.	Estimates - The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the period.  Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the fair value of foreclosed real estate, the evaluation of other than temporary impairment of investment securities and the valuation of deferred income tax assets.
D.	Investment Securities Held to Maturity – Investment securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity.  Declines in the fair value of held to maturity securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses.  In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer and (3) determines if the Bank does not intend to sell the security before recovery of its amortized cost.

F-7

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies - Continued

E.	Federal Home Loan Bank Stock – Federal Home Loan Bank of Atlanta (the “FHLB”) stock is an equity interest in the FHLB, which does not have a readily determinable fair value for purposes of generally accepted accounting principles, because its ownership is restricted and it lacks a market.  FHLB stock can be sold back only at par value of $100 per share and only to the FHLB or another member institution.  As of December 31, 2011 and 2010, the Company owned shares totaling $6,943,000 and $7,692,000, respectively. The Company evaluated the FHLB stock for impairment in accordance with generally accepted accounting principles.  The Company’s determination of whether this investment is impaired is based on an assessment of the ultimate recoverability of its cost rather than by recognizing temporary declines in value.  The determination of whether a decline in value affects the ultimate recoverability of its cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB and (3) the impact of legislative and regulatory changes on institutions and accordingly on the customer base of the FHLB.  Management has evaluated the FHLB stock for impairment and believes that no impairment charge is necessary as of December 31, 2011.
F.	Loans Held for Sale - Loans held for sale are carried at lower of cost or market value in the aggregate based on investor quotes.  Net unrealized losses are recognized through a valuation allowance by charges to income.  Mortgage loans held for sale are sold either with the mortgage servicing rights released or retained by the Bank.  Gains and losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.
G.	Loans - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans.  Interest income is accrued on the unpaid principal balance.  Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
	Residential lending is generally considered to involve less risk than other forms of lending, although payment experience on these loans is dependent to some extent on economic and market conditions in the Bank's lending area. Multifamily residential, commercial, construction and other loan repayments are generally dependent on the operations of the related properties or the financial condition of its borrower or guarantor.  Accordingly, repayment of such loans can be more susceptible to adverse conditions in the real estate market and the regional economy. A substantial portion of the Bank's loans receivable is mortgage loans secured by residential and commercial real estate properties located in the State of Maryland.  Loans are extended only after evaluation by management of customers' creditworthiness and other relevant factors on a case-by-case basis. The Bank generally does not lend more than 80% of the appraised value of a property and requires private mortgage insurance on residential mortgages with loan-to-value ratios in excess of 80%.

F-8

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies – Continued

In addition, the Bank generally obtains personal guarantees of repayment from borrowers and/or others for construction, commercial and multifamily residential loans and disburses the proceeds of construction and similar loans only as work progresses on the related projects.

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

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

H. Allowance for Loan Losses - An allowance for loan losses is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based on evaluations of the collectability of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.  Determining the amount of the allowance for loan losses requires the use of estimates and assumptions, which is permitted under generally accepted accounting principles. Actual results could differ significantly from those estimates.  Management believes the allowance for losses on loans is adequate. While management uses available information to estimate losses on loans, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the State of Maryland.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans.  Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.   The allowance consists of specific and general components.  The specific component relates to loans that are classified as impaired.  When a real estate secured loan becomes impaired, a decision is made as to whether an updated certified appraisal of the real estate is necessary.  This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property.  Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value.  The discounts also include estimated costs to sell the property.   For loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices.  Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

F-9

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies - Continued

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 (nonaccural loans); or

· Loans where, based on current information and events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement.

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

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

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

.

.

F-10

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies – Continued

I. Foreclosed Real Estate - Real estate acquired through or in the process of foreclosure is recorded at fair value less estimated disposal costs.  Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using estimates as described under the caption "Allowance for Loan Losses". In the event of a subsequent decline, management provides a specific reserve 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.

J.	Transfers of Financial Assets – Transfers of financial assets, including loan and loan participation sales, are accounted for as sales when control over the assets has been surrendered.  Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from Bancorp, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) Bancorp does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return the specific assets.
K.	Premises and Equipment - Premises and equipment are carried at cost less accumulated depreciation. Depreciation and amortization of premises and equipment is accumulated by the use of the straight-line method over the estimated useful lives of the assets. Additions and improvements are capitalized, and charges for repairs and maintenance are expensed when incurred. The related cost and accumulated depreciation are eliminated from the accounts when an asset is sold or retired and the resultant gain or loss is credited or charged to income.
L.	Statement of Cash Flows - In the statement of cash flows, cash and cash equivalents include cash on hand, amounts due from banks, Federal Home Loan Bank of Atlanta overnight deposits, and federal funds sold.  Generally, federal funds are sold for one day periods.
M.	Income Taxes - Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities based on enacted tax rates expected to be in effect when such amounts are realized or settled. Deferred tax assets are recognized only to the extent that it is more likely than not that such amount will be realized based on consideration of available evidence. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  To the extent that current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established.  The judgment about the level of future taxable income is inherently subjective and is reviewed on a continual basis as regulatory and business factors change. Bancorp recognizes interest and penalties on income taxes as a component of income tax expense.

F-11

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies – Continued

N.

Earnings Per Share - Basic earnings (loss) per share of common stock for the years ended December 31, 2011, 2010 and 2009 is computed by dividing net income (loss) available to common stockholders by 10,066,679, the weighted average number of shares of common stock outstanding for each year. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Potential common shares that may be issued by Bancorp relate to outstanding stock options, warrants, and convertible preferred stock, and are determined using the treasury stock method.  Diluted earnings per share of common stock for the years ended December 31, 2011, 2010 and 2009, is computed by dividing net income (loss) for each year by 10,066,679, the weighted average number of diluted shares of common stock for each year.

O.

Advertising Cost - Advertising cost is expensed as incurred and totaled $510,000,  $422,000 and $370,000 for the years ended December 31, 2011, 2010, and 2009, respectively.

P. Recent Accounting Pronouncements - In January 2011, the FASB issued ASU 2011-1, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No.2010-20 (ASU 2011-1).  The FASB determined that certain provisions relating to troubled debt restructurings (TDRs) should be deferred until additional guidance and clarification on the definition of TDRs is issued.   In April 2011, the FASB issued ASU No. 2011-2, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (ASU 2011-2).  ASU 2011-2 amends ASC Topic 310 – Receivables, by clarifying guidance for creditors in determining whether a concession has been granted and whether a debtor is experiencing financial difficulties.  The amendments are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption.  ASU 2011-2 also makes disclosure requirements deferred under ASU 2011-1 effective for interim and annual periods beginning on or after June 15, 2011.   In June 2011, the FASB issued amendments to ASU No. 2011-2 to clarify the accounting principles applied to loan modifications, as defined by FASB ASC Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors.  The ASU clarifies guidance on a creditor’s evaluation of whether or not a concession has been granted, with an emphasis on evaluating all aspects of the modification rather than a focus on specific criteria, such as the effective interest rate test, to determine a concession.  The ASU goes on to provide guidance on specific types of modifications such as changes in the interest rate of borrowing, and significant delays in payments, as well as guidance on the creditor’s evaluation of whether or not a debtor is experiencing financial difficulty.  The amendments to ASU No. 2011-2 are effective for the first interim or annual periods beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption.  The application of ASU 2011-2, as amended, did not have a material effect on the consolidated financial statements.

F-12

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies - Continued

In June 2011, ASU 2011-4 was issued to amend FASB ASC Topic 820, Fair Value Measurements, to bring U.S. GAAP for fair value measurements in line with International Accounting Standards.  ASU No. 2011-4 clarifies existing guidance for items such as: the application of the highest and best use concept to non-financial assets and liabilities; the application of fair value measurement to financial instruments classified in a reporting entity’s stockholder’s equity; and disclosure requirements regarding quantitative information about unobservable inputs used in the fair value measurements of level 3 assets.  ASU No. 2011-4 also creates an exception to Topic 820 for entities which carry financial instruments within a portfolio or group, under which the entity is now permitted to base the price used for fair valuation upon a price that would be received to sell the net asset position or transfer a net liability position in an orderly transaction.  ASU No. 2011-4 also allows for the application of premiums and discounts in a fair value measurement if the financial instrument is categorized in level 2 or 3 of the fair value hierarchy.  Lastly, ASU 2011-4 contains new disclosure requirements regarding fair value amounts categorized as level 3 in the fair value hierarchy such as: disclosure of the valuation process used; effects of relationships between unobservable inputs; usage of nonfinancial assets for purposes other than their highest and best use when that is the basis of the disclosed fair value; and categorization by level of items disclosed at fair value, but not measured at fair value for financial statement purposes. ASU 2011-4 is effective for interim and annual periods beginning after December 15, 2011.  Bancorp has evaluated the effect of ASU 2011-4, as amended, and believes adoption will not have a material effect on the consolidated financial statements.

In June 2011, ASU 2011-5 was issued to amend FASB ASC Topic 220, Comprehensive Income, to facilitate the continued alignment of U.S. GAAP with International Accounting Standards.  ASU No. 2011-5 prohibits the presentation of components of comprehensive income in the statement of stockholder’s equity.  Reporting entities are allowed to present either: a statement of comprehensive income, which reports both net income and other comprehensive income; or separate, but consecutive, statements of net income and other comprehensive income.  Under previous GAAP, all three presentations were acceptable.  Regardless of the presentation selected, the reporting entity is required to present all reclassifications between other comprehensive and net income on the face of the new statement or statements.  The provisions of ASU No. 2011-5 are effective for fiscal years and interim periods beginning after December 15, 2011. Bancorp has evaluated the effect of ASU 2011-5, as amended, and believes adoption will not have a material effect on the consolidated financial statements.

F-13

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies - Continued

In September 2011, the FASB issued ASU No. 2011-8, Testing Goodwill for Impairment.  The purpose of this ASU is to simplify how entities test goodwill for impairment by adding a new first step to the preexisting goodwill impairment test under ASC Topic 350, Intangibles – Goodwill and Other.  This amendment gives the entity the option to first assess a variety of qualitative factors such as economic conditions, cash flows, and competition to determine whether it was more likely than not that the fair value of goodwill has fallen below its carrying value.  If the entity determines that it is not likely that the fair value has fallen below its carrying value, then the entity will not have to complete the original two-step test under Topic 350.  The amendments in this ASU are effective for impairment tests performed for fiscal years beginning after December 15, 2011.  Early adoption is permitted.  Bancorp has evaluated the effect of ASU 2011-8, as amended, and believes adoption will not have a material effect on the consolidated financial statements.

In December 2011, the FASB issued ASC 2011-10, Derecognition of in Substance Real Estate – a Scope Clarificaiton. This ASU clarifies previous guidance for situations in which a reporting entity would relinquish control of the assets of a subsidiary in order to satisfy the nonrecourse debt of the subsidiary.  The ASU concludes that if control of the assets has been transferred to the lender, but not legal ownership of the assets; then the reporting entity must continue to include the assets of the subsidiary in its consolidated financial statements.  The amendments in the ASU are effective for public entities for annual and interim periods beginning on or after June 15, 2012.  For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2013.  Early adoption is permitted.  Bancorp has evaluated the effect of ASU 2011-10 and believes its application has not had a material effect on the consolidated financial statements.

In December, 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, in an effort to improve comparability between U.S. GAAP and IFRS financial statements with regard to the presentation of offsetting assets and liabilities on the statement of financial position arising from financial and derivative instruments, and repurchase agreements. The ASU establishes additional disclosures presenting the gross amounts of recognized assets and liabilities, offsetting amounts, and the net balance reflected in the statement of financial position. Descriptive information regarding the nature and rights of the offset must also be disclosed when effective. Bancorp has evaluated the effect of ASU 2011-11, and believes adoption will not have a material effect on the consolidated financial statements.

F-14

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Summary of Significant Accounting Policies - Continued

In December, 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-5. In response to stakeholder concerns regarding the operational ramifications of the presentation of these reclassifications for current and previous years, the FASB has deferred the implementation date of this provision to allow time for further consideration. The requirement in ASU 2011-5, Presentation of Comprehensive Income, for the presentation of a combined statement of comprehensive income or separate, but consecutive, statements of net income and other comprehensive income is still effective for fiscal years and interim periods beginning after December 15, 2011 for public companies, and fiscal years ending after December 15, 2011 for nonpublic companies. Bancorp is evaluating the impact of this ASU 2011-12 on its consolidated financial statements.

Q. Subsequent Events – Bancorp has evaluated events and transactions occurring subsequent to December 31, 2011, the date of the consolidated statements of financial condition, for items that should potentially be recognized or disclosed in the consolidated financial statements.  The evaluation was conducted through the date these consolidated financial statements were issued.

R. Concentration of Credit Risk – From time to time, the Bank will maintain balances with its correspondent bank that exceed the $250,000 federally insured deposit limit.  Management routinely evaluates the credit worthiness of the correspondent bank and does not feel they pose a significant risk to Bancorp.

F-15

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Investment Securities

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

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(dollars in thousands)
December 31, 2011:
US Treasury securities	$	34,498	$	1,285	$	(5	)	$	35,778
US Agency securities		5,206		43		(4	)		5,245
US Government sponsored
mortgage-backed securities		653		48		-			701
Total	$	40,357	$	1,376	$	(9	)	$	41,724
December 31, 2010:
US Treasury securities	$	21,104	$	223	$	(2	)	$	21,325
US Agency securities		5,233		-		(37	)		5,196
US Government sponsored
mortgage-backed securities		974		61		-			1,035
Total	$	27,311	$	284	$	(39	)	$	27,556

As of December 31, 2011 and 2010, there were $6,432,000 and $8,760,000, respectively, of US Treasury securities or mortgage-backed securities pledged by Bancorp as collateral for borrowers’ letters of credit with Anne Arundel County.

The following tables show fair value and unrealized losses, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position as of December 31, 2011 and 2010. Included in the table for 2011 are two US Treasury securities and one US Agency security. Management believes that the unrealized losses are the result of interest rate levels differing from those existing at the time of purchase of the securities and actual and estimated prepayment speeds.  The Bank does not consider any of these securities to be other than temporarily impaired at December 31, 2011, because the unrealized losses are related primarily to changes in market interest rates and widening of sector spreads and are not necessarily related to the underlying credit quality of the issuers of the securities.

F-16

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 - Investment Securities – Continued

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

	Less than 12 months					12 Months or More					Total
			Unrealized					Unrealized					Unrealized
	Fair Value		Losses			Fair Value		Losses			Fair Value		Losses
December 31, 2011:	(dollars in thousands)
US Treasury securities	$	2,046	$	(5	)	$	-	$	(-	)	$	2,046	$	(5	)
US Agency securities		1,032		(4	)		-		(-	)		1,032		(4	)
Total	$	3,078	$	(9	)	$	-	$	(-	)	$	3,078	$	(9	)
December 31, 2010:
US Treasury securities	$	1,033	$	(2	)	$	-	$	(-	)	$	1,033	$	(2	)
US Agency securities		5,196		(37	)		-		(-	)		5,196		(37	)
Total	$	6,229	$	(39	)	$	-	$	(-	)	$	6,229	$	(39	)

The amortized cost and estimated fair value of debt securities as of December 31, 2011, by contractual maturity, are shown in the following table.  Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Held to Maturity
	(dollars in thousands)
	Amortized		Estimated
	Cost		Fair Value
Due in one year or less	$	7,000	$	7,035
Due from one year to five years		27,610		28,451
Due from five years to ten years		5,094		5,537
US Government sponsored
Mortgage-backed securities		653		701
	$	40,357	$	41,724

F-17

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable

Loans receivable consist of the following:

	December 31
	2011			2010
	(dollars in thousands)
Residential mortgage, total	$	295,876		$	326,255
Individually evaluated for impairment		51,007			59,189
Collectively evaluated for impairment		244,869			267,066
Construction, land acquisition and
development, total		99,122			144,098
Individually evaluated for impairment		35,398			21,937
Collectively evaluated for impairment		63,724			122,161
Land, total		59,649			63,155
Individually evaluated for impairment		11,384			10,196
Collectively evaluated for impairment		48,265			52,959
Lines of credit, total		34,278			36,642
Individually evaluated for impairment		5,735			4,564
Collectively evaluated for impairment		28,543			32,078
Commercial real estate, total		203,010			212,477
Individually evaluated for impairment		24,354			23,683
Collectively evaluated for impairment		178,656			188,794
Commercial non-real estate, total		5,599			8,434
Individually evaluated for impairment		32			305
Collectively evaluated for impairment		5,567			8,129
Home equity, total		41,309			43,501
Individually evaluated for impairment		2,340			975
Collectively evaluated for impairment		38,969			42,526
Consumer, total		897			1,302
Individually evaluated for impairment		24			61
Collectively evaluated for impairment		873			1,241
Total Loans		739,740			835,864
Individually evaluated for impairment		130,274			120,910
Collectively evaluated for impairment		609,466			714,954
Less
Loans in process		(18,014	)		(23,851
Allowance for loan losses		(25,938	)		(29,871
Deferred loan origination fees and costs, net		(2,485	)		(3,205
	$	693,303		$	778,937

F-18

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 Note 3 - Loans Receivable - Continued

The following is a summary of the allowance for loan losses for the years ended December 31, 2011, 2010 and 2009 (dollars in thousands):

2011	Total			Residential Mortgage			Acquisition and Development			Land			Lines of Credit			Commercial Real Estate			Commercial Non-Real Estate			Home Equity			Consumer
Beginning Balance	$	29,871		$	16,339		$	3,997		$	4,225		$	458		$	3,949		$	131		$	762		$	10
Provision		4,612			385			1,422			(766	)		267			1,019			38			1,534			713
Charge-offs		(8,545	)		(4,421	)		(1,503	)		(1,054	)		(-	)		(811	)		(-	)		(39	)		(717	)
Recoveries		-			-			-			-			-			-			-			-			-
Ending Balance	$	25,938		$	12,303		$	3,916		$	2,405		$	725		$	4,157		$	169		$	2,257		$	6
Loans individually evaluated for impairment	$	12,994		$	5,509		$	2,624		$	1,365		$	510		$	960		$	28		$	1,998		$	-
Loans collectively evaluated for impairment	$	12,944		$	6,794		$	1,292		$	1,040		$	215		$	3,197		$	141		$	259		$	6
2010
Beginning Balance	$	34,693		$	19,621		$	1,492		$	5,539		$	20		$	5,506		$	82		$	2,425		$	8
Provision		5,744			3,443			2,505			1,782			438			(1,034	)		49			(1,446	)		7
Charge-offs		(10,666	)		(6,825	)		(-	)		(3,096	)		(-	)		(523	)		(-	)		(217	)		(5	)
Recoveries		100			100			-			-			-			-			-			-			-
Ending Balance	$	29,871		$	16,339		$	3,997		$	4,225		$	458		$	3,949		$	131		$	762		$	10
Loans individually evaluated for impairment	$	14,540		$	8,149		$	2,645		$	2,282		$	264		$	766		$	-		$	434		$	-
Loans collectively evaluated for impairment	$	15,331		$	8,190		$	1,352		$	1,943		$	194		$	3,183		$	131		$	328		$	10
2009
Beginning Balance	$	14,813
Provision		31,402
Charge-offs		(11,579	)
Recoveries		57
Ending Balance	$	34,693

F-19

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

The allowance for loan losses is based on management’s judgment and evaluation of the loan portfolio.  Management assesses the adequacy of the allowance for loan losses and the need for any addition thereto, by considering the nature and size of the loan portfolio, overall portfolio quality, review of specific problem loans, economic conditions that may affect the borrowers’ ability to pay or the value of property securing loans, and other relevant factors.  While management believes the allowance was adequate as December 31, 2011, changing economic and market conditions may require future adjustments to the allowance for loan losses.

The following table presents Bancorp’s non-performing assets as of December 31, 2011 and December 31, 2010 (dollars in thousands):

	December 31,  2011			Number of loans		December 31, 2010			Number of loans
Loans accounted for on a non-accrual basis:
Residential  mortgage	$	8,912			25	$	18,778			46
Home equity		343			3		118			2
Lines of credit		2,019			4		4,265			8
Commercial real estate		2,140			5		1,927			6
Acquisition and development		10,997			11		15,160			17
Land		6,813			14		5,890			21
Commercial non-real estate		5			1		-			-
Consumer		203			4		26			2
Total non-accrual loans	$	31,432			67	$	46,164			102
Accruing loans greater than 90 days past due	$	-				$	-
Foreclosed real-estate	$	19,932				$	20,955
Total non-performing assets	$	51,364				$	67,119
Total troubled debt restructurings	$	59,775			115	$	72,029			135
Total non-accrual loans to net loans		4.5	%				5.9	%
Allowance for loan losses	$	25,938				$	29,871
Allowance to total loans		3.6	%				3.7	%
Allowance for loan losses to total non-performing loans,
including loans contractually past due 90 days or more		82.5	%				64.7	%
Total non-accrual and accruing loans greater than
90 days past due to total assets		3.5	%				4.8	%
Total non-performing assets to total assets		5.7	%				7.0	%

F-20

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

The following tables summarize impaired loans at December 31, 2011 (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
December 31, 2011
Residential mortgage	$	26,736	$	5,509	$	24,271	$	51,007	$	50,310
Home equity		2,170		1,998		170		2,340		2,340
Lines of credit		1,548		510		4,187		5,735		5,735
Commercial real estate		4,694		960		19,660		24,354		24,354
Acquisition and development		18,023		2,624		17,375		35,398		34,535
Land		2,850		1,365		8,534		11,384		9,949
Commercial non-real estate		28		28		4		32		32
Consumer		-		-		24		24		24
Total Impaired loans	$	56,049	$	12,994	$	74,225	$	130,274	$	127,279

	Impaired Loans with Specific Allowance				Impaired Loans with No Specific Allowance				Total Impaired Loans
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
December 31, 2011
Residential mortgage	$	26,826	$	1,080	$	25,659	$	1,201	$	52,485	$	2,281
Home equity		1,772		66		170		4		1,942		70
Lines of credit		590		87		4,187		143		4,777		230
Commercial real estate		4,723		191		19,821		1,185		24,544		1,376
Acquisition and development		19,968		793		19,199		696		39,167		1,489
Land		3,770		236		9,143		261		12,913		497
Commercial non-real estate		28		-		5		-		33		-
Consumer		-		-		23		-		23		-
Total Impaired loans	$	57,677	$	2,453	$	78,207	$	3,490	$	135,884	$	5,943

Changes in impaired loans during 2011 are as follows (dollars in thousands):

Impaired loans at December 31, 2010	$	120,910
Added to impaired loans		53,134
Gross loans transferred to foreclosed real estate		(19,820	)
Paid off prior to foreclosure		(23,950	)
Impaired loans at December 31, 2011	$	130,274

F-21

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

The following tables summarize impaired loans at December 31, 2010 (dollars in thousands):

	Impaired Loans with Specific Allowance				Impaired Loans with No Specific Allowance		Total Impaired Loans
	Recorded Investment		Related Investment		Recorded Investment		Recorded Investment		Unpaid Principal Balance
December 31, 2010
Residential mortgage	$	38,251	$	8,149	$	20,938	$	59,189	$	59,189
Home equity		568		434		407		975		975
Lines of credit		836		264		3,728		4,564		4,564
Commercial real estate		3,975		766		19,708		23,683		23,683
Acquisition and development		17,273		2,645		4,664		21,937		21,937
Land		6,567		2,282		3,629		10,196		10,196
Commercial non-real estate		-		-		305		305		305
Consumer		-		-		61		61		61
Total Impaired loans	$	67,470	$	14,540	$	53,440	$	120,910	$	120,910

	Impaired Loans with Specific Allowance				Impaired Loans with No Specific Allowance				Total Impaired Loans
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
December 31, 2010
Residential mortgage	$	39,382	$	1,508	$	21,611	$	1,057	$	60,993	$	2,565
Home equity		568		21		407		17		975		38
Lines of credit		985		167		3,294		115		4,279		282
Commercial real estate		4,034		248		19,838		1,420		23,872		1,668
Acquisition and development		19,327		1,212		5,307		303		24,634		1,515
Land		6,572		288		3,772		492		10,344		780
Commercial non-real estate		-		-		900		45		900		45
Consumer		-		-		61		-		61		-
Total Impaired loans	$	70,868	$	3,444	$	55,190	$	3,449	$	126,058	$	6,893

 Changes in impaired loans during 2010 are as follows (dollars in thousands):

Impaired loans at December 31, 2009	$	122,941
Added to impaired loans		62,025
Gross loans transferred to foreclosed  real estate		(32,283	)
Paid off prior to foreclosure		(31,773	)
Impaired loans at December 31, 2010	$	120,910

F-22

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

Included in the above impaired loans amount at December 31, 2011 is $98,842,000 of loans that are not in non-accrual status.  In addition, there was a total of $51,007,000 of residential real estate loans included in impaired loans at December 31, 2011, of which $43,768,000 were to consumers and $7,239,000 to builders. The collateral supporting impaired loans is individually reviewed by management to determine its estimated fair market value, less estimated disposal cost and a specific allowance is established, if necessary, for the difference between the carrying amount of any loan and the estimated fair value of the collateral less estimated disposal cost.

Of the impaired loans, $56,049,000 and $67,470,000 had a specific valuation allowance of $12,994,000 and $14,540,000 at December 31, 2011 and 2010, respectively. Impaired loans averaged $135,884,000 during 2011, $126,058,000 during 2010 and $105,484,000 during 2009. Interest income recognized on these loans totaled $5,943,000 during 2011, $6,893,000 during 2010 and $4,073,000 during 2009.

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 December 31, 2011 and 2010 (dollars in thousands):

	Pass		Special Mention		Substandard		Doubtful		Total
December 31, 2011
Residential mortgage	$	259,359	$	8,624	$	27,689	$	204	$	295,876
Home equity		38,456		712		2,141		-		41,309
Lines of credit		27,067		1,708		5,503		-		34,278
Commercial real estate		180,635		10,702		11,673		-		203,010
Acquisition and development		62,054		6,521		30,547		-		99,122
Land		44,443		4,909		10,297		-		59,649
Commercial non-real estate		5,567		-		4		28		5,599
Consumer		874		-		23		-		897
Total loans	$	618,455	$	33,176	$	87,877	$	232	$	739,740
	Pass		Special Mention		Substandard		Doubtful		Total
December 31, 2010
Residential mortgage	$	281,027	$	9,999	$	35,229	$	-	$	326,255
Home equity		41,030		1,497		974		-		43,501
Lines of credit		28,979		2,796		4,867		-		36,642
Commercial real estate		197,031		3,667		11,779		-		212,477
Acquisition and development		105,052		13,481		25,565		-		144,098
Land		48,384		5,708		9,063		-		63,155
Commercial non-real estate		8,091		38		305		-		8,434
Consumer		1,243		-		59		-		1,302
Total loans	$	710,837	$	37,186	$	87,841	$	-	$	835,864

F-23

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

Interest income that would have been recorded under the original terms of non-accrual loans and the interest income actually recognized for the years ended December 31, are summarized below (dollars in thousands):

	2011		2010		2009
Interest income that would have
been recorded	$	2,905	$	4,905	$	4,588
Interest income recognized		822		2,599		1,271
Interest income not recognized	$	2,083	$	2,306	$	3,317

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.  The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans as of December 31, 2011 and 2010 (dollars in thousands):

	Current		30-59 Days Past Due		60-89 Days Past Due		90 Days+ Past Due		Total Past Due		Non- Accrual		Total Loans
December 31, 2011
Residential mortgage	$	272,543 4$$2,000	$	9,696	$	4,725	$	-	$	14,421	$	8,912	$	295,876
Home equity		40,021		945		-		-		945		343		41,309
Lines of credit		32,221		-		38		-		38		2,019		34,278
Commercial real estate		198,049		2,535		286		-		2,821		2,140		203,010
Acquisition and development		87,756		369		-		-		369		10,997		99,122
Land		51,094		1,517		225		-		1,742		6,813		59,649
Commercial non-real estate		5,584		10		-		-		10		5		5,599
Consumer		694		-		-		-		-		203		897
Total Impaired loans	$	687,962	$	15,072	$	5,274	$	-	$	20,346	$	31,432	$	739,740
	Current		30-59 Days Past Due		60-89 Days Past Due		90 Days+  Past Due		Total Past Due		Non- Accrual		Total Loans
December 31, 2010
Residential mortgage	$	297,793 4$$2,000	$	5,028	$	4,656	$	-	$	9,684	$	18,778	$	326,255
Home equity		43,138		115		130		-		245		118		43,501
Lines of credit		29,465		854		2,058		-		2,912		4,265		36,642
Commercial real estate		206,434		3,058		1,058		-		4,116		1,927		212,477
Acquisition and development		122,858		1,950		4,130		-		6,080		15,160		144,098
Land		52,492		3,865		908		-		4,773		5,890		63,155
Commercial non-real estate		8,434		-		-		-		-		-		8,434
Consumer		1,272		4		-		-		4		26		1,302
Total Impaired loans	$	761,886	$	14,874	$	12,940	$	-	$	27,814	$	46,164	$	835,864

Mortgage loans serviced for others not included in the accompanying consolidated statements of financial condition totaled $84,745,000 and $82,082,000 at December 31, 2011 and 2010, respectively.

F-24

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable – Continued

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

The Bank's exposure to credit loss from non-performance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments.

The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk.

Financial Instruments Whose Contract Amounts Represent Credit Risk	Contract Amount At December 31,
	2011		2010
	(dollars in thousands)
Standby letters of credit	$	15,319	$	17,959
Home equity lines of credit		14,623		14,340
Unadvanced construction commitments		18,014		26,662
Mortgage loan commitments		1,059		5,827
Lines of credit		31,525		25,833
Loans sold with limited
repurchase provisions	$	17,558	$	37,943

Standby letters of credit are conditional commitments issued by the Bank guaranteeing performance by a customer to various municipalities. These guarantees are issued primarily to support performance arrangements, limited to real estate transactions.  The majority of these standby letters of credit expire within the next twelve months.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments.  The Bank requires collateral supporting these letters of credit as deemed necessary.  Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees.  The current amount of the liability as of December 31, 2011 and 2010 for guarantees under standby letters of credit issued is not material.

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

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

F-25

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable – Continued

Mortgage loan commitments not reflected in the accompanying statements of financial condition at December 31, 2011 include $1,059,000 at a fixed interest rate range of 3.25% to 5.50% and none at floating interest rates.

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

The Bank has entered into several agreements to sell mortgage loans to third parties. The loans sold under these agreements for the years ended December 31, 2011, 2010 and 2009 were $43,403,000, $59,113,000 and $31,346,000, respectively. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within the terms specified by the agreement. The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. No amount has been recognized in the consolidated statement of financial condition at December 31, 2011 and 2010 as a liability for credit loss related to these loans.  The Bank had to repurchase one loan under these agreements in 2011.

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 December 31, 2011 and December 31, 2010.

F-26

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

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

·   Rate Modification – A modification in which the interest rate is changed.

·   Term Modification – A modification in which the maturity date, timing of payments or frequency of payments is changed.

·   Interest Only Modification – A modification in which the loan is converted to interest only payments for a period of time.

·   Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification above.

·   Combination Modification – Any other type of modification, including the use of multiple categories above.

Bancorp considers a modification of a loan term a TDR if Bancorp for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the debtor that it would not otherwise consider.  Prior to entering into a loan modification, Bancorp assesses the borrower’s financial condition to determine if the borrower has the means to meet the terms of the modification.  This includes obtaining a credit report on the borrower as well as the borrower’s tax returns and financial statements.

The following tables summarize troubled debt restructurings at December 31, 2011 (dollars in thousands):

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification    Outstanding  Recorded Investment
Troubled Debt Restructurings:
Residential mortgage		68	$	30,372	$	29,815
Home equity		-		-		-
Lines of credit		2		332		332
Commercial real estate		8		8,215		8,046
Acquisition and development		8		11,152		10,260
Land		9		3,985		3,802
Commercial non-real estate		-		-		-
Consumer		-		-		-
Total loans		95	$	54,056	$	52,255

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification   Outstanding  Recorded Investment
Troubled Debt Restructurings That Subsequently Defaulted:
Residential mortgage		14	$	4,568	$	4,542
Home equity		-		-		-
Lines of credit		1		140		140
Commercial real estate		1		288		286
Acquisition and development		1		2,090		2,090
Land		3		464		462
Commercial non-real estate		-		-		-
Consumer		-		-		-
Total loans		20	$	7,550	$	7,520

F-27

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

The following tables present newly restructured loans that occurred during the year ended December 31, 2011 (dollars in thousands):

	Year ended December 31, 2011
	Rate Modification		Contracts		Combination  Modifications		Contracts		Total		Total Contracts
Pre-Modification Outstanding Recorded Investment:
Residential mortgage	$	817		2	$	22,282		43	$	23,099		45
Home equity		-		-		-		-		-		-
Lines of credit		-		-		332		2		332		2
Commercial real estate		262		1		7,427		6		7,689		7
Acquisition and development		3,930		1		5,580		5		9,510		6
Land		552		1		1,927		6		2,479		7
Commercial non-real estate		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total loans	$	5,561		5	$	37,548		62	$	43,109		67
Post-Modification Outstanding Recorded Investment:
Residential mortgage	$	738		2	$	21,861		43	$	22,599		45
Home equity		-		-		-		-		-		-
Lines of credit		-		-		332		2		332		2
Commercial real estate		262		1		7,433		6		7,695		7
Acquisition and development		3,930		1		4,914		5		8,844		6
Land		551		1		1,916		6		2,467		7
Commercial non-real estate		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total loans	$	5,481		5	$	36,456		62	$	41,937		67

In addition, the collateral securing the TDR, which is always real estate, is evaluated for impairment based on either an appraisal or broker price opinion.  If the borrower performs under the terms of the modification, 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.

F-28

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable – Continued

Interest on TDRs was accounted for under the following methods as of December 31, 2011 and December 31, 2010 (dollars in thousands):

	Number of Contracts		Accrual Status		Number of Contracts		Non-Accrual Status		Total Number of Contracts		Total Modifications
December 31, 2011
Residential mortgage		57	$	22,820		25	$	11,537		82	$	34,357
Home equity		-		-		-		-		-		-
Lines of credit		1		140		2		332		3		472
Commercial real estate		5		3,169		4		5,163		9		8,332
Acquisition and development		8		11,962		1		388		9		12,350
Land		6		2,333		6		1,931		12		4,264
Commercial non-real estate		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total loans		77	$	40,424		38	$	19,351		115	$	59,775
December 31, 2010
Total loans		88	$	39,834		47	$	32,195		135	$	72,029

Management does not charge off a TDR, or a portion of a TDR, until one of the following conditions has been met:

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

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

Prior to either of the above conditions, a loan is assessed for impairment when a loan becomes a TDR.  If, based on management’s assessment of the underlying collateral of the loan, it is determined that a reserve is needed, a specific reserve is recorded.  That reserve is included in the Allowance for Loan Losses in the Consolidated Statement of Financial Condition.

Bancorp performs A note/B note workout structures as a subset of Bancorp’s troubled debt restructuring strategy.  The amount of loans restructured using this structure were $1,505,000 and $0 as of December 31, 2011 and December 31, 2010, respectively.

Under an A note/B note workout structure, the new A note is underwritten in accordance with customary troubled debt restructuring underwriting standards and is reasonably assured of full repayment while the B note is not.  The B note is immediately charged off upon restructuring.

If the loan was on accrual status prior to the troubled debt restructuring being documented with the loan legally bifurcated into an A note fully supporting accrual status and a B note or amount contractually forgiven and charged off, the A note may remain on accrual status.  If the loan was on nonaccrual status at the time the troubled debt restructuring was documented with the loan legally bifurcated into an A note fully supporting accrual status and a B note or amount contractually forgiven and fully charged off, the A note may be returned to accrual status, and risk rated accordingly, after a reasonable period of performance under the troubled debt restructuring terms.  Six months of payment performance is generally required to return these loans to accrual status.

F-29

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable - Continued

The A note will continue to be classified as a troubled debt restructuring and may only be removed from impaired status in years after the restructuring if (a) the restructuring agreement specifies an interest rate equal to or greater than the rate that Bancorp was willing to accept at the time of the restructuring for a new loan with a comparable risk and (b) the loan is not impaired based on the terms specified by the restructuring agreement.

Note 4 - Premises and Equipment

Premises and equipment are summarized by major classification as follows:

	December 31,						Estimated
	2011			2010			Useful Lives
	(dollars in thousands)
Land	$	1,537		$	1,537			-
Building		29,028			29,023		39 Years
Leasehold improvements		1,206			1,161		15-27.5 Years
Furniture, fixtures and equipment		3,232			3,143		3-10 Years
Total at cost		35,003			34,864
Accumulated depreciation		(7,785	)		(6,537	)
	$	27,218		$	28,327

Depreciation expense was $1,248,000, $1,238,000, and $1,276,000 for the years ended December 31, 2011, 2010 and 2009, respectively.

Bancorp has four retail branch locations in Anne Arundel County, Maryland, of which it owns three and leases the fourth from a third party.  The initial lease term expired July 2010 and the first option to renew for an additional five year term was exercised. There is an option remaining to renew the lease for one more additional five year term.  In addition, the Bank leases office space in Annapolis, Maryland from a third party.  The lease expires January 2016, with the option to renew the lease for one additional five year term.

The minimum future annual rental payments on leases are as follows:

Years Ended December 31, (in thousands)
2012	$	96
2013		97
2014		97
2015		72
2016		3
Thereafter		-

Total rent expense was $96,000, $95,000, and $94,000 for the years ended December 31, 2011, 2010 and 2009, respectively.

F-30

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 5 – Foreclosed Real Estate

As of December 31, 2011, Bancorp had foreclosed real estate consisting of 57 residential properties with a carrying value of $19,932,000.  During the year ended December 31, 2011, Bancorp sold a total of 60 properties previously included in foreclosed real estate.  The properties sold during 2011 had a combined net book value of $14,258,000 after total write-downs taken subsequent to their transfer from loans to foreclosed real estate of $2,691,000, and were sold at a combined net loss of $639,000.  In addition, Bancorp incurred $1,179,000 in expenses related to the sale of the properties.  The following table summarizes the changes in foreclosed real estate for the years ended December 31, 2011, 2010 and 2009 (dollars in thousands):

Foreclosed real estate at December 31, 2008	$	6,317
Transferred from impaired loans, net of specific reserves of $7,453		28,478
Property improvements		413
Additional write downs		(3,911	)
Property sold, including loss on sale		(9,723	)
Foreclosed real estate at December 31, 2009		21,574
Transferred from impaired loans, net of specific reserves of $8,146		24,137
Property improvements		430
Additional write downs		(3,451	)
Property sold, including loss on sale		(21,735	)
Foreclosed real estate at December 31, 2010		20,955
Transferred from impaired loans, net of specific reserves of $3,584		16,295
Property improvements	��	502
Additional write downs		(3,562	)
Property sold, including loss on sale		(14,258	)
Foreclosed real estate at December 31, 2011	$	19,932

Note 6 - Investment in Federal Home Loan Bank of Atlanta Stock

The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank of Atlanta ("FHLB") in an amount equal to at least 1% of the unpaid principal balances of the Bank's residential mortgage loans or 1/20 of its outstanding advances from the FHLB, whichever is greater. Purchases and sales of stock are made directly with the FHLB at par value.

Note 7 – Deposits

Deposits in the Bank as of December 31, 2011 and 2010 consisted of the following:

	2011					2010
Category	Amount		Percent			Amount		Percent
	(dollars in thousands)
NOW accounts	$	16,654		2.55	%	$	13,465		1.88	%
Money market accounts		43,344		6.64	%		41,168		5.76	%
Passbooks		189,696		29.06	%		222,183		31.08	%
Certificates of deposit		383,103		58.69	%		420,133		58.78	%
Non-interest bearing accounts		19,960		3.06	%		17,827		2.50	%
Total deposits	$	652,757		100.00	%	$	714,776		100.00	%

F-31

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 7 – Deposits - continued

At December 31, 2011 scheduled maturities of certificates of deposit are as follows:

	Amount
	(dollars in thousands)
One year or less	$	254,873
More than 1 year to 2 years		83,412
More than 2 years to 3 years		20,757
More than 3 years to 4 years		7,977
More than 4 years to 5 years		16,084
	$	383,103

The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100,000 was $164,877,000 and $185,716,000 at December 31, 2011 and 2010, respectively.

Interest expense on deposits is summarized as follows (dollars in thousands):

	For Years Ended December 31,
	2011		2010		2009
NOW accounts	$	54	$	52	$	65
Money market accounts		273		405		626
Passbooks		1,567		2,982		2,589
Certificates of deposit		8,511		10,296		16,502
	$	10,405	$	13,735	$	19,782

Note 8 - Federal Home Loan Bank Advances

The Bank's credit availability under the FHLB of Atlanta’s credit availability program was $184,400,000 and $194,360,000 at December 31, 2011 and 2010, respectively.  The Bank is able to borrow up to 20% of total assets.  There were no short-term borrowings with the FHLB at December 31, 2011 and 2010.   Long-term advances outstanding were $115,000,000 at both December 31, 2011 and 2010.  The maturities of these long-term advances at December 31, 2011 are as follows (dollars in thousands):

Rate			Amount		Maturity
	-	%	$	-		2012
	-	%		-		2013
2.940% to 4.210%				25,000		2014
3.710% to 4.340%				40,000		2015
	-	%		-		2016
2.580% to 4.050%				50,000	Thereafter
			$	115,000

The Bank's stock in the FHLB of Atlanta is pledged as security for the advances and under a blanket floating lien security agreement with the FHLB of Atlanta. The Bank is required to maintain as collateral for its advances, qualified loans in varying amounts depending on the loan type.  Loans with an approximate fair value of $217,706,000 are pledged as collateral at December 31, 2011.

F-32

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 9 - Subordinated Debentures

As of December 31, 2011, Bancorp had outstanding approximately $20,619,000 principal amount of Junior Subordinated Debt Securities Due 2035 (the “2035 Debentures”).  The 2035 Debentures were issued pursuant to an Indenture dated as of December 17, 2004 (the “2035 Indenture”) between Bancorp and Wells Fargo Bank, National Association as Trustee.  The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.40% December 31, 2011) plus 200 basis points, and mature on January 7, 2035.  Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of Bancorp, as defined in the 2035 Indenture.  The 2035 Debentures became redeemable, in whole or in part, by Bancorp on January 7, 2010.

The 2035 Debentures were issued and sold to Severn Capital Trust I (the “Trust”), of which 100% of the common equity is owned by Bancorp.  The Trust was formed for the purpose of issuing corporation-obligated mandatorily redeemable Capital Securities (“Capital Securities”) to third-party investors and using the proceeds from the sale of such Capital Securities to purchase the 2035 Debentures.  The 2035 Debentures held by the Trust are the sole assets of the Trust.  Distributions on the Capital Securities issued by the Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Trust on the 2035 Debentures.  The Capital Securities are subject to mandatory redemption, in whole or in part, upon repayment of the 2035 Debentures.  Bancorp has entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee.$17,000,000 of the proceeds from Bancorp’s issuance of the debentures was contributed to the Bank, and qualifies as Tier 1 capital for the Bank under Federal Reserve Board guidelines.

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

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

Note 10 – Employee Benefit Plans

The Bank has a 401(k) Retirement Savings Plan.  Employees may contribute a percentage of their salary up to the maximum amount allowed by law. The Bank is obligated to contribute 50% of the employee's contribution, not to exceed 6% of the employee's annual salary. All employees who have completed one year of service with the Bank are eligible to participate. The Bank's contribution to this plan was $139,000, $127,000 and $130,000 for the years ended December 31, 2011, 2010 and 2009, respectively.

The Bank has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of participating employees. The Bank recognized ESOP expense of $140,000 for the years ended December 31, 2011, 2010 and 2009, and had unallocated shares to participants in the plan totaling 47,500, 29,807 and 2,100 as of December 31, 2011, 2010 and 2009, respectively.  The fair value of the unallocated shares at December 31, 2011 was $117,000.

F-33

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11 - Stockholders’ Equity

As part of the private placement offering discussed in Note 9, Bancorp issued a total of 437,500 shares of its Series A 8.0% Non-Cumulative Convertible Preferred Stock (“Series A Preferred Stock”). The liquidation preference is $8.00 per share.  Holders of Series A Preferred Stock will not be entitled to any further liquidation distribution on the Series A Preferred Stock. Each share of Series A Preferred Stock is convertible at the option of the holder into one share of Bancorp 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 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 common stock at the then-applicable conversion rate.  Costs related to the issuance of the preferred stock totaled $247,000 and were netted against the proceeds.

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

On November 21, 2008, Bancorp entered into an agreement with the United States Department of the Treasury (“Treasury”), pursuant to which Bancorp issued and sold (i) 23,393 shares of its Series B Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share and liquidation preference $1,000 per share, (the “Series B Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 556,976 shares of Bancorp’s common stock, par value $0.01 per share, for an aggregate purchase price of $23,393,000.  Costs related to the issuance of the preferred stock and warrants totaled $45,000 and were netted against the proceeds.

The Series B Preferred Stock qualifies as Tier 1 capital and will pay cumulative compounding dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series B Preferred Stock may be redeemed by Bancorp after three years. Prior to the end of three years, the Series B Preferred Stock may not be redeemed by Bancorp except with proceeds from one or more Qualified Equity Offerings, as defined in the Purchase Agreement.

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

The Series B Preferred Stock is non-voting, other than class voting rights on certain matters that could adversely affect the Series B Preferred Stock. If dividends on the Series B Preferred Stock have not been paid for an aggregate of six quarterly dividend periods or more, whether consecutive or not, Bancorp’s authorized number of directors will be automatically increased by two and the holders of the Series B Preferred Stock, voting together with holders of any then outstanding voting parity stock, will have the right to elect those directors at Bancorp’s next annual meeting of stockholders or at a special meeting of stockholders called for that purpose. These preferred share directors will be elected annually and serve until all accrued and unpaid dividends on the Series B Preferred Stock have been paid.

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.

F-34

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11 - Stockholders’ Equity - Continued

Bancorp’s ability to declare dividends on its common stock are limited by the terms of Bancorp’s Series A preferred stock and Series B preferred stock.  Bancorp may not declare or pay any dividend on, make any distributions relating to, or redeem, purchase, acquire or make a liquidation payment relating to, or make any guarantee payment with respect to its common stock in any quarter until the dividend on the Series A Preferred Stock has been declared and paid for such quarter, subject to certain minor exceptions.  Additionally, Bancorp may not declare or pay dividend or distribution on its common stock, and Bancorp may not purchase, redeem or otherwise acquire for consideration any of its common stock, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Series B preferred stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside), subject to certain minor exceptions.

Additionally, under the terms of Bancorp's 2035 Debentures, if (i) there has occurred and is continuing an event of default, (ii) Bancorp is in default with respect to payment of any obligations under the related guarantee or (iii) Bancorp has given notice of its election to defer payments of interest on the 2035 Debentures by extending the interest distribution period as provided in the indenture governing the 2035 Debentures and such period, or any extension thereof, has commenced and is continuing, then 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.

Note 12- Stock-Based Compensation

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

Bancorp follows FASB ASC 718, Compensation – Stock Compensation (FASB ASC 718) to account for stock-based compensation.  FASB ASC 718 requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the statement of operations at fair value.  FASB ASC 718 requires an entity to recognize the expense of employee services received in share-based payment transactions and measure the expense based on the grant date fair value of the award.  The expense is recognized over the period during which an employee is required to provide service in exchange for the award. Stock-based compensation expense included in the consolidated statements of operations for the years ended December 31, 2011, 2010 and 2009 totaled $61,000, $162,000 and $128,000, respectively.  There was no income tax benefit recognized in the consolidated statements of operations for stock-based compensation for the years ended December 31, 2011, 2010 and 2009.

There were 0 options granted in 2011, 100,000 options granted in 2010 and 0 options granted in 2009.

F-35

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 12- Stock-Based Compensation – Continued

Information regarding Bancorp’s stock option plan as of and for the years ended December 31, 2011, 2010 and 2009 is as follows:

						Weighted
				Weighted		Average	Aggregate
				Average		Remaining	Intrinsic
	Shares			Price		Life	Value
Options outstanding, December 31, 2008		114,950		$	15.87
Options granted		-			-
Options exercised		-			-
Options forfeited		(4,235	)		15.62		$	-
Options outstanding, December 31, 2009		110,715			15.88
Options granted		100,000			4.21
Options exercised		-			-
Options forfeited		(19,965	)		15.62		$	-
Options outstanding, December 31, 2010		190,750			9.79
Options granted		-			-
Options exercised		-			-
Options forfeited		(90,750	)		15.93
Options outstanding, December 31, 2011		100,000		$	4.21	4.21	$	-
Options exercisable, December 31, 2011		35,834		$	4.21	3.21	$	-
Option price range at December 31, 2011	$	4.13 to $4.54

The stock-based compensation expense amounts were derived using the Black-Scholes option-pricing model.  The following weighted average assumptions were used to value options granted in current and prior periods presented.

	2011	2010	2009
Expected life of options	5.00 years	4.91 years	4.83 years
Risk-free interest rate	2.37%	3.60%	4.59%
Expected volatility	58.78%	55.94%	53.66%
Expected dividend yield	-%	2.52%	4.54%

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility.  Because Bancorp’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

F-36

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 12- Stock-Based Compensation – Continued

The following table summarizes the nonvested options in Bancorp’s stock option plan as of December 31, 2011.

				Weighted
				Average
	Shares			Grant Date Fair Value
Nonvested options outstanding, December 31, 2010		86,949		$	4.59
Nonvested options granted		-			-
Nonvested options vested		(20,000	)		4.21
Nonvested options forfeited		(2,783	)		15.93
Nonvested options outstanding, December 31, 2011		64,166		$	4.21

As of December 31, 2011, there was $136,000 of total unrecognized stock-based compensation cost related to non-vested stock options, which is expected to be recognized over a period of thirty-nine months.

Note 13- Regulatory Matters

The Bank is required to maintain an average daily balance with the Federal Reserve Bank in a non-interest bearing account. The amount in such account at December 31, 2011 was $300,000.

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bancorp’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.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  Management believes, as of December 31, 2011, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2011, the most recent notification from the regulators categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and ratios are also presented in the table.

F-37

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13- Regulatory Matters – Continued

The following table presents the Bank's actual capital amounts and ratios at December 31, 2011 and 2010:

	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		%			Amount		%			Amount		%
	(dollars in thousands)
December 31, 2011
Tangible (1)	$	115,224		13.0	%	$	13,345		1.50	%		N/A		N/A
Tier I capital (2)		115,224		17.1	%		N/A		N/A		$	40,292		6.00	%
Core (1)		115,224		13.0	%		35,586		4.00	%		44,482		5.00	%
Total (2)		123,626		18.4	%		53,723		8.00	%		67,154		10.00	%
December 31, 2010
Tangible (1)	$	117,733		12.3	%	$	14,340		1.50	%		N/A		N/A
Tier I capital (2)		117,733		15.6	%		N/A		N/A		$	45,342		6.00	%
Core (1)		117,733		12.3	%		38,240		4.00	%		47,800		5.00	%
Total (2)		127,175		16.8	%		60,456		8.00	%		75,570		10.00	%

(1) To adjusted total assets.

(2) To risk-weighted assets.

On November 23, 2009, Bancorp and the Bank entered into supervisory agreements with their regulators.  The agreements require, among other things, in accordance with specific guidelines set forth in the agreements, that the Bank revise its policies regarding problem assets, revise its allowance for loan and lease losses policies, revise policies and procedures for the use of interest reserves, develop and implement a program for managing risks associated with concentrations of credit, revise its loan modification policy and furnish written quarterly progress reports to its regulators detailing the actions taken to comply with the agreements. In addition, Bancorp and the Bank must obtain prior regulatory approval before any dividends or capital distributions can be made.  Bancorp’s main source of income is dividends from the Bank.  As a result, Bancorp's dividends to its shareholders will depend primarily upon receipt of dividends from the Bank and compliance with the supervisory agreements.  Management believes that Bancorp and the Bank are in compliance with these agreements at December 31, 2011.

F-38

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14 - Income Taxes

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

	2011		2010			2009
	(dollars in thousands)
Current
Federal	$	28	$	(1,005	)	$	(617	)
State		23		(115	)		(117	)
		51		(1,120	)		(734	)
Deferred
Federal		660		1,741			(7,342	)
State		271		419			(1,852	)
		931		2,160			(9,194	)
Total income tax provision (benefit)	$	982	$	1,040		$	(9,928	)

The amount computed by applying the statutory federal income tax rate to income (loss) before taxes is less than the tax provision (benefit) for the following reasons for the years

ended December 31:

	2011					2010					2009
	Amount		Percent of  Pretax Income			Amount		Percent of Pretax Income			Amount			Percent of Pretax (Loss)
	(dollars in thousands)
Statutory Federal
income tax rate	$	748		34.0	%	$	747		34.0	%	$	(8,553	)		34.0	%
State tax net of
Federal income
tax benefit		182		8.3	%		201		9.1	%		(1,384	)		5.5	%
Other adjustments		52		2.3	%		92		4.2	%		9			0	%
	$	982		44.6	%	$	1,040		47.3	%	$	(9,928	)		39.5	%

Bancorp does not have any unrecognized tax benefits at December 31, 2011 or 2010.

F-39

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14 - Income Taxes - Continued

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2011 and 2010 are presented below:

	2011			2010
	(dollars in thousands)
Deferred Tax Assets:
Allowance for loan losses	$	10,468		$	12,057
Reserve on foreclosed real estate		1,420			1,146
Reserve for uncollected interest		540			676
Federal net operating loss carryforwards		639			-
State net operating loss carryforwards		278			188
Other		104			69
Total deferred tax assets		13,449			14,136
Valuation allowance		(216	)		(167	)
Total deferred tax assets, net of valuation allowance		13,233			13,969
Deferred Tax Liabilities:
Federal Home Loan Bank stock dividends		(84	)		(84	)
Loan origination costs		(321	)		(382	)
Accelerated depreciation		(1,437	)		(1,273	)
Prepaid expenses		(199	)		(107	)
Total deferred tax liabilities		(2,041	)		(1,846	)
Net deferred tax assets	$	11,192		$	12,123

The valuation allowance relates to state net operating loss carryforwards of $4,036,000 and $3,122,000 at December 31, 2011 and 2010, respectively, for which realizability is uncertain.  At December 31, 2011 and 2010, Bancorp had state net operating loss carryforwards of approximately $5,187,000 and $3,518,000, respectively, which were available to offset state taxable income, and expire at various dates through 2031.  Bancorp also had federal net operating loss carryforwards of approximately $1,826,000 at December 31, 2011 which were available to offset federal taxable income, and expire in 2031.

In assessing the realizability of federal or state deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.  The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible.  Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and prudent, feasible and permissible as well as available tax planning strategies in making this assessment.  Based on the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible as well as available tax planning strategies, management believes it is more likely than not that Bancorp will realize the benefits of these deferred tax assets.

The statute of limitations for Internal Revenue Service examination of Bancorp’s federal consolidated tax returns remains open for tax years 2008 through 2011.

F-40

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 15 - Related Party Transactions

During the years ended December 31, 2011, 2010 and 2009, the Bank engaged in the transactions described below with parties that may be deemed affiliated.

During January, 2007, a law firm, in which the President of Bancorp and the Bank is a partner, entered into a five year lease agreement with a subsidiary of Bancorp.  The term of the lease is five years with the option to renew the lease for three additional five year terms.  The total lease payments received by the subsidiary were $372,000, $375,000 and $405,000 for the years ended December 31, 2011, 2010 and 2009, respectively.  In addition, the law firm represents Bancorp and the Bank in certain legal matters. The fees for services rendered by that firm were $827,000, $830,000 and $769,000 for the years ended December 31, 2011, 2010 and 2009, respectively.

Note 16 - Fair Value of Financial Instruments

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

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

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

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

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

F-41

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 - Fair Value of Financial Instruments – Continued

The following table summarizes the valuation of assets re-measured at fair value on a nonrecurring basis, as of December 31, 2011 and 2010 (dollars in thousands):

	Fair Value Measurement at December 31, 2011
	Total		Level 1		Level 2		Level 3
Impaired loans	$	43,055		-		-	$	43,055
Foreclosed real estate		19,932		-		-		19,932

	Fair Value Measurement at December 31, 2010
	Total		Level 1		Level 2		Level 3
Impaired loans	$	52,930		-		-	$	52,930
Foreclosed real estate		20,955		-		-		20,955

There were no liabilities that were required to be re-measured on a nonrecurring basis as of December 31, 2011 or 2010.

The following information should not be interpreted as an estimate of the fair value of Bancorp since a fair value calculation is only provided for a limited portion of Bancorp’s assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between Bancorp’s disclosures and those of other companies may not be meaningful.  The following methods and assumptions were used to estimate the fair values of Bancorp’s financial instruments at December 31, 2011 and 2010.

Cash and cash equivalents:

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

Investment Securities:

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 1.

FHLB stock:

The carrying amount of FHLB stock approximates fair value based on the redemption provisions of the FHLB.  There have been no identified events or changes in circumstances that may have a significant adverse effect on the FHLB stock.  Based on our evaluation, we have concluded that our FHLB stock was not impaired at December 31, 2011 and 2010.

Loans held for sale:

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

F-42

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 - Fair Value of Financial Instruments – Continued

Loans receivable:

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

Impaired loans are those for which Bancorp has measured impairment generally based 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 $56,049,000 and $67,470,000 at December 31, 2011 and 2010, respectively, less their valuation allowances of $12,994,000 and $14,540,000 at December 31, 2011 and 2010, respectively.

   Foreclosed Real Estate:

Real estate acquired through foreclosure is included in the following disclosure at the lower of carrying value or fair value less estimated disposal costs. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using current estimates of fair value. In the event of a subsequent decline, management provides a specific allowance to reduce real estate acquired through foreclosure to fair value less estimated disposal cost. Expenses incurred on foreclosed real estate prior to disposition are charged to expense. Gains or losses on the sale of foreclosed real estate are recognized upon disposition of the property.

Accrued interest receivable and payable:

The carrying amounts of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities:

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

FHLB advances:

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

Subordinated debentures:

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

Off-balance sheet financial instruments:

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

F-43

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 - Fair Value of Financial Instruments – Continued

The following table summarizes the roll forward of level 3 assets for the years ended December 31, 2011, 2010 and 2009 (dollars in thousands):

	Impaired  Loans			Foreclosed Real Estate
Balance at December 31, 2008	$	32,043		$	6,317
Transfer to foreclosed real estate		(22,850	)		28,478
Additions		77,889			413
(Increase) decrease in additional reserves		(10,093	)		(3,911	)
Paid off/sold		(26,597	)		(9,723	)
Balance at December 31, 2009		50,403			21,574
Transfer to foreclosed real estate		(26,526	)		24,137
Additions		59,212			430
(Increase) decrease in additional reserves		944			(3,451	)
Paid off/sold		(31,103	)		(21,735	)
Balance at December 31, 2010	$	52,930		$	20,955
Transfer to foreclosed real estate		(14,155	)		16,295
Additions		40,029			502
(Increase) decrease in additional reserves		1,545			(3,562	)
Paid off/sold		(37,294	)		(14,258	)
Balance at December 31, 2011	$	43,055		$	19,932

The $1,545,000 in reduced reserves recorded against impaired loans was included in the provision for loan losses on the statement of operations for the year ended December 31, 2011.  The $3,562,000 of additional reserves recorded against foreclosed real estate was included in non-interest expenses on the statement of operations for the year ended December 31, 2011.  Included in the $16,295,000 of loans transferred to foreclosed real estate, were 13 loans totaling $5,134,000 that did not require a specific reserve at the date of transfer from loans to foreclosed real estate.

The $944,000 in reduced reserves recorded against impaired loans was included in the provision for loan losses on the statement of operations for the year ended December 31, 2010.  The $3,451,000 of additional reserves recorded against foreclosed real estate was included in non-interest expenses on the statement of operations for the year ended December 31, 2010.  Included in the $24,137,000 of loans transferred to foreclosed real estate, were 22 loans totaling $7,197,000 that did not require a specific reserve at the date of transfer from loans to foreclosed real estate.

F-44

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 - Fair Value of Financial Instruments – Continued

The estimated fair values of Bancorp’s financial instruments are as follows:

	December 31, 2011				December 31, 2010
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(dollars in thousands)
Financial Assets
Cash and cash equivalents	$	87,390	$	87,390	$	70,955	$	70,955
Investment securities		40,357		41,724		27,311		27,556
Loans held for sale		4,128		4,128		3,426		3,426
Loans receivable, net		693,303		743,668		778,937		819,864
FHLB stock		6,943		6,943		7,692		7,692
Accrued interest receivable		3,420		3,420		3,918		3,918
Financial Liabilities
Deposits	$	652,757	$	656,854	$	714,776	$	719,142
FHLB advances		115,000		102,260		115,000		105,546
Subordinated debentures		24,119		24,119		24,119		24,119
Accrued interest payable		699		699		694		694
Off Balance Sheet Commitments	$	-	$	-	$	-	$	-

F-45

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17 - Condensed Financial Information (Parent Company Only)

Information as to the financial position of Severn Bancorp, Inc. as of December 31, 2011 and 2010 and results of operations and cash flows for each of the years ended December 31, 2011, 2010 and 2009 is summarized below.

	December 31,
	2011		2010
	(dollars in thousands)
Statements of Financial Condition
Cash	$	1,346	$	1,857
Equity in net assets of subsidiaries:
Bank		122,141		120,258
Non-Bank		4,728		5,633
Loans, net of allowance for loan losses of     $19 and $232, respectively		607		947
Other assets		1,341		1,632
Total assets	$	130,163	$	130,327
Subordinated debentures	$	24,119	$	24,119
Other liabilities		114		108
Total liabilities		24,233		24,227
Stockholders’ equity		105,930		106,100
Total liabilities and stockholders’ equity	$	130,163	$	130,327

	For the Years Ended December 31,
	2011			2010			2009
	(dollars in thousands)
Statements of Operations
Interest income	$	82		$	65		$	76
Interest expense on subordinated debentures		772			899			880
Net interest expense		(690	)		(834	)		(804	)
Dividends received from subsidiaries		-			-			1,567
General and administrative expenses		13			386			599
Income (loss) before income taxes and equity in		(703	)		(1,220	)		164
undistributed net income (loss) of subsidiaries
Income tax (expense) benefit		(55	)		528			342
Equity in undistributed net income (loss) of subsidiaries		1,977			1,849			(15,734	)
Net income (loss)	$	1,219		$	1,157		$	(15,228	)

F-46

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17 - Condensed Financial Information (Parent Company Only) - Continued

	For the Years Ended December 31,
	2011			2010			2009
	(dollars in thousands)
Statements of Cash Flows
Cash Flows from Operating Activities:
Net income (loss)	$	1,219		$	1,157		$	(15,228	)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Equity in undistributed (earnings) loss of subsidiaries		(1,977	)		(1,849	)		15,734
Provision for loan losses		-			-			209
(Increase) decrease in other assets		290			(314	)		(1	)
Stock-based compensation expense		61			162			128
Increase (decrease) in other liabilities		6			-			(646	)
Cash provided by (used in) operating activities		(401	)		(844	)		196
Cash Flows from Investing Activities:
Net decrease in loans		340			-			2
Contribution from (investment in) subsidiaries		1,000			-			(2,000	)
Cash provided by (used in) investing activities		1,340			-			(1,998	)
Cash Flows from Financing Activities:
Dividends paid on common stock		-			-			(906	)
Series A preferred stock dividend paid		(280	)		(280	)		(280	)
Series B preferred stock dividend paid		(1,170	)		(1,170	)		(1,150	)
Cash used in financing activities		(1,450	)		(1,450	)		(2,336	)
Decrease in cash and cash equivalents		(511	)		(2,294	)		(4,138	)
Cash and cash equivalents at beginning of year		1,857			4,151			8,289
Cash and cash equivalents at end of year	$	1,346		$	1,857		$	4,151

F-47

SEVERN BANCORP, INC. AND SUBSIDIARIES

Annapolis, Maryland

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 18 - Quarterly Financial Data (Unaudited)

Summarized unaudited quarterly financial data for the year ended December 31, 2011 is as follows:

	First Quarter		Second Quarter			Third Quarter		Fourth Quarter
	(dollars in thousands, except per share data)
Interest income	$	11,698	$	11,254		$	10,991	$	10,558
Interest expense		4,126		3,946			3,856		3,659
Net interest income		7,572		7,308			7,135		6,899
Provision for loan losses		634		2,987			850		141
Net interest income after provision for         loan losses		6,938		4,321			6,285		6,758
Other income		562		447			628		873
Other expenses		6,709		6,171			5,959		5,772
Income (loss) before income tax provision (benefit)		791		(1,403	)		954		1,859
Income tax provision (benefit)		344		(557	)		403		792
Net income (loss)	$	447	$	(846	)	$	551	$	1,067
Per share data:
Earnings (loss) – basic	$	0.00	$	(.13	)	$	0.01	$	0.06
Earnings (loss) – diluted	$	0.00	$	(.13	)	$	0.01	$	0.06

      Summarized unaudited quarterly financial data for the year ended December 31, 2010 is as follows:

	First Quarter			Second Quarter		Third Quarter		Fourth Quarter
	(dollars in thousands, except per share data)
Interest income	$	12,596		$	13,045	$	12,083	$	11,809
Interest expense		4,980			4,995		4,906		4,448
Net interest income		7,616			8,050		7,177		7,361
Provision for loan losses		2,544			1,000		1,000		1,200
Net interest income after provision for         loan losses		5,072			7,050		6,177		6,161
Other income		563			537		724		921
Other expenses		6,464			6,533		6,031		5,980
Income (loss) before income tax provision (benefit)		(829	)		1,054		870		1,102
Income tax provision (benefit)		(301	)		461		385		495
Net income (loss)	$	(528	)	$	593	$	485	$	607
Per share data
Earnings (loss) – basic	$	(.10	)	$	0.02	$	0.01	$	0.02
Earnings (loss) – diluted	$	(.10	)	$	0.02	$	0.01	$	0.02

F-48