Severn Bancorp (SVBI) 10-Q 2019 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2019

or

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

For the transition period from     to   .

Commission File Number 0‑49731

SEVERN BANCORP, INC.

(Exact name of registrant as specified in its charter)

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

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

410‑260‑2000

(Registrant’s telephone number, including area code)

N/A

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

Securities registered pursuant to Section 12(b) of the Act:

Title of each class:	Trading Symbol	Name of each exchange on which registered:
Common Stock, par value $0.01 per share	SVBI	The NASDAQ Stock Market, LLC

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

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

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

Large accelerated filer ☐	Accelerated filer  ☑
Non- accelerated filer ☐	Smaller reporting company ☑
Emerging growth company  ☐

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

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

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

Common Stock, $0.01 par value –12,809,637 shares outstanding as of November 8, 2019

SEVERN BANCORP, INC. AND SUBSIDIARIES

Table of Contents

		Page
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Statements of Financial Condition as of September 30, 2019 and December 31, 2018 (unaudited)	3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2019 and 2018 (unaudited)	4
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2019 and 2018 (unaudited)	5
	Consolidated Statements of Changes in Stockholders’ Equity for the Three and Nine Months Ended September 30, 2019 and 2018 (unaudited)	6
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2019 and 2018 (unaudited)	8
	Notes to Consolidated Financial Statements (unaudited)	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	48
Item 4.	Controls and Procedures	49
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	51
Item 1A.	Risk Factors	51
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 3.	Defaults Upon Senior Securities	51
Item 4.	Mine Safety Disclosures	51
Item 5.	Other Information	51
Item 6.	Exhibits	51
EXHIBIT INDEX		52
SIGNATURES		53

1

Caution Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10‑Q, as well as other periodic reports filed with the Securities and Exchange Commission (“SEC”), and written or oral communications made from time to time by or on behalf of Severn Bancorp and its subsidiaries (the “Company”), may contain statements relating to future events or future results of the Company that are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “intend,” and “potential,” or words of similar meaning, or future or conditional verbs such as “should,” “could,” or “may.”  Forward-looking statements include statements of our goals, intentions and expectations; statements regarding our business plans, prospects, growth, and operating strategies; statements regarding the quality of our loan and investment portfolios; and estimates of our risks and future costs and benefits.

Forward-looking statements reflect our expectation or prediction of future conditions, events, or results based on information currently available. These forward-looking statements are subject to significant risks and uncertainties that may cause actual results to differ materially from those in such statements. These risks and uncertainties include, but are not limited to, the risks identified in Item 1A of the Company’s 2018 Annual Report on Form 10‑K, Item 1A of Part II of the Company’s March 31, 2019 Quarterly Report on Form 10-Q, Item 1A of Part II of the Company’s June 30, 2019 Quarterly Report on Form 10-Q,  Item 1A of Part II of this Quarterly Report on Form 10‑Q, and the following:

· general business and economic conditions nationally or in the markets that the Company serves could adversely affect, among other things, real estate prices, unemployment levels, and consumer and business confidence, which could lead to decreases in the demand for loans, deposits, and other financial services that we provide and increases in loan delinquencies and defaults;

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

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

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

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

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

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

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

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

· the effect of any change in federal government enforcement of federal laws affecting the medical-use cannabis industry;

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

· geopolitical conditions, including acts or threats of terrorism, actions taken by the U.S. or other governments in response to acts or threats of terrorism, and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad.

Forward-looking statements speak only as of the date of this report. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date of this report or to reflect the occurrence of unanticipated events except as required by federal securities laws.

2

PART I – FINANCIAL INFORMATION

Item 1.Financial Statements

Severn Bancorp, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in thousands, except per share data)

(unaudited)

	September 30,		December 31,
	2019		2018
ASSETS
Cash and due from banks	$	2,478	$	2,880
Federal funds sold and interest-bearing deposits in other banks		62,775		185,460
Cash and cash equivalents		65,253		188,340
Certificates of deposit held for investment		7,540		8,780
Securities available for sale, at fair value		9,029		11,978
Securities held to maturity (fair value of $30,459 and $38,212 at September 30, 2019 and December 31, 2018, respectively)		30,302		38,912
Mortgage loans held for sale, at fair value		17,587		9,686
Loans receivable		660,879		682,349
Allowance for loan losses		(7,431)		(8,044)
Loans, net		653,448		674,305
Real estate acquired through foreclosure		1,873		1,537
Restricted stock investments		2,431		3,766
Premises and equipment, net		22,384		22,745
Accrued interest receivable		2,514		2,848
Deferred income taxes		1,902		2,363
Bank owned life insurance		5,341		5,225
Goodwill		1,104		1,104
Other assets		5,211		2,644
Total assets	$	825,919	$	974,233
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest bearing	$	129,777	$	146,604
Interest-bearing		527,377		632,902
Total deposits		657,154		779,506
Long-term borrowings		38,498		73,500
Subordinated debentures		20,619		20,619
Accrued expenses and other liabilities		5,029		2,155
Total liabilities		721,300		875,780
Stockholders' Equity:
Common stock, $0.01 par value, 20,000,000 shares authorized; 12,777,537 and 12,759,576 shares issued and outstanding at September 30, 2019 and December 31, 2018, respectively		128		128
Additional paid-in capital		65,744		65,538
Retained earnings		38,750		32,860
Accumulated other comprehensive loss		(3)		(73)
Total stockholders' equity		104,619		98,453
Total liabilities and stockholders' equity	$	825,919	$	974,233

See accompanying notes to consolidated financial statements

3

Severn Bancorp, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data)

(unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Interest income:
Loans	$	9,146	$	8,844	$	27,539	$	25,731
Securities		224		293		724		920
Other earning assets		484		423		2,358		787
Total interest income		9,854		9,560		30,621		27,438
Interest expense:
Deposits		1,732		1,531		5,499		3,938
Borrowings and subordinated debentures		473		684		1,543		2,244
Total interest expense		2,205		2,215		7,042		6,182
Net interest income		7,649		7,345		23,579		21,256
Reversal of provision for loan losses		(500)		(300)		(500)		(300)
Net interest income after reversal of provision for loan losses		8,149		7,645		24,079		21,556
Noninterest income:
Mortgage-banking revenue		1,108		740		2,915		1,970
Real estate commissions		430		408		1,290		1,153
Real estate management fees		144		157		470		527
Deposit service charges		565		426		1,621		1,067
Title company revenue		362		316		841		751
Other noninterest income		204		214		551		654
Total noninterest income		2,813		2,261		7,688		6,122
Noninterest expense:
Compensation and related expenses		5,065		4,661		14,499		13,359
Occupancy		379		416		1,183		1,151
Legal fees		59		37		134		79
Write-downs, losses, and costs of real estate acquired through foreclosure, net of gains		105		7		254		21
Federal Deposit Insurance Corporation insurance premiums		58		58		177		171
Professional fees		255		109		838		323
Advertising		235		302		635		751
Data processing		414		286		1,110		805
Credit report and appraisal fees		69		99		133		140
Licensing and software		266		129		741		407
Other noninterest expense		765		853		2,229		2,250
Total noninterest expense		7,670		6,957		21,933		19,457
Net income before income tax provision		3,292		2,949		9,834		8,221
Income tax provision		911		784		2,668		2,253
Net income		2,381		2,165		7,166		5,968
Dividends on preferred stock		—		—		—		(70)
Net income available to common stockholders	$	2,381	$	2,165	$	7,166	$	5,898
Net income per common share - basic	$	0.19	$	0.17	$	0.56	$	0.47
Net income per common share - diluted	$	0.19	$	0.17	$	0.56	$	0.47

See accompanying notes to consolidated financial statements

4

Severn Bancorp, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands)

(unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Net income	$	2,381	$	2,165	$	7,166	$	5,968
Other comprehensive income (loss) items:
Unrealized holding gains (losses) on available-for-sale securities arising during the period (net of tax expense (benefit) of $5, $(2), $26, and $(27))		8		(5)		70		(71)
Total other comprehensive income (loss)		8		(5)		70		(71)
Total comprehensive income	$	2,389	$	2,160	$	7,236	$	5,897

See accompanying notes to consolidated financial statements

5

Severn Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(dollars in thousands, except per share data)

(unaudited)

	Three Months Ended September 30, 2019
	Number of	Number of									Accumulated
	Shares of	Shares of					Additional				Other		Total
	Preferred	Common	Preferred		Common		Paid-In		Retained		Comprehensive		Stockholders'
	Stock	Stock	Stock		Stock		Capital		Earnings		Loss		Equity
Balance at July 1, 2019	—	12,775,137	$	—	$	128	$	65,696	$	36,878	$	(11)	$	102,691
Net income	—	—		—		—		—		2,381		—		2,381
Stock-based compensation	—	—		—		—		32		—		—		32
Dividends paid on common stock at $0.04 per share	—	—		—		—		—		(509)		—		(509)
Exercise of stock options	—	2,400		—		—		16		—		—		16
Other comprehensive income	—	—		—		—		—		—		8		8
Balance at September 30, 2019	—	12,777,537	$	—	$	128	$	65,744	$	38,750	$	(3)	$	104,619

	Three Months Ended September 30, 2018
	Number of	Number of									Accumulated
	Shares of	Shares of					Additional				Other		Total
	Preferred	Common	Preferred		Common		Paid-In		Retained		Comprehensive		Stockholders'
	Stock	Stock	Stock		Stock		Capital		Earnings		Loss		Equity
Balance at July 1, 2018	—	12,694,926	$	—	$	127	$	65,157	$	28,858	$	(101)	$	94,041
Net income	—	—		—		—		—		2,165		—		2,165
Stock-based compensation	—	—		—		—		56		—		—		56
Dividends paid on common stock at $0.03 per share	—	—		—		—		—		(381)		—		(381)
Exercise of stock options	—	875		—		—		3		—		—		3
Other comprehensive loss	—	—		—		—		—		—		(5)		(5)
Balance at September 30, 2018	—	12,695,801	$	—	$	127	$	65,216	$	30,642	$	(106)	$	95,879

	Nine Months Ended September 30, 2019
	Number of	Number of									Accumulated
	Shares of	Shares of					Additional				Other		Total
	Preferred	Common	Preferred		Common		Paid-In		Retained		Comprehensive		Stockholders'
	Stock	Stock	Stock		Stock		Capital		Earnings		Loss		Equity
Balance at January 1, 2019	—	12,759,576	$	—	$	128	$	65,538	$	32,860	$	(73)	$	98,453
Net income	—	—		—		—		—		7,166		—		7,166
Stock-based compensation	—	—		—		—		109		—		—		109
Dividends paid on common stock at $0.10 per share	—	—		—		—		—		(1,276)		—		(1,276)
Exercise of stock options	—	17,961		—		—		97		—		—		97
Other comprehensive income	—	—		—		—		—		—		70		70
Balance at September 30, 2019	—	12,777,537	$	—	$	128	$	65,744	$	38,750	$	(3)	$	104,619

6

	Nine Months Ended September 30, 2018
	Number of	Number of									Accumulated
	Shares of	Shares of					Additional				Other		Total
	Preferred	Common	Preferred		Common		Paid-In		Retained		Comprehensive		Stockholders'
	Stock	Stock	Stock		Stock		Capital		Earnings		Loss		Equity
Balance at January 1, 2018	437,500	12,233,424	$	4	$	122	$	65,137	$	25,872	$	(35)	$	91,100
Net income	—	—		—		—		—		5,968		—		5,968
Stock-based compensation	—	—		—		—		169		—		—		169
Redemption of preferred stock	(437,500)	437,500		(4)		4		—		—		—		—
Dividend declared on Series A preferred stock	—	—		—		—		—		(70)		—		(70)
Dividends paid on common stock at $0.09 per share	—	—		—		—		—		(1,128)		—		(1,128)
Exercise of stock options	—	24,877		—		1		99		—		—		100
Other	—	—		—		—		(189)		—		—		(189)
Other comprehensive loss	—	—		—		—		—		—		(71)		(71)
Balance at September 30, 2018	—	12,695,801	$	—	$	127	$	65,216	$	30,642	$	(106)	$	95,879

See accompanying notes to consolidated financial statements

7

Severn Bancorp, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(unaudited)

	Nine Months Ended September 30,
	2019		2018
Cash flows from operating activities:
Net income	$	7,166	$	5,968
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		1,061		966
Amortization of deferred loan fees		(1,403)		(1,317)
Net amortization of premiums and discounts		120		174
Reversal of provision for loan losses		(500)		(300)
Write-downs and losses on real estate acquired through foreclosure, net of gains		244		54
Gain on sale of mortgage loans		(2,915)		(1,970)
Proceeds from sale of mortgage loans held for sale		130,129		64,815
Originations of loans held for sale		(135,766)		(67,338)
Stock-based compensation		109		169
Increase in cash surrender value of bank-owned life insurance		(116)		(122)
Deferred income taxes		435		2,083
Decrease (increase) in accrued interest receivable		334		(49)
Increase in other assets		(2,567)		(1,408)
Increase in accrued expenses and other liabilities		2,874		2,808
Net cash (used in) provided by operating activities		(795)		4,533
Cash flows from investing activities:
Redemption of certificates of deposit held for investment		1,240		—
Loan principal repayments, net of (disbursements)		22,722		(19,943)
Redemption of restricted stock investments		1,335		623
Purchases of premises and equipment, net		(700)		(758)
Activity in securities held to maturity:
Maturities/calls/repayments		8,535		11,093
Activity in available-for-sale securities:
Purchases		—		(2,000)
Maturities/calls/repayments		3,000		—
Proceeds from sales of real estate acquired through foreclosure		107		64
Net cash provided by (used in) investing activities		36,239		(10,921)
Cash flows from financing activities:
Net (decrease) increase in deposits		(122,352)		91,949
Additional long-term borrowings		—		46,500
Repayments of long-term borrowings		(35,000)		(61,500)
Common stock dividends		(1,276)		(1,128)
Preferred stock dividends		—		(70)
Exercise of stock options		97		100
Net cash (used in) provided by financing activities		(158,531)		75,851
(Decrease) increase in cash and cash equivalents		(123,087)		69,463
Cash and cash equivalents at beginning of period		188,340		21,853
Cash and cash equivalents at end of period	$	65,253	$	91,316
Supplemental Noncash Disclosures:
Interest paid on deposits and borrowed funds	$	7,148	$	6,144
Income taxes paid		1,919		96
Real estate acquired in satisfaction of loans		687		—
Initial recognition of operating lease right-of-use asset		2,684		—
Initial recognition of operating lease liability		2,684		—
Transfers of loans held for sale to loan portfolio		648		—

See accompanying notes to consolidated financial statements

8

Severn Bancorp, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 -  Summary of Significant Accounting Policies

Basis of Presentation

The accounting and reporting policies of Severn Bancorp, Inc. and subsidiaries (the “Company”) conform to accounting principles generally accepted in the United States of America (“U.S.”) (“GAAP”) and prevailing practices within the financial services industry for interim financial information and Rule 8‑01 of Regulation S-X. Accordingly, they do not include all of the information and notes required for complete financial statements and prevailing practices within the banking industry. In the opinion of management, all adjustments (comprising only of those of a normal recurring nature) necessary for a fair presentation of the results of operations for the interim periods presented have been made. The results of operations for the three and nine months ended September 30, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2019 or any other interim or future period. Events occurring after the date of the financial statements up to the date the financial statements were available to be issued were considered in the preparation of the consolidated financial statements.

These statements should be read in conjunction with the financial statements and accompanying notes included in the Company’s 2018 Annual Report on Form 10‑K as filed with the Securities and Exchange Commission (“SEC”).

Principles of Consolidation

The unaudited consolidated financial statements include the accounts of Severn Bancorp, Inc., and its wholly-owned subsidiaries, Mid-Maryland Title Company, Inc., SBI Mortgage Company, and Severn Savings Bank, FSB (the “Bank”), along with 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. Also included are the accounts of SBI Mortgage Company’s subsidiary, Crownsville Development Corporation, and its subsidiary, Crownsville Holdings I, LLC. All intercompany accounts and transactions have been eliminated in the accompanying consolidated financial statements.

Use of Estimates

The preparation of the financial statements requires management to exercise significant judgment or discretion or make significant assumptions and estimates based on the information available that have, or could have, a material impact on the carrying value of certain assets or on income. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. The accounting policies we view as critical are those relating to the allowance for loan losses (“Allowance”), the valuation of securities, the valuation of real estate acquired through foreclosure, and the valuation of deferred tax assets and liabilities.

Cash Flows

We consider all highly liquid securities with original maturities of three months or less to be cash equivalents. For reporting purposes, assets grouped in the Consolidated Statements of Financial Condition under the captions “Cash and due from banks” and “Federal funds sold and interest-bearing deposits in other banks” are considered cash or cash equivalents.  For financial statement purposes, these assets are carried at cost. Federal funds sold and interest-bearing deposits in other banks generally have overnight maturities and are in excess of amounts that would be recoverable under Federal Deposit Insurance Corporation (“FDIC”) insurance.

Reclassifications

Certain reclassifications have been made to amounts previously reported to conform to current period presentation.

9

Recent Accounting Pronouncements

Pronouncements Adopted

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016‑02, Leases, which requires a lessee to recognize the assets and liabilities that arise from all leases with a term greater than 12 months. The core principle requires the lessee to recognize a liability to make lease payments and a right-of-use (“ROU”) asset. The accounting applied by the lessor is relatively unchanged. The ASU also requires expanded qualitative and quantitative disclosures. For public business entities, the guidance was effective for interim and annual reporting periods beginning after December 15, 2018 and mandated a modified retrospective transition for all entities. We adopted this standard using the option to apply the transition provisions of the new standard at the adoption date instead of the earliest period presented as provided in ASU 2018-11. Additionally, we elected to apply all practical expedients as provided in ASU 2016-02, with the exception of the hindsight practical expedient which was not elected. As a result of the adoption of this standard, effective January 1, 2019, we recognized both an ROU asset and a lease liability of $2.7 million to be recorded in other assets and other liabilities, respectively, on the balance sheet.  The lease liability represented the present value of the future payments on five leased properties and six leased pieces of equipment within the Company’s footprint, while the ROU asset reflected the lease liability adjusted for deferred rent balances of the respective properties as of the adoption date of January 1, 2019. The Company expects its regulatory capital ratios to remain above the thresholds necessary to be classified as a “well capitalized” institution.

In March 2017, FASB issued ASU No. 2017‑08, Receivables - Nonrefundable Fees and Other costs, which provided guidance that called for the shortening of the amortization period for certain callable debt securities held at a premium. The standard was effective for interim and annual reporting periods beginning after December 15, 2018. The adoption of ASU No. 2017‑08 did not have a material impact on our financial position, results of operations, or cash flows.

In February 2018, FASB issued ASU No. 2018-02, Reclassification of Certain Tax Effects From Accumulated Other Comprehensive Income, which allowed a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. The ASU was effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The adoption of ASU No. 2018-02 did not have a material impact on its financial position, results of operations, or cash flows. 

Pronouncements Issued

In September 2016, FASB issued ASU No. 2016‑13, Financial Instruments – Credit Losses, which sets forth a current expected credit loss (“CECL”) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. In July 2019, the FASB issued a proposal to delay the implementation for smaller reporting companies such as us until January 2023.  In October, 2019, that proposal was finalized. 

We have contracted with a third party vendor to assist in the transition to CECL. The Bank has purchased the third party vendor’s CECL software and has separately contracted with their advisory services group to help with the installation and transition. As the Bank has been using other software of this specific vendor, they have access to the Bank’s historical data. The third party vendor has been analyzing the Bank’s data, and the Bank has been updating the data and the process by which data will be transferred to the third party vendor, so that they have all of the information necessary for CECL calculations. This process is almost complete. The third party vendor has also begun determining which economic factors are most directly responsible for Bank’s historical losses. They have also started to recommend pools to be used for CECL calculations, and appropriate methods (as proscribed by CECL) to calculate the reserve for the various pools. As the third party vendor has many financial institution clients, they will be able to provide peer group data to the extent the Bank’s data is not sufficient to make the many determinations required under CECL.

Although the implementation of CECL has been delayed, the Bank will continue with the implementation at a pace to

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ensure that we will be in position to completely transition to CECL by the required date. 

While we are currently in the process of evaluating the impact of the amended guidance on our Consolidated Financial Statements, it is quite possible that the Allowance will increase upon adoption given that the Allowance will be required to cover the full remaining expected life of the portfolio upon adoption, rather than the incurred loss model under current GAAP. The extent of this increase is still being evaluated and will depend on economic conditions and the composition of our loan and lease portfolio at the time of adoption.

Note 2 - Securities

The amortized cost and fair values of our available-for-sale (“AFS”) securities portfolio were as follows:

	September 30, 2019
	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses		Fair Value
	(dollars in thousands)
U.S. Treasury securities	$	999	$	—	$	—	$	999
U.S. government agency notes		8,034		—		4		8,030
	$	9,033	$	—	$	4	$	9,029

	December 31, 2018
	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses		Fair Value
	(dollars in thousands)
U.S. Treasury securities	$	1,992	$	—	$	11	$	1,981
U.S. government agency notes		10,086		—		89		9,997
	$	12,078	$	—	$	100	$	11,978

The amortized cost and fair values of our held-to-maturity (“HTM”) securities portfolio were as follows:

	September 30, 2019
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(dollars in thousands)
U.S. Treasury securities	$	1,993	$	17	$	—	$	2,010
U.S. government agency notes		6,987		108		12		7,083
Mortgage-backed securities		21,322		78		34		21,366
	$	30,302	$	203	$	46	$	30,459

	December 31, 2018
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(dollars in thousands)
U.S. Treasury securities	$	1,991	$	17	$	—	$	2,008
U.S. government agency notes		11,992		45		92		11,945
Mortgage-backed securities		24,929		6		676		24,259
	$	38,912	$	68	$	768	$	38,212

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Gross unrealized losses and fair value by length of time that the individual AFS securities have been in an unrealized loss position at the dates indicated are presented in the following tables:

	September 30, 2019
	Less than 12 months					12 months or more					Total
	# of	Fair		Unrealized		# of	Fair		Unrealized		# of	Fair		Unrealized
	Securities	Value		Losses		Securities	Value		Losses		Securities	Value		Losses
	(dollars in thousands)
U.S. government agency notes	2	$	3,009		1	4	$	5,021		3	6	$	8,030		4
	2	$	3,009	$	1	4	$	5,021	$	3	6	$	8,030	$	4

	December 31, 2018
	Less than 12 months					12 months or more					Total
	# of	Fair		Unrealized		# of	Fair		Unrealized		# of	Fair		Unrealized
	Securities	Value		Losses		Securities	Value		Losses		Securities	Value		Losses
	(dollars in thousands)
U.S. Treasury securities	1	$	990	$	5	1	$	991	$	6	2	$	1,981	$	11
U.S. government agency notes	—		—		—	8		9,997		89	8		9,997		89
	1	$	990	$	5	9	$	10,988	$	95	10	$	11,978	$	100

Gross unrealized losses and fair value by length of time that the individual HTM securities have been in an unrealized loss position at the dates indicated are presented in the following tables:

	September 30, 2019
	Less than 12 months					12 months or more					Total
	# of	Fair		Unrealized		# of	Fair		Unrealized		# of	Fair		Unrealized
	Securities	Value		Losses		Securities	Value		Losses		Securities	Value		Losses
	(dollars in thousands)
U.S. government agency notes	—	$	—	$	—	4	$	3,999	$	12	4	$	3,999	$	12
Mortgage-backed securities	4		5,158		12	3		3,920		22	7		9,078		34
	4	$	5,158	$	12	7	$	7,919	$	34	11	$	13,077	$	46

	December 31, 2018
	Less than 12 months					12 months or more					Total
	# of	Fair		Unrealized		# of	Fair		Unrealized		# of	Fair		Unrealized
	Securities	Value		Losses		Securities	Value		Losses		Securities	Value		Losses
	(dollars in thousands)
U.S. government agency notes	—	$	—	$	—	10	$	9,927	$	92	10		9,927		92
Mortgage-backed securities	—		—		—	18		24,011		676	18		24,011		676
	—	$	—	$	—	28	$	33,938	$	768	28	$	33,938	$	768

All of the securities that are currently in a gross unrealized loss position are so due to declines in fair values resulting from changes in interest rates or increased liquidity spreads since the time they were purchased. We have the intent and ability to hold these debt securities to maturity (including the AFS securities) and do not intend to sell, nor do we believe it will be more likely than not that we will be required to sell, any impaired securities prior to a recovery of amortized cost. We expect these securities will be repaid in full, with no losses realized. As such, management considers any impairment to be temporary.

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Contractual maturities of debt securities at September 30, 2019 are shown below. Actual maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

	AFS Securities				HTM Securities
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
	(dollars in thousands)
Due in one year or less	$	9,033	$	9,029	$	5,002	$	4,998
Due after one through five years		—		—		3,978		4,095
Mortgage-backed securities		—		—		21,322		21,366
	$	9,033	$	9,029	$	30,302	$	30,459

We did not sell any securities during the three and nine months ended September 30, 2019 or 2018.

There were no securities pledged as collateral as of September 30, 2019 or December 31, 2018.

Note 3 -  Loans Receivable and Allowance for Loan Losses

Loans receivable are summarized as follows:

	September 30, 2019		December 31, 2018
	(dollars in thousands)
Residential mortgage	$	271,336	$	276,389
Commercial		44,774		35,884
Commercial real estate		240,764		244,088
Construction, land acquisition, and development		93,350		114,540
Home equity/2nds		11,930		13,386
Consumer		1,545		1,087
Total loans receivable		663,699		685,374
Unearned loan fees		(2,820)		(3,025)
Loans receivable	$	660,879	$	682,349

Certain loans in the amount of $162.3 million have been pledged under a blanket floating lien to the Federal Home Loan Bank of Atlanta (“FHLB”) as collateral against advances at September 30, 2019.

At September 30, 2019, the Bank was servicing $27.0 million in loans for the Federal National Mortgage Association (“FNMA”) and $13.6 million in loans for the Federal Home Loan Mortgage Corporation (“FHLMC”). At December 31, 2018, the Bank was servicing $29.4 million in loans for FNMA and $15.1 million in loans for FHLMC.

Credit Quality

An Allowance is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible based on evaluations of the collectability of loans and prior loan loss experience. Management has an established methodology to determine the adequacy of the Allowance that assesses the risks and losses inherent in the loan portfolio. The methodology takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay. Determining the amount of the Allowance requires the use of estimates and assumptions. Actual results could differ significantly from those estimates. While management uses all available information to estimate losses on loans, future additions to the Allowance may be necessary based on changes in economic conditions and our actual loss experience. In addition, various regulatory agencies periodically review the Allowance as an integral part of their examination process. Such agencies may require us to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination. Management believes the Allowance is adequate as of September 30, 2019 and December 31, 2018.

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At December 31, 2018, due to a re-evaluation of our qualitative factors, we changed our estimates of the Allowance relative to historical loss experience within specific loan portfolio segments in order to better align our qualitative factors with historical losses experienced over a longer period of time, relative to those specific loan segments. The result of this change in estimate did not result in a material increase in the Allowance compared to the year ended December 31, 2017, however there were material changes to the Allowance between loan segments. Due to the change in accounting estimate, Allowance allocated to commercial loans and ADC loans increased approximately $2.2 million and $1.1 million, respectively, while the Allowance allocated to residential mortgage loans and commercial real estate loans decreased approximately $600,000 and $2.7 million, respectively, as of December 31, 2018. This change in accounting estimate had no impact on earnings or diluted earnings per share.

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

Inherent Credit Risks

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

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

Commercial - underwritten in accordance with our policies and include evaluating historical and projected profitability and cash flow to determine the borrower’s ability to repay the obligation as agreed. Commercial loans are made primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral supporting the loan. Accordingly, the repayment of a commercial loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment. These loans are viewed primarily as cash flow dependent and, secondarily, as loans secured by real-estate and/or other assets. Repayment of these loans is generally dependent upon the principal business conducted on the property securing the loan. Line of credit loans may be adversely affected by conditions in the real estate markets or the economy in general. Management monitors and evaluates line of credit loans based on collateral and risk-rating criteria.

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

ADC - underwritten in accordance with our underwriting policies which include a financial analysis of the developers, property owners, construction cost estimates, and independent appraisal valuations. These loans will rely on the value associated with the project upon completion. These cost and valuation estimates may be inaccurate. Construction loans generally involve the disbursement of substantial funds over a short period of time with repayment substantially dependent upon the success of the completed project rather than the ability of the borrower or guarantor to repay principal and interest. Additionally, land is underwritten according to our policies which include independent appraisal valuations as well as the estimated value associated with the land upon completion of development. These cost and valuation estimates may be inaccurate.

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

If the Bank is forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of the loan as well as related foreclosure and holding costs. In addition, the Bank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time.

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

Consumer - consist of loans to individuals through the Bank’s retail network and typically unsecured or secured by personal property. Consumer loans have a greater credit risk than residential loans because of the lower value of the underlying collateral, if any.

The following tables present, by portfolio segment, the changes in the Allowance and the recorded investment in loans:

	Three Months Ended September 30, 2019
	Residential				Commercial				Home Equity/
	Mortgage		Commercial		Real Estate		ADC		2nds		Consumer		Unallocated		Total
	(dollars in thousands)
Beginning Balance	$	2,566	$	1,566	$	792	$	2,683	$	223	$	—	$	263	$	8,093
Charge-offs		—		—		(199)		—		—		(2)		—		(201)
Recoveries		3		—		30		—		3		3		—		39
Net (charge-offs) recoveries		3		—		(169)		—		3		1		—		(162)
Provision for (reversal of) loan losses		(182)		(54)		346		(370)		—		(1)		(239)		(500)
Ending Balance	$	2,387	$	1,512	$	969	$	2,313	$	226	$	—	$	24	$	7,431

	Nine Months Ended September 30, 2019
	Residential				Commercial				Home Equity/
	Mortgage		Commercial		Real Estate		ADC		2nds		Consumer		Unallocated		Total
	(dollars in thousands)
Beginning Balance	$	2,224	$	2,736	$	457	$	2,239	$	222	$	1	$	165	$	8,044
Charge-offs		(20)		—		(199)		—		—		(14)		—		(233)
Recoveries		11		—		97		—		9		3		—		120
Net (charge-offs) recoveries		(9)		—		(102)		—		9		(11)		—		(113)
Provision for (reversal of) loan losses		172		(1,224)		614		74		(5)		10		(141)		(500)
Ending Balance	$	2,387	$	1,512	$	969	$	2,313	$	226	$	—	$	24	$	7,431
Ending balance - individually evaluated for impairment	$	799	$	—	$	65	$	32	$	2	$	—	$	—	$	898
Ending balance - collectively evaluated for impairment		1,588		1,512		904		2,281		224		—		24		6,533
	$	2,387	$	1,512	$	969	$	2,313	$	226	$	—	$	24	$	7,431
Ending loan balance -individually evaluated for impairment	$	11,272	$	—	$	1,685	$	729	$	579	$	71			$	14,336
Ending loan balance -collectively evaluated for impairment		258,518		44,774		237,805		92,621		11,351		1,474				646,543
	$	269,790	$	44,774	$	239,490	$	93,350	$	11,930	$	1,545			$	660,879

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	December 31, 2018
	Residential				Commercial					Home Equity/
	Mortgage		Commercial		Real Estate		ADC		2nds		Consumer		Unallocated		Total
	(dollars in thousands)
Ending balance - individually evaluated for impairment	$	927	$	430	$	142	$	32	$	2	$	—	$	—	$	1,533
Ending balance - collectively evaluated for impairment		1,297		2,306		315		2,207		220		1		165		6,511
	$	2,224	$	2,736	$	457	$	2,239	$	222	$	1	$	165	$	8,044
Ending loan balance - individually evaluated for impairment	$	12,579	$	430	$	1,992	$	1,278	$	871	$	76			$	17,226
Ending loan balance - collectively evaluated for impairment		262,180		35,454		240,701		113,262		12,515		1,011				665,123
	$	274,759	$	35,884	$	242,693	$	114,540	$	13,386	$	1,087			$	682,349

	Three Months Ended September 30, 2018
	Residential				Commercial				Home Equity/
	Mortgage		Commercial		Real Estate		ADC		2nds		Consumer		Unallocated		Total
	(dollars in thousands)
Beginning Balance	$	2,962	$	414	$	2,591	$	2,060	$	229	$	1	$	—	$	8,257
Charge-offs		(148)		—		—		(6)		—		—		—		(154)
Recoveries		3		—		31		—		219		—		—		253
Net (charge-offs) recoveries		(145)		—		31		(6)		219		—		—		99
Provision for (reversal of) loan losses		204		219		10		(494)		(267)		—		28		(300)
Ending Balance	$	3,021	$	633	$	2,632	$	1,560	$	181	$	1	$	28	$	8,056

	Nine Months Ended September 30, 2018
	Residential				Commercial				Home Equity/
	Mortgage		Commercial		Real Estate		ADC		2nds		Consumer		Unallocated		��	Total
	(dollars in thousands)
Beginning Balance	$	3,099	$	527	$	2,805	$	1,236	$	386	$	2	$	—		$	8,055
Charge-offs		(508)		—		—		(19)		—		—		—			(527)
Recoveries		225		—		364		—		239		—		—			828
Net (charge-offs) recoveries		(283)		—		364		(19)		239		—		—			301
Provision for (reversal of) loan losses		205		106		(537)		343		(444)		(1)		28			(300)
Ending Balance	$	3,021	$	633	$	2,632	$	1,560	$	181	$	1	$	28		$	8,056
Ending balance - individually evaluated for impairment	$	1,090	$	—	$	166	$	900	$	2	$	1	$	—		$	2,159
Ending balance - collectively evaluated for impairment		1,931		633		2,466		660		179		—		28			5,897
	$	3,021	$	633	$	2,632	$	1,560	$	181	$	1	$	28		$	8,056
Ending loan balance - individually evaluated for impairment	$	15,038	$	—	$	2,053	$	1,582	$	772	$	78				$	19,523
Ending loan balance - collectively evaluated for impairment		270,432		43,180		232,777		111,412		11,401		987					670,189
	$	285,470	$	43,180	$	234,830	$	112,994	$	12,173	$	1,065				$	689,712

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The following tables present the credit quality breakdown of our loan portfolio by class:

	September 30, 2019
			Special
	Pass		Mention		Substandard		Total
	(dollars in thousands)
Residential mortgage	$	266,224	$	—	$	3,566	$	269,790
Commercial		43,571		1,203		—		44,774
Commercial real estate		235,048		2,965		1,477		239,490
ADC		92,914		—		436		93,350
Home equity/2nds		11,375		410		145		11,930
Consumer		1,545		—		—		1,545
	$	650,677	$	4,578	$	5,624	$	660,879

	December 31, 2018
			Special
	Pass		Mention		Substandard		Total
	(dollars in thousands)
Residential mortgage	$	270,727	$	827	$	3,205	$	274,759
Commercial		35,435		19		430		35,884
Commercial real estate		237,387		3,523		1,783		242,693
ADC		113,072		—		1,468		114,540
Home equity/2nds		12,536		434		416		13,386
Consumer		1,087		—		—		1,087
	$	670,244	$	4,803	$	7,302	$	682,349

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 tables present the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans:

	September 30, 2019
	Past Due
	30-59		60-89		90+								Non-
	Days		Days		Days		Total		Current		Total		Accrual
	(dollars in thousands)
Residential mortgage	$	1,382	$	293	$	3,326	$	5,001	$	264,789	$	269,790	$	3,386
Commercial		—		—		—		—		44,774		44,774		—
Commercial real estate		—		—		578		578		238,912		239,490		692
ADC		76		391		—		467		92,883		93,350		99
Home equity/2nds		—		—		145		145		11,785		11,930		156
Consumer		—		16		—		16		1,529		1,545		—
	$	1,458	$	700	$	4,049	$	6,207	$	654,672	$	660,879	$	4,333

	December 31, 2018
	Past Due
	30-59		60-89		90+								Non-
	Days		Days		Days		Total		Current		Total		Accrual
	(dollars in thousands)
Residential mortgage	$	1,060	$	—	$	1,794	$	2,854	$	271,905	$	274,759	$	2,580
Commercial		—		—		430		430		35,454		35,884		430
Commercial real estate		137		—		660		797		241,896		242,693		660
ADC		255		—		387		642		113,898		114,540		558
Home equity/2nds		96		—		428		524		12,862		13,386		428
Consumer		13		—		—		13		1,074		1,087		—
	$	1,561	$	—	$	3,699	$	5,260	$	677,089	$	682,349	$	4,656

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We did not have any loans greater than 90 days past due and still accruing as of September 30, 2019 or December 31, 2018.

The interest which would have been recorded on the above nonaccrual loans if those loans had been performing in accordance with their contractual terms was approximately $440,000 and $713,000 for the nine months ended September 30, 2019 and 2018, respectively. The actual interest received on such loans amounted to $107,000 and $208,000 for the nine months ended September 30, 2019 and 2018, respectively.

The following tables summarize impaired loans:

	September 30, 2019						December 31, 2018
	Unpaid						Unpaid
	Principal		Recorded		Related		Principal		Recorded		Related
	Balance		Investment		Allowance		Balance		Investment		Allowance
With no related Allowance:	(dollars in thousands)
Residential mortgage	$	6,534	$	6,339	$	—	$	7,054	$	6,808	$	—
Commercial		—		—		—		—		—		—
Commercial real estate		1,363		1,126		—		1,244		1,206		—
ADC		599		599		—		1,142		1,143		—
Home equity/2nds		1,010		566		—		1,290		859		—
Consumer		68		68		—		76		76		—
With a related Allowance:
Residential mortgage		5,053		4,933		799		5,888		5,771		927
Commercial		—		—		—		476		430		430
Commercial real estate		559		559		65		795		786		142
ADC		130		130		32		135		135		32
Home equity/2nds		13		13		2		13		12		2
Consumer		3		3		—		—		—		—
Totals:
Residential mortgage		11,587		11,272		799		12,942		12,579		927
Commercial		—		—		—		476		430		430
Commercial real estate		1,922		1,685		65		2,039		1,992		142
ADC		729		729		32		1,277		1,278		32
Home equity/2nds		1,023		579		2		1,303		871		2
Consumer		71		71		—		76		76		—

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	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
	Average		Interest		Average		Interest		Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income		Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized		Investment		Recognized		Investment		Recognized
With no related Allowance:	(dollars in thousands)
Residential mortgage	$	6,355	$	57	$	6,718	$	75	$	6,797	$	198	$	9,618	$	229
Commercial		—		—		6		—		—		—		59		—
Commercial real estate		1,259		15		1,572		21		1,215		52		1,240		56
ADC		599		8		674		7		925		22		547		20
Home equity/2nds		574		11		371		10		775		32		552		34
Consumer		68		1		—		—		52		4		—		—
With a related Allowance:
Residential mortgage		4,943		66		6,020		79		5,532		206		6,899		219
Commercial		—		—		—		—		108		—		—		—
Commercial real estate		561		6		774		4		660		25		1,243		19
ADC		130		2		176		2		133		6		1,103		9
Home equity/2nds		11		—		400		4		17		1		6		11
Consumer		3		—		79		1		22		—		81		2
Totals:
Residential mortgage		11,298		123		12,738		154		12,329		404		16,517		448
Commercial		—		—		6		—		108		—		59		—
Commercial real estate		1,820		21		2,346		25		1,875		77		2,483		75
ADC		729		10		850		9		1,058		28		1,650		29
Home equity/2nds		585		11		771		14		792		33		558		45
Consumer		71		1		79		1		74		4		81		2

There were $1.3 million and $1.4 million in consumer mortgage properties included in real estate acquired through foreclosure at September 30, 2019 and December 31, 2018, respectively. Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process according to local requirements of the applicable jurisdiction totaled $3.5 million as of September 30, 2019 and $1.9 million at December 31, 2018.

Troubled Debt Restructure Loans (“TDR” or “TDRs”)

Our portfolio of TDRs was accounted for under the following methods:

	September 30, 2019
							Total	Total
	Number of	Accrual		Number of	Nonaccrual		Number of	Balance of
	Modifications	Status		Modifications	Status		Modifications	Modifications
	(dollars in thousands)
Residential mortgage	32	$	7,828	2	$	292	34	$	8,120
Commercial real estate	2		993	—		—	2		993
ADC	1		131	—		—	1		131
Consumer	3		71	—		—	3		71
	38	$	9,023	2	$	292	40	$	9,315

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	December 31, 2018
							Total	Total
	Number of	Accrual		Number of	Nonaccrual		Number of	Balance of
	Modifications	Status		Modifications	Status		Modifications	Modifications
	(dollars in thousands)
Residential mortgage	36	$	9,469	3	$	446	39	$	9,915
Commercial real estate	2		1,019	—		—	2		1,019
ADC	1		134	—		—	1		134
Consumer	3		76	—		—	3		76
	42	$	10,698	3	$	446	45	$	11,144

There were no TDRs that defaulted during the three and nine months ended September 30, 2019 or 2018 which were modified during the previous 12 month period.

We did not modify any loans during the three and nine months ended September 30, 2019 or 2018.

Note 4 -  Regulatory Matters

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

In July 2013, federal bank regulatory agencies issued final rules to revise their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act (“Basel III”). On January 1, 2015, the Basel III rules became effective and included transition provisions which implement certain portions of the rules through January 1, 2019. Under the final rules, the effects of certain accumulated other comprehensive income items are not excluded, however, banking organizations like us that are not considered “advanced approaches” banking organizations may make a one-time permanent election to continue to exclude these items. With the submission of the Call Report for the first quarter of 2015, we made this election in order to avoid significant variations in the level of capital that can be caused by interest rate fluctuations on the fair value of the Bank’s AFS securities portfolio.

The Basel III rules also establish a “capital conservation buffer” of 2.5% above the regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses to executive officers if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

As a result of the Economic Growth, Regulatory Relief, and Consumer Protection Act, the federal banking agencies have developed a “Community Bank Leverage Ratio” (the ratio of a bank’s tier 1 capital to average total consolidated assets) for financial institutions with assets of less than $10 billion. A “qualifying community bank” that exceeds this ratio will be deemed to be in compliance with all other capital and leverage requirements, including the capital requirements to be considered “well capitalized” under Prompt Corrective Action statutes. The federal banking agencies have set the Community Bank Leverage Ratio at 9%. A financial institution can elect to be subject to this new definition. The new rule will take effect on January 1, 2020.

As of the date of the last regulatory exam, the Bank was considered “well capitalized” and as of September 30, 2019, the Bank continued to meet the requirements to be considered “well capitalized” based on applicable U.S. regulatory capital ratio requirements.

20

The Bank’s regulatory capital amounts and ratios were as follows:

					Minimum				Minimum				To be Well
					Requirements				Requirements				Capitalized Under
					for Capital Adequacy				with Capital				Prompt Corrective
	Actual				Purposes				Conservation Buffer				Action Provision
	Amount		Ratio		Amount		Ratio		Amount		Ratio		Amount		Ratio
September 30, 2019	(dollars in thousands)
Common Equity Tier 1 Capital (to risk-weighted assets)	$	120,432	18.5	%	$	29,256	4.5	%	$	45,509	7.0	%	$	42,259	6.5	%
Total capital (to risk-weighted assets)		127,839	19.7	%		52,011	8.0	%		68,264	10.5	%		65,014	10.0	%
Tier 1 capital (to risk-weighted assets)		120,432	18.5	%		39,008	6.0	%		55,261	8.5	%		52,011	8.0	%
Tier 1 capital (to average quarterly assets)		120,432	13.5	%		35,652	4.0	%		57,935	6.5	%		44,565	5.0	%
December 31, 2018
Common Equity Tier 1 Capital (to risk-weighted assets)	$	114,749	17.4	%	$	29,651	4.5	%	$	42,006	6.4	%	$	42,830	6.5	%
Total capital (to risk-weighted assets)		122,889	18.7	%		52,713	8.0	%		65,068	9.9	%		65,892	10.0	%
Tier 1 capital (to risk-weighted assets)		114,749	17.4	%		39,535	6.0	%		51,890	7.9	%		52,713	8.0	%
Tier 1 capital (to average quarterly assets)		114,749	13.5	%		33,932	4.0	%		49,838	5.9	%		42,415	5.0	%

Note 5 -  Earnings Per Share

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

There were no anti-dilutive shares for the three or nine months ended September 30, 2019 or 2018. 

On April 2, 2018, the Company exercised its option to convert all 437,500 outstanding shares of Series A Preferred Stock into shares of the Company’s common stock. The conversion ratio was one share of Series A Preferred Stock for one share of common stock. As of April 2, 2018, the Series A Preferred Stock was no longer deemed outstanding and all rights with respect to such stock ceased and terminated.

Information relating to the calculations of our income per common share is summarized as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(dollars in thousands, except for per share data)
Weighted-average shares outstanding - basic		12,776,911		12,695,136		12,775,104		12,541,032
Dilution		64,768		137,497		78,708		110,228
Weighted-average share outstanding - diluted		12,841,679		12,832,633		12,853,812		12,651,260
Net income available to common stockholders	$	2,381	$	2,165	$	7,166	$	5,898
Net income per share - basic	$	0.19	$	0.17	$	0.56	$	0.47
Net income per share - diluted	$	0.19	$	0.17	$	0.56	$	0.47

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Note 6 - Stock-Based Compensation

We have maintained a stock-based compensation plan for directors, officers, and other key employees of the Company. The aggregate number of shares of common stock that could be issued with respect to the awards granted under the 2008 plan was 500,000 plus any shares forfeited under the Company’s old stock-based compensation plan. Under the terms of the 2008 stock-based compensation plan, the Company had the ability to grant various stock compensation incentives, including stock options, stock appreciation rights, and restricted stock. The 2008 stock-based compensation was granted under terms and conditions determined by the Compensation Committee of the Board of Directors. Under the 2008 stock-based compensation plan, stock options generally had a maximum term of ten years, and were granted with an exercise price at least equal to the fair market value of the common stock on the date the options were granted. Generally, options granted to directors, officers, and employees of the Company vested over a five-year period, although the Compensation Committee had the authority to provide for different vesting schedules. The ability to grant new options from the 2008 plan expired in March of 2018. The 2019 Equity Incentive Plan, with similar provisions as the 2008 plan and 500,000 shares available for grant was approved at the stockholders’ meeting in May of 2019.  No shares have been granted from this plan as of September 30, 2019.

We account for stock-based compensation in accordance with FASB Accounting Standards Codification (“ASC”) Topic 718, Compensation – Stock Compensation, whichrequires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense in the Statement of Income at fair value. Additionally, we are required to recognize the expense of employee services received in share-based payment transactions and measure the expense based on the grant date fair value of the award. The expense is recognized over the period during which an employee is required to provide service in exchange for the award.  Stock-based compensation expense included in the consolidated Statements of Income for the three months ended September 30, 2019 and 2018 totaled $32,000 and $56,000, respectively. Stock-based compensation expense included in the consolidated Statements of Income for the nine months ended September 30, 2019 and 2018 totaled $109,000 and $169,000, respectively. 

Information regarding our stock-based compensation plan is as follows as of and for the nine months ended September 30:

	2019						2018
				Weighted-						Weighted-
		Weighted-		Average	Aggregate			Weighted-		Average	Aggregate
		Average		Remaining	Intrinsic			Average		Remaining	Intrinsic
	Number	Exercise		Contractual	Value		Number	Exercise		Contractual	Value
	of Shares	Price		Term (in years)	(in thousands)		of Shares	Price		Term (in years)	(in thousands)
Outstanding at beginning of period	349,023	$	6.32				434,025	$	5.87
Granted	—		—				6,500		7.41
Exercised	(17,961)		5.39				(24,877)		3.98
Forfeited	(54,000)		6.58				(2,600)		5.78
Outstanding at end of period	277,062	$	6.33	2.6	$	461	413,048	$	6.01	5.8	$	1,565
Exercisable at end of period	185,970	$	5.94	2.0	$	383	229,687	$	5.26	5.7	$	1,043

The cash received from the exercise of stock options amounted to $16,000 and $3,000 for the three months ended September 30, 2019 and 2018, respectively, and $97,000 and $100,000 for the nine months ended September 30, 2019 and 2018, respectively.

The stock-based compensation expense amounts and fair values of options at the time of the grants were derived using the Black-Scholes option-pricing model. The following weighted average assumptions were used to value options granted for the nine months ended September 30, 2018.  There were no options granted in 2019.

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Expected life		5.5 years
Risk-free interest rate		2.67	%
Expected volatility		32.20	%
Expected dividend yield		—
Weighted average per share fair value of options granted	$	2.57

As of September 30, 2019, there was $290,305 of total unrecognized stock-based compensation expense related to nonvested stock options, which is expected to be recognized over the next 48 months.

Note 7 - Commitments and Contingencies

Off-Balance Sheet Instruments

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

Our exposure to credit loss from nonperformance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with off-balance sheet credit risk.

	September 30,		December 31,
	2019		2018
	(dollars in thousands)
Standby letters of credit	$	3,577	$	3,321
Home equity lines of credit		17,375		17,015
Unadvanced construction commitments		79,385		75,326
Mortgage loan commitments		1,628		1,649
Lines of credit		21,990		20,990
Loans sold and serviced with limited repurchase provisions		66,194		49,623

Standby letters of credit are conditional commitments issued by the Bank guaranteeing performance by a customer to various municipalities. These guarantees are issued primarily to support performance arrangements and are limited to real estate transactions. The majority of these standby letters of credit expire within twelve months, with automatic one year renewals. The Bank has the option to stop any automatic renewal. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Bank requires collateral supporting these letters of credit as deemed necessary. Management believes, except for certain standby letters of credit, that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of September 30, 2019 and December 31, 2018 for guarantees under standby letters of credit issued was $13,000 and $42,000, respectively.

Home equity lines of credit are loan commitments to individuals as long as there is no violation of any condition established in the contract. Commitments under home equity lines expire ten years after the date the loan closes and are secured by real estate. We evaluate 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.

Residential mortgage loan commitments at both September 30, 2019 and December 31, 2018 consisted of three loans totaling $1.6 million.

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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. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within a period ranging generally from 120 to 180 days after the sale date depending on the investor agreement. The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. We did not repurchase any loans during the nine months ended September 30, 2019 or 2018.

Other Contingencies

The Company provides banking services to customers who do business in the medical-use cannabis industry. While the growing, processing, and sales of medical-use cannabis is legal in the state of Maryland, the business currently violates Federal law. The Company may be deemed to be aiding and abetting illegal activities through the services that it provides to these customers. The strict enforcement of Federal laws regarding medical-use cannabis would likely result in the Company’s inability to continue to provide banking services to these customers and the Company could have legal action taken against it by the Federal government, including imprisonment and fines. There is an uncertainty of the potential impact to the Company’s consolidated financial statements if the Federal government takes actions against the Company. As of September 30, 2019, the Company has not accrued an amount for the potential impact of any such actions.

Following is a summary of the level of business activities with our medical-use cannabis customers:

•  Deposit and loan balances at September 30, 2019 were approximately $20.6 million, or 3.1% of total deposits, and $15.4 million, or 2.3% of total loans, respectively. Deposit and loan balances at December 31, 2018 were approximately $17.0 million, or 2.2% of total deposits, and $14.1 million, or 2.1% of total loans, respectively.

•Interest and noninterest income for the three months ended September 30, 2019 were approximately $227,000 and $515,000, respectively. Interest and noninterest income for the three months ended September 30, 2018 were approximately $231,000 and $376,000, respectively.

•Interest and noninterest income for the nine months ended September 30, 2019 were approximately $655,000 and $1.5 million, respectively. Interest and noninterest income for the nine months ended September 30, 2018 were approximately $541,000 and $921,000, respectively.

•The volume of deposits in the accounts of medical-use cannabis customers for the three and nine months ended September 30, 2019 was approximately $70.5 million and $176.6 million, respectively. The volume of deposits in the accounts of medical-use cannabis customers for the three and nine months ended September 30, 2018 was approximately $41.5 million and $70.8 million, respectively.

Note 8 - 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.

24

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.

We record transfers between levels at the end of the reporting period in which the change in significant inputs occurs.

Assets Measured on a Recurring Basis

The following table presents fair value measurements for assets that are measured at fair value on a recurring basis as of and for the nine months ended September 30,  2019:

					Significant
					Other		Significant		Total Changes
			Quoted		Observable		Unobservable		In Fair Values
	Carrying		Prices		Inputs		Inputs		Included In
	Value		(Level 1)		(Level 2)		(Level 3)		Period Income
Assets:	(dollars in thousands)
AFS Securities - U.S. Treasury notes	$	999	$	999	$	—	$	—	$	—
AFS Securities - U.S. government agency notes		8,030		—		8,030		—		—
Loans held for sale ("LHFS")		17,587		—		17,587		—		(373)
Mortgage servicing rights ("MSRs")		316		—		—		316		(121)
Interest-rate lock commitments ("IRLCs")		180		—		—		180		80
Best efforts forward contracts		26		—		26		—		26
Mandatory forward contracts		46		—		46		—		63

The following table presents fair value measurements for assets and liabilities that are measured at fair value on a recurring basis as of and for the year ended December 31, 2018:

					Significant
					Other		Significant		Total Changes
			Quoted		Observable		Unobservable		In Fair Values
	Carrying		Prices		Inputs		Inputs		Included In
	Value		(Level 1)		(Level 2)		(Level 3)		Period Income
Assets:	(dollars in thousands)
AFS Securities - U.S. Treasury notes	$	1,981	$	1,981	$	—	$	—	$	—
AFS Securities - U.S. government agency notes		9,997		—		9,997		—		—
LHFS		9,686		—		9,686		—		192
MSRs		437		—		—		437		(40)
IRLCs		100		—		—		100		78
Liabilities:
Mandatory forward contracts		16		—		16		—		(30)
Best efforts forward contracts		—		—		—		—		(3)

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

	Fair Value		Valuation	Unobservable	Range
	Estimate		Technique	Input	(Weighted-Average)
September 30, 2019:	(dollars in thousands)
MSRs	$	316	Market Approach	Weighted average prepayment speed	13.60	%
IRLCs		180	Market Approach	Range of pull through rate	80% - 95	%
				Average pull through rate	90	%
December 31, 2018:
MSRs	$	437	Market Approach	Weighted average prepayment speed	9.80	%
IRLCs		100	Market Approach	Range of pull through rate	70% - 95	%
				Average pull through rate	84	%

The following table shows the activity in the MSRs:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(dollars in thousands)
Beginning balance	$	343	$	501	$	437	$	477
Valuation adjustment		(27)		(19)		(121)		5
Ending balance	$	316	$	482	$	316	$	482

The following table shows the activity in the IRLCs:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(dollars in thousands)
Beginning balance	$	345	$	168	$	100	$	22
Valuation adjustment		(165)		19		80		165
Ending balance	$	180	$	187	$	180	$	187

AFS Securities

The estimated fair values of AFS debt securities are obtained from a nationally-recognized pricing service. This pricing service develops estimated fair values by analyzing like securities and applying available market information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing to prepare valuations. Matrix pricing is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things, and are based on market data obtained from sources independent from the Bank. U.S Treasury Securities are considered Level 1 and all of our other securities are considered Level 2. The Level 2 investments in the Bank’s portfolio are priced using those inputs that, based on the analysis prepared by the pricing service, reflect the assumptions that market participants would use to price the assets. The Bank has determined that the Level 2 designation is appropriate for these securities because, as with most fixed-income securities, those in the Bank’s portfolio are not exchange-traded, and such nonexchange-traded fixed income securities are typically priced by correlation to observed market data.

LHFS

LHFS are carried at fair value, which is determined based on outstanding investor commitments or, in the absence of such commitments, on current investor yield requirements or third party pricing models. 

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MSRs

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

IRLCs

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

Forward Contracts

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

Assets Measured on a Nonrecurring Basis

We may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market value (“LCM”) accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis, the following tables provide the level of valuation assumptions used to determine each adjustment and the carrying value of assets:

	September 30, 2019
					Significant
					Other		Significant
			Quoted		Observable		Unobservable
	Carrying		Prices		Inputs		Inputs		Range of	Weighted
	Value		(Level 1)		(Level 2)		(Level 3)		Discount (1)	Average
	(dollars in thousands)
Impaired loans	$	4,849	$	—	$	—	$	4,849	0% - 160%	8	%
Real estate acquired through foreclosure		551		—		—		551	0% - 16%	15	%

(1) Discount based on current market conditions and estimated selling costs

	December 31, 2018
					Significant
					Other		Significant
			Quoted		Observable		Unobservable
	Carrying		Prices		Inputs		Inputs		Range of	Weighted
	Value		(Level 1)		(Level 2)		(Level 3)		Discount (1)	Average
	(dollars in thousands)
Impaired loans	$	5,678	$	—	$	—	$	5,678	0% - 16%	6.7	%

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(1) Discount based on current market conditions and estimated selling costs

Impaired Loans

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

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

Real Estate Acquired Through Foreclosure

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

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Fair Value of All Financial Instruments

The carrying value and fair value of all financial instruments are summarized in the following tables:

	September 30, 2019
	Carrying		Fair Value
	Value		Level 1		Level 2		Level 3		Total
Assets:	(dollars in thousands)
Cash and cash equivalents	$	65,253	$	65,253	$	—	$	—	$	65,253
Certificates of deposit held for investment		7,540		7,540		—		—		7,540
AFS securities		9,029		999		8,030		—		9,029
HTM securities		30,302		2,010		28,449		—		30,459
LHFS		17,587		—		17,587		—		17,587
Loans receivable, net		653,448		—		—		679,547		679,547
Restricted stock investments		2,431		—		2,431		—		2,431
Accrued interest receivable		2,514		—		2,514		—		2,514
ROU asset		2,534		—		2,534		—		2,534
MSRs		316		—		—		316		316
IRLCs		180		—		—		180		180
Mandatory forward contracts		46		—		46		—		46
Best effort forward contracts		26		—		26		—		26
Liabilities:
Deposits		657,154		—		660,174		—		660,174
Accrued interest payable		332		—		332		—		332
Borrowings		38,498		—		35,022		—		35,022
Subordinated debentures		20,619		—		—		20,619		20,619
Lease liability		2,572		—		2,572		—		2,572

	December 31, 2018
	Carrying		Fair Value
	Value		Level 1		Level 2		Level 3		Total
Assets:	(dollars in thousands)
Cash and cash equivalents	$	188,340	$	188,340	$	—	$	—	$	188,340
Certificates of deposit held for investment		8,780		8,780		—		—		8,780
AFS securities		11,978		1,981		9,997		—		11,978
HTM securities		38,912		2,008		36,204		—		38,212
LHFS		9,686		—		9,686		—		9,686
Loans receivable, net		674,305		—		—		670,512		670,512
Restricted stock investments		3,766		—		3,766		—		3,766
Accrued interest receivable		2,848		—		2,848		—		2,848
MSRs		437		—		—		437		437
IRLCs		100		—		—		100		100
Liabilities:
Deposits		779,506		—		778,313		—		778,313
Accrued interest payable		419		—		419		—		419
Borrowings		73,500		—		69,210		—		69,210
Subordinated debentures		20,619		—		—		20,619		20,619
Mandatory forward contracts		16		—		16		—		16

At September 30, 2019 and December 31, 2018 the Bank had loan funding commitments of $120.4 million and $115.0 million, respectively, and standby letters of credit outstanding of $3.6 million and $3.3 million, respectively. The fair value of these commitments is nominal.

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Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about financial instruments. These estimates do not reflect any premium or discount that could result from a one-time sale of our total holdings of a particular financial instrument. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect estimates. The above information should not be interpreted as an estimate of the fair value of the Company since a fair value calculation is only provided for a limited portion of our assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful.

There were no transfers between any of Levels 1, 2 and 3 for the nine months ended September 30, 2019 or 2018 or for the year ended December 31, 2018.

Note 9 - Leases

A lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration. On January 1, 2019, we adopted ASU No. 2016-02 “Leases” (“Topic 842”) and all subsequent ASUs that modified Topic 842. For us, Topic 842 primarily affected the accounting treatment for operating lease agreements in which we are the lessee.

Substantially all of the leases in which we are the lessee are comprised of real estate property for branches, ATM locations, office equipment, and office space with terms extending through 2035. All of our leases are classified as operating leases, and therefore, were previously not recognized on the our consolidated statements of financial condition. With the adoption of Topic 842, operating lease agreements are required to be recognized on the consolidated statements of financial condition as an ROU asset and a corresponding lease liability.

The following table represents the consolidated statements of financial condition classification of our ROU assets and lease liabilities, included in other assets and other liabilities, respectively. We elected not to include short-term leases (i.e., leases with initial terms of twelve months or less) on the consolidated statements of financial condition.

	September 30, 2019
	(dollars in thousands)
Lease ROU assets	$	2,534
Lease liabilities		2,572

The calculated amount of the ROU assets and lease liabilities in the table above are impacted by the length of the lease term and the discount rate used to present value the minimum lease payments. Our lease agreements often include one or more options to renew at our discretion. If at lease inception, we consider the exercising of a renewal option to be reasonably certain we will include the extended term in the calculation of the ROU asset and lease liability. Regarding the discount rate, Topic 842 requires the use of the rate implicit in the lease whenever this rate is readily determinable. As this rate is rarely determinable, we utilize our incremental borrowing rate at lease inception over a similar term. For operating leases existing prior to January 1, 2019, the rate for the remaining lease term as of January 1, 2019 was used. The weighted-average remaining lease term was 11.85 years and the weighted-average discount rate was 3.26% as of September 30, 2019.

The following table represents lease costs and other lease information. As we elected, for all classes of underlying assets, not to separate lease and non-lease components and instead to account for them as a single lease component, the variable lease cost primarily represents variable payments such as common area maintenance and utilities. Variable lease cost also includes payments for ATM location leases in which payments are based on a percentage of ATM transactions (i.e., ATM surcharge fees), rather than a fixed amount.

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	Three Months Ended		Nine Months Ended
	September 30, 2019		September 30, 2019
	(dollars in thousands)
Operating lease costs	$	110	$	323
Variable lease cost		—		—
Total lease cost		110		323

Cash paid on operating lease liabilities amounted to $81,000 and $240,000 for the three and nine months ended September 30, 2019 and  2018, respectively.

Future minimum payments for finance leases and operating leases with initial or remaining terms of one year or more were as follows:

	September 30, 2019
Lease payments due:	(dollars in thousands)
September 30, 2020	$	353
September 30, 2021		330
September 30, 2022		326
September 30, 2023		279
September 30, 2024		250
Thereafter		1,627
Total future minimum lease payments		3,165
Amounts representing interest		(593)
Present value of net future minimum lease payments		2,572

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

When used in this report, the terms “the Company,” “we,” “us,” and “our” refer to Severn Bancorp and, unless the context requires otherwise, its consolidated subsidiaries. The following discussion should be read and reviewed in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in Severn Bancorp’s Annual Report on Form 10‑K as of and for the year ended December 31, 2018.

The Company

The Company is a savings and loan holding company chartered as a corporation in the state of Maryland in 1990. It conducts business primarily through three subsidiaries, Severn Savings Bank, FSB (the “Bank”), Mid-Maryland Title Company, Inc. (the “Title Company”), and SBI Mortgage Company (“SBI”). SBI holds mortgages that do not meet the underwriting criteria of the Bank, and is the parent company of Crownsville Development Corporation (“Crownsville”), which is doing business as Annapolis Equity Group and acquires real estate for syndication and investment purposes. The Title Company is a real estate settlement company that handles commercial and residential real estate settlements in Maryland. The Bank’s principal subsidiary, Louis Hyatt, Inc. (“Hyatt Commercial”), conducts business as Hyatt Commercial, a commercial real estate brokerage and property management company. We maintain seven branches in Anne Arundel County, Maryland at September 30, 2019. The branches offer a full range of deposit products and we originate mortgages in the Bank’s primary market of Anne Arundel County, Maryland and, to a lesser extent, in other parts of Maryland, Delaware, and Virginia. As of September 30, 2019, we had 170 full-time equivalent employees.

Overview

The Company provides a wide range of personal and commercial banking services. Personal services include mortgage lending and various other lending services as well as deposit products such as personal Internet banking and online bill pay, checking accounts, individual retirement accounts, money market accounts, and savings and time deposit accounts. Commercial services include commercial secured and unsecured lending services as well as business Internet banking, corporate cash management services, and deposit services to commercial customers, including those in the medical-use

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cannabis industry. The Company also provides ATMs, credit cards, debit cards, safe deposit boxes, and telephone banking, among other products and services.

We have experienced an improved level of profitability for the three and nine months ended September 30, 2019, primarily due to an improvement in net interest income as well as improved profitability of our mortgage-banking operations. We recognized increased deposit service charges as a result of fees from medical-use cannabis deposit accounts. Noninterest expenses increased for the three and nine months ended September 30, 2019 due to increased consulting fees and investments in staff and systems to enhance production and efficiency.

The Company expects to experience similar market conditions during the remainder of 2019, provided interest rates do not increase or decrease rapidly. If interest rates change rapidly, demand for loans may fluctuate and our interest rate spread could change significantly. We continue to manage loan and deposit pricing against the risks of rising costs of our deposits and borrowings. Interest rates are outside of our control, so we must attempt to balance the pricing and duration of the loan portfolio against the risks of rising or declining costs of our deposits and borrowings. The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to our ability to originate and grow loans and deposits, as will our continued focus on maintaining a low overhead. If volatility in the market and the economy occurs, our business, financial condition, results of operations, access to funds, and the price of our stock could be materially and adversely impacted.

Critical Accounting Policies

Our accounting and financial reporting policies conform to accounting principles generally accepted in the United States of America (“U.S.”) (“GAAP”) and prevailing practices within the banking industry. Accordingly, preparation of the financial statements requires management to exercise significant judgment or discretion or make significant assumptions and estimates based on the information available that have, or could have, a material impact on the carrying value of certain assets or on income. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. The accounting policies we view as critical are those relating to the allowance for loan losses (“Allowance”), the valuation of securities, the valuation of real estate acquired through foreclosure, and the valuation of deferred tax assets and liabilities. Significant accounting policies are discussed in detail in “Notes to Consolidated Financial Statements - Note 1 - Summary of Significant Account Policies” in our Annual Report on Form 10-K as of and for the year ended December 31, 2018. There have been no material changes to the significant accounting policies as described in the Annual Report other than those mentioned in Note 1 to the financial statements in this Quarterly Report on Form 10-Q. Disclosures regarding the effects of new accounting pronouncements are included in Note 1 to our Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

Results of Operations

Net Income

Three Months Ended September 30

Net income increased by $216,000, or 10.0%, to $2.4 million for the three months ended September 30, 2019 compared to $2.2 million for the three months ended September 30, 2018. Basic and diluted income per share were $0.19 for the three months ended September 30, 2019, compared to basic and diluted income per share of $0.17 for the three months ended September 30, 2018. The increase in net income reflected increased net interest income, noninterest income, and an increase in the reversal of the provision for loan losses, partially offset by increased noninterest expense and income tax provision.

Nine Months Ended September 30

Net income increased $1.2 million, or 20.1%, to $7.2 million for the nine months ended September 30, 2019, compared to $6.0 million for the nine months ended September 30, 2018. Basic and diluted income per share were $0.56 for the nine months ended September 30, 2019, compared to basic and diluted income per share of $0.47 for the nine months ended

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September 30, 2018. The increase in net income reflected improved net interest income, noninterest income, and an increase in the reversal of the provision for loan losses, partially offset by increased noninterest expense and income tax provision.

Net Interest Income

Three Months Ended September 30

Net interest income increased by $304,000, or 4.1%, to $7.6 million for the three months ended September 30, 2019, compared to $7.3 million for the same period of 2018. Our net interest margin decreased from 3.65% for the three months ended September 30, 2018 to 3.53% for the three months ended September 30, 2019. Our net interest spread decreased from 3.33% for the three months ended September 30, 2018 to 3.19% for the three months ended September 30, 2019.

Nine Months Ended September 30

Net interest income increased by $2.3 million, or 10.9%, to $23.6 million for the nine months ended September 30, 2019, compared to $21.3 million for the nine months ended September 30, 2018. Our net interest margin decreased from 3.63% for the nine months ended September 30, 2018 to 3.58% for the nine months ended September 30, 2019. Our net interest spread decreased from 3.34% for the nine months ended September 30, 2018 to 3.24% for the nine months ended September 30, 2019.

Interest Income

Three Months Ended September 30

Interest income increased by $294,000, or 3.1%, to $9.9 million for the three months ended September 30, 2019, compared to $9.6 million for the three months ended September 30, 2018, primarily due to an increase in interest income from an increased volume of other interest-earning assets. Average interest-earning assets increased from $797.7 million for the three months ended September 30, 2018 to $860.3 million for the three months ended September 30, 2019, due primarily to growth in average other interest-earning assets of $73.4 million. Such increase resulted primarily from increased average interest-earning deposits in banks, which was the result of increased deposits from our medical-use cannabis customers, most of which occurred in the latter part of 2018. Average loans outstanding decreased $961,000 from $678.8 million for the three months ended September 30, 2018 to $677.8 million for the three months ended September 30, 2019. The average yield on interest-earning assets decreased 21 basis points to 4.54% for the three months ended September 30, 2019 from 4.75% for the three months ended September 30, 2018, due to growth in lower yielding other interest-earning assets. The average yield on other interest-earning assets decreased to 1.43% for the three months ended September 30, 2019 from 3.03% for the three months ended September 30, 2018, primarily due to a change in the mix of other interest-earning asset types. We held less Federal Home Loan Bank of Atlanta (“FHLB”) stock and certificates of deposit held for investment during the three months ended September 30, 2019 than during the three months ended September 30, 2018. The average yield on loans held for investment increased from 5.11% for the three months ended September 30, 2018 to 5.33% for the three months ended September 30, 2019 as a result of the increased interest rate environment in 2019 compared to 2018.

Nine Months Ended September 30

Interest income increased by $3.2 million, or 11.6%, to $30.6 million for the nine months ended September 30, 2019, compared to $27.4 million for the nine months ended September 30, 2018, primarily due to increases in interest income on loans and other interest-earning assets. Average interest-earning assets increased from $783.2 million for the nine months ended September 30, 2018 to $881.4 million for the nine months ended September 30, 2019 due primarily to growth in average other interest-earning assets of $104.8 million, most of which consisted of interest-earning deposits in banks. The increase in interest-bearing deposits in banks was the result of increased deposits from our medical-use cannabis customers in the latter part of 2018. The average yield on interest-earning assets decreased four basis points to 4.64% for the nine months ended September 30, 2019 from 4.68% for the nine months ended September 30, 2018, also due to growth in lower yielding other interest-earning assets. The average yield on other interest-earning assets decreased to 2.06% for the nine months ended September 30, 2019 from 2.18% for the nine months ended September 30, 2018,

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primarily due to a change in the mix of other interest-earning asset types, with a lower volume of FHLB stock and certificates of deposit held for investment during the nine months ended September 30, 2019, compared to the same period of 2018. Average loans outstanding increased $4.8 million from $673.7 million for the nine months ended September 30, 2018 to $678.5 million for the nine months ended September 30, 2019. The average yield on loans held for investment increased from 5.06% for the nine months ended September 30, 2018 to 5.41% for the nine months ended September 30, 2019 as a result of the increased interest rate environment in 2019 compared to 2018.

Interest Expense

Three Months Ended September 30

Total interest expense remained relatively stable at $2.2 million for both the three months ended September 30, 2019 and 2018. We experienced an increase in deposit interest expense, primarily due to an increase in the average rate paid on certificates of deposit from 1.81% for the three months ended September 30, 2018 to 2.54% for the same period of 2019. We also experienced an increase in the average balance of interest-bearing deposits from $510.1 million for the three months ended September 30, 2018 to $577.5 million for the three months ended September 30, 2019. The average balance of checking and savings accounts increased significantly from $283.6 million for the three months ended September 30, 2018 to $378.4 million for the three months ended September 30, 2019, primarily due to increases in our medical-use cannabis related accounts, occurring mostly in the latter part of 2018. The average balance of certificates of deposit decreased from $226.4 million for the three months ended September 30, 2018 to $199.1 million for the same period of 2019 due to runoff from maturing certificates of deposit. Average borrowings decreased $36.8 million during the three months ended September 30, 2019 compared to the same period of 2018, due to payoffs of FHLB advances.

Nine Months Ended September 30

Interest expense increased by $860,000, or 13.9%, to $7.0 million for the nine months ended September 30, 2019, compared to $6.2 million for the nine months ended September 30, 2018 as a result of a $1.6 million increase in interest expense on deposits, partially offset by a $701,000 decrease in interest expense on borrowings. The increase in deposit interest expense was primarily due to an increase in the average rate paid on interest-bearing deposits, driven by the higher interest rate environment that existed in the earlier part of 2019 as well as increased effects of competition with other financial institutions. These factors increased the average rate paid on deposits from 1.04% for the nine months ended September 30, 2018 to 1.23% for the nine months ended September 30, 2019. The average rate paid on certificates of deposit increased from 1.68% for the nine months ended September 30, 2018 to 2.22% for the same period of 2019. Additionally, the average rate paid on checking and savings accounts increased from 0.53% for the nine months ended September 30, 2018 to 0.71% for the nine months ended September 30, 2019. The average balance of checking and savings accounts increased significantly from $280.7 million for the nine months ended September 30, 2018 to $391.6 million for the nine months ended September 30, 2019, primarily due to increases in our medical-use cannabis related accounts in the latter part of 2018.  The average balance of certificates of deposit decreased from $224.2 million for the nine months ended September 30, 2018 to $205.4 million for the same period of 2019 due to runoff from maturing certificates of deposit. Average borrowings decreased $36.9 million during the nine months ended September 30, 2019 compared to the same period of 2018 due to payoffs of FHLB advances.

The following tables set forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities and the resulting yields on average interest-earning assets and average rates paid on

34

average interest-bearing liabilities. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.

	Three Months Ended September 30,
	2019						2018
	Average				Yield/		Average				Yield/
	Balance		Interest (2)		Rate(4)		Balance		Interest (2)		Rate(4)
ASSETS	(dollars in thousands)
Loans (1)	$	677,792	$	9,109	5.33	%	$	678,753	$	8,744	5.11	%
Loans held for sale ("LHFS")		12,797		37	1.15	%		6,337		100	6.26	%
Available-for-sale ("AFS") securities		11,169		47	1.67	%		11,867		53	1.77	%
HTM securities		34,977		177	2.01	%		49,040		240	1.94	%
Other interest-earning assets (3)		120,605		434	1.43	%		47,201		360	3.03	%
Restricted stock investments, at cost		2,952		50	6.72	%		4,504		63	5.55	%
Total interest-earning assets		860,292		9,854	4.54	%		797,702		9,560	4.75	%
Allowance		(8,091)						(8,218)
Cash and other noninterest-earning assets		46,755						42,969
Total assets	$	898,956		9,854			$	832,453		9,560
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing deposits:
Checking and savings	$	378,360		459	0.48	%	$	283,635		498	0.70	%
Certificates of deposit		199,127		1,273	2.54	%		226,415		1,033	1.81	%
Total interest-bearing deposits		577,487		1,732	1.19	%		510,050		1,531	1.19	%
Borrowings		72,397		473	2.59	%		109,155		684	2.49	%
Total interest-bearing liabilities		649,884		2,205	1.35	%		619,205		2,215	1.42	%
Noninterest-bearing deposit accounts		137,598						115,416
Other noninterest-bearing liabilities		8,181						2,206
Stockholders' equity		103,293						95,626
Total liabilities and stockholders' equity	$	898,956		2,205			$	832,453		2,215
Net interest income/net interest spread			$	7,649	3.19	%			$	7,345	3.33	%
Net interest margin					3.53	%					3.65	%

(1)Nonaccrual loans are included in average loans.

(2)There are no tax equivalency adjustments.

(3)Other interest-earning assets include interest-earning deposits, federal funds sold, and certificates of deposit held for investment.

(4)Annualized.

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	Nine Months Ended September 30,
	2019						2018
	Average				Yield/		Average				Yield/
	Balance		Interest (2)		Rate(4)		Balance		Interest (2)		Rate(4)
ASSETS	(dollars in thousands)
Loans (1)	$	678,495	$	27,436	5.41	%	$	673,689	$	25,523	5.06	%
LHFS		9,851		103	1.40	%		4,977		208	5.59	%
AFS securities		11,593		148	1.71	%		11,753		156	1.77	%
HTM securities		36,336		576	2.12	%		50,767		764	2.01	%
Other interest-earning assets (3)		142,039		2,192	2.06	%		37,261		607	2.18	%
Restricted stock investments, at cost		3,110		166	7.14	%		4,705		180	5.11	%
Total interest-earning assets		881,424		30,621	4.64	%		783,152		27,438	4.68	%
Allowance		(8,080)						(8,181)
Cash and other noninterest-earning assets		43,788						43,224
Total assets	$	917,132		30,621			$	818,195		27,438
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing deposits:
Checking and savings	$	391,596		2,083	0.71	%	$	280,739		1,122	0.53	%
Certificates of deposit		205,416		3,416	2.22	%		224,248		2,816	1.68	%
Total interest-bearing deposits		597,012		5,499	1.23	%		504,987		3,938	1.04	%
Borrowings		77,005		1,543	2.68	%		113,929		2,244	2.63	%
Total interest-bearing liabilities		674,017		7,042	1.40	%		618,916		6,182	1.34	%
Noninterest-bearing deposits		135,763						108,671
Other noninterest-bearing liabilities		5,227						2,224
Stockholders' equity		102,125						88,384
Total liabilities and stockholders' equity	$	917,132		7,042			$	818,195		6,182
Net interest income/net interest spread			$	23,579	3.24	%			$	21,256	3.34	%
Net interest margin					3.58	%					3.63	%

(1)Nonaccrual loans are included in average loans.

(2)There are no tax equivalency adjustments.

(3)Other interest-earning assets include interest-earning deposits, federal funds sold, and certificates of deposit held for investment.

(4)Annualized.

The “Rate/Volume Analysis” below indicates the changes in our net interest income as a result of changes in volume and rates. We maintain an asset and liability management policy designed to provide a proper balance between rate-sensitive assets and rate-sensitive liabilities to attempt to optimize interest margins while providing adequate liquidity for our

36

anticipated needs. Changes in interest income and interest expense that result from variances in both volume and rates have been allocated to rate and volume changes in proportion to the absolute dollar amounts of the change in each.

	Three Months Ended September 30, 2019 vs. 2018						Nine Months Ended September 30, 2019 vs. 2018
	Due to Variances in						Due to Variances in
	Rate		Volume		Total		Rate		Volume		Total
Interest earned on:	(dollars in thousands)
Loans	$	449	$	(84)	$	365	$	1,730	$	183	$	1,913
LHFS		(388)		325		(63)		(282)		177		(105)
AFS securities		(3)		(3)		(6)		(6)		(2)		(8)
HTM Securities		54		(117)		(63)		62		(250)		(188)
Other interest-earning assets		(1,109)		1,183		74		(55)		1,640		1,585
Restricted stock investments, at cost		61		(74)		(13)		80		(94)		(14)
Total interest income		(936)		1,230		294		1,529		1,654		3,183
Interest paid on:
Interest-bearing deposits:
Checking and savings		(652)		613		(39)		438		523		961
Certificates of deposit		944		(704)		240		979		(379)		600
Total interest-bearing deposits		292		(91)		201		1,417		144		1,561
Borrowings		179		(390)		(211)		63		(764)		(701)
Total interest expense		471		(481)		(10)		1,480		(620)		860
Net interest income	$	(1,407)	$	1,711	$	304	$	49	$	2,274	$	2,323

Provision for Loan Losses

Our loan portfolio is subject to varying degrees of credit risk and an Allowance is maintained to absorb losses inherent in our loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what we determined it was worth at the time of the granting of the loan. We monitor loan delinquencies at least monthly. All loans that are delinquent and all loans within the various categories of our portfolio as a group are evaluated. Management, with the advice and recommendation of the Company’s Board of Directors, estimates an Allowance to be set aside for loan losses. Included in determining the calculation are such factors as historical losses for each loan portfolio, current market value of the loan’s underlying collateral, inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectability.

We recorded a reversal of the provision for loan losses of $500,000 during the three and nine months ended September 30, 2019. We recorded a $300,000 reversal of the provision for loan losses for the three and nine months ended September 30, 2018.

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

Noninterest Income

Three Months Ended September 30

Total noninterest income increased by $552,000, or 24.4%, to $2.8 million for the three months ended September 30, 2019, compared to $2.3 million for the three months ended September 30, 2018, with the majority of the increase from mortgage-banking revenue and deposit service charges. Mortgage-banking revenue increased $368,000, or 49.7%, due to the increased volume of loans originated from $26.5 million during the three months ended September 30, 2018 to $46.9 million during the three months ended September 30, 2019. Deposit service charges increased $139,000, or 32.6%, due primarily to on-boarding and monthly fees associated with medical-use cannabis customer accounts. The Title Company

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generated $362,000 in revenue during the three months ended September 30, 2019 compared to $316,000 for the three months ended September 30, 2018 due to an increase in loan closings and related title work.

Nine Months Ended September 30

Total noninterest income increased by $1.6 million, or 25.6%, to $7.7 million for the nine months ended September 30, 2019, compared to $6.1 million for the nine months ended September 30, 2018, with increases in most noninterest income categories. Mortgage-banking revenue increased $945,000, or 48.0%, due to the increased volume of loans originated from $67.3 million during the nine months ended September 30, 2018 to $135.8 million during the nine months ended September 30, 2019. Deposit service charges increased $554,000, or 51.9%, due primarily to on-boarding and monthly fees associated with medical-use cannabis customer accounts. Real estate commissions increased $137,000, or 11.9% due to an increase in the volume of properties sold during the nine months ended September 30, 2019 compared to the same period of 2018. The Title Company generated $841,000 in revenue during the nine months ended September 30, 2019 compared to $751,000 for the nine months ended September 30, 2018 due to an increase in loan closings and related title work.

Noninterest Expense

Three Months Ended September 30

Total noninterest expense increased $713,000, or 10.2%, to $7.7 million for the three months ended September 30, 2019, compared to $7.0 million for the three months ended September 30, 2018, primarily due to increases in compensation and related expenses, increased write-downs on real estate acquired through foreclosure, professional fees, data processing fees, and licensing and software expenses. Compensation and related expenses increased by $404,000, or 8.7%, to $5.1 million for the three months ended September 30, 2019, compared to $4.7 million for the three months ended September 30, 2018. This increase was primarily due to annual salary increases, additional hirings for our new branch, and increased commission expense that corresponds with our increased mortgage-banking volumes. Professional fees increased $146,000 due to increased consulting costs. Data processing fees and licensing and software expense increased $128,000 and $137,000, respectively, due to additional efficiency and security enhancements to our core and related systems, as well as the implementation of a new customer relationship management (“CRM”) system. We experienced write-downs and costs related to real estate acquired through foreclosure of $105,000 during the three months ended September 30, 2019 compared to $7,000 during the same period of 2018. The majority of the increase from the three month period ended September 30, 2018 to the three month period ended September 30, 2019 was due to the write down of one property.

Nine Months Ended September 30

Total noninterest expense increased $2.5 million, or 12.7%, to $21.9 million for the nine months ended September 30, 2019, compared to $19.5 million for the nine months ended September 30, 2018, primarily due to increases in compensation and related expenses, professional fees, data processing fees, licensing and software expenses, and increased write-downs on real estate acquired through foreclosure. Compensation and related expenses increased by $1.1 million, or 8.5%, to $14.5 million for the nine months ended September 30, 2019, compared to $13.4 million for the nine months ended September 30, 2018. This increase was primarily due to the aforementioned annual salary increases, additional hirings, and commission expense. Professional fees increased $515,000 due to increased consulting costs. Data processing fees and licensing and software expense increased $305,000 and $334,000, respectively, due to the aforementioned efficiency and security system enhancements and the new CRM system. We experienced write-downs and costs related to real estate acquired through foreclosure of $254,000 during the nine months ended September 30, 2019 compared to $21,000 during the same period of 2018. The majority of the increase from the nine month period ended September 30, 2018 to the nine month period ended September 30, 2019 was due to the write down of three properties.

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Income Tax Provision

Three Months Ended September 30

We recorded a $911,000 tax provision on net income before income taxes of $3.3 million for the three months ended September 30, 2019 for an effective tax rate of 27.7%, compared to an income tax provision of $784,000 on net income before income taxes of $2.9 million for the three months ended September 30, 2018, for an effective tax rate of 26.6%.

Nine Months Ended September 30

We recorded a $2.7 million tax provision on net income before income taxes of $9.8 million for the nine months ended September 30, 2019 for an effective tax rate of 27.1%, compared to an income tax provision of $2.3 million on net income before income taxes of $8.2 million for the nine months ended September 30, 2018, for an effective tax rate of 27.4%.

Financial Condition

Total assets decreased $148.3 million to $825.9 million at September 30, 2019, compared to $974.2 million at December 31, 2018. This decrease was primarily due to a $123.1 million, or 65.4%, decrease in cash and cash equivalents, to $65.3 million at September 30, 2019 from $188.3 million at December 31, 2018 due to the runoff of certain medical-use cannabis related deposit accounts. Additionally, we experienced a decrease in loans of $21.5 million, or 3.1%, to $660.9 million at September 30, 2019 from $682.3 million at December 31, 2018. Total deposits decreased $122.4 million, or 15.7%, to $657.2 million at September 30, 2019 compared to $779.5 million at December 31, 2018. Total borrowings decreased by $35.0 million or 47.6%, to $38.5 million at September 30, 2019 compared to $73.5 million at December 31, 2018 due to the paydown of FHLB advances. Stockholders’ equity increased $6.2 million to $104.6 million at September 30, 2019 compared to $98.5 million at December 31, 2018, primarily due to the increase in retained earnings, partially offset by dividends paid to stockholders.

Securities

We utilize the securities portfolio as part of our overall asset/liability management practices to enhance interest revenue while providing necessary liquidity for the funding of loan growth or deposit withdrawals. We continually monitor the credit risk associated with investments and diversify the risk in the securities portfolios. We held $9.0 million and $12.0 million in securities classified as AFS as of September 30, 2019 and December 31, 2018, respectively. We held $30.3 millionand $38.9 million, respectively, in securities classified as HTM as of September 30, 2019 and December 31, 2018, respectively.

Changes in current market conditions, such as interest rates and the economic uncertainties in the mortgage, housing, and banking industries impact the securities market. Quarterly, we review each security in our portfolio to determine the nature of any decline in value and evaluate if any impairment should be classified as other-than-temporary impairment (“OTTI”). For the  three and nine months ended September 30, 2019, we determined that no OTTI charges were required.

All of the AFS and HTM securities that are temporarily impaired as of September 30, 2019 are so due to declines in fair values resulting from changes in interest rates or decreased credit/liquidity spreads compared to the time they were purchased. We have the intent to hold these securities to maturity (including those designated as AFS) and it is more likely than not that we will not be required to sell the securities before recovery of value. As such, management considers the impairments to be temporary.

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Our securities portfolio composition is as follows:

	AFS				HTM
	September 30, 2019		December 31, 2018		September 30, 2019		December 31, 2018
	(dollars in thousands)
U.S. Treasury securities	$	999	$	1,981	$	1,993	$	1,991
U.S. government agency notes		8,030		9,997		6,987		11,992
Mortgage-backed securities		—		—		21,322		24,929
	$	9,029	$	11,978	$	30,302	$	38,912

LHFS

We originate residential mortgage loans for sale on the secondary market. Such LHFS, which are carried at fair value, amounted to $17.6 million at September 30, 2019 and $9.7 million at December 31, 2018, the majority of which are subject to purchase commitments from investors. The increase in LHFS was primarily due to increased originations and to the timing of loans pending sale on the secondary market.

Loans

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

The following table sets forth the composition of our loan portfolio:

	September 30, 2019				December 31, 2018
			Percent				Percent
	Amount		of Total		Amount		of Total
	(dollars in thousands)
Residential Mortgage	$	269,790	40.8	%	$	274,759	40.3	%
Commercial		44,774	6.8	%		35,884	5.2	%
Commercial real estate		239,490	36.2	%		242,693	35.6	%
Land acquisition, development, and construction ("ADC")		93,350	14.1	%		114,540	16.8	%
Home equity/2nds		11,930	1.8	%		13,386	2.0	%
Consumer		1,545	0.3	%		1,087	0.1	%
	$	660,879	100.0	%	$	682,349	100.0	%

Loans decreased by $21.5 million, or 3.1%, to $660.9 million at September 30, 2019, compared to $682.3 million at December 31, 2018. This decrease was due to decreased demand and originations, as well as increased payoffs of residential real estate, commercial real estate, ADC and home equity/2nds loans. We did experience an increase in commercial loan demand during the nine months ended September 30, 2019.

Credit Risk Management and the Allowance

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

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

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Management has an established methodology to determine the adequacy of the Allowance that assesses the risks and losses inherent in the loan portfolio. Our Allowance methodology employs management’s assessment as to the level of future losses on existing loans based on our internal review of the loan portfolio, including an analysis of the borrowers’ current financial position, and the consideration of current and anticipated economic conditions and their potential effects on specific borrowers and/or lines of business. In determining our ability to collect certain loans, we also consider the fair value of any underlying collateral. In addition, we evaluate credit risk concentrations, including trends in large dollar exposures to related borrowers, industry and geographic concentrations, and economic and environmental factors. Our risk management practices are designed to ensure timely identification of changes in loan risk profiles; however, undetected losses may inherently exist within the loan portfolio. The assessment aspects involved in analyzing the quality of individual loans and assessing collateral values can also contribute to undetected, but probable, losses. For more detailed information about our Allowance methodology and risk rating system, see Note 3 to the Consolidated Financial Statements.

The following table summarizes the activity in our Allowance by portfolio segment:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
	(dollars in thousands)
Allowance, beginning of year	$	8,093		$	8,257		$	8,044		$	8,055
Charge-offs:
Residential mortgage		—			(148)			(20)			(508)
Commercial		—			—			—			—
Commercial real estate		(199)			—			(199)			—
ADC		—			(6)			—			(19)
Home equity/2nds		—			—			—			—
Consumer		(2)			—			(14)			—
Total charge-offs		(201)			(154)			(233)			(527)
Recoveries:
Residential mortgage		3			3			11			225
Commercial		—			—			—			—
Commercial real estate		30			31			97			364
ADC		—			—			—			—
Home equity/2nds		3			219			9			239
Consumer		3			—			3			—
Total recoveries		39			253			120			828
Net (charge-offs) recoveries		(162)			99			(113)			301
Reversal of provision for loan losses		(500)			(300)			(500)			(300)
Allowance, end of period	$	7,431		$	8,056		$	7,431		$	8,056
Loans:
Period-end balance	$	660,879		$	689,712		$	660,879		$	689,712
Average balance during period		677,792			678,753			678,495			673,689
Allowance as a percentage of
period-end loan balance		1.12	%		1.17	%		1.12	%		1.17	%
Percent of average loans (annualized):
Reversal of provision for loan losses		0.29	%		0.18	%		0.10	%		0.06	%
Net (charge-offs) recoveries		(0.09)	%		0.06	%		(0.02)	%		0.06	%

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The following table summarizes our allocation of the Allowance by loan segment:

	September 30, 2019						December 31, 2018
					Percent						Percent
					of Loans						of Loans
			Percent		to Total				Percent		to Total
	Amount		of Total		Loans		Amount		of Total		Loans
	(dollars in thousands)
Residential mortgage	$	2,387	32.1	%	40.8	%	$	2,224	27.6	%	40.3	%
Commercial		1,512	20.3	%	6.8	%		2,736	34.0	%	5.2	%
Commercial real estate		969	13.1	%	36.2	%		457	5.7	%	35.6	%
ADC		2,313	31.1	%	14.1	%		2,239	27.8	%	16.8	%
Home equity/2nds		226	3.1	%	1.8	%		222	2.8	%	2.0	%
Consumer		—	—	%	0.3	%		1	—	%	0.1	%
Unallocated		24	0.3	%	—	%		165	2.1	%	—	%
Total	$	7,431	100.0	%	100.0	%	$	8,044	100.0	%	100.0	%

Based upon management’s evaluation, provisions are made to maintain the Allowance as a best estimate of inherent losses within the portfolio. The Allowance totaled  $7.4 million at  September 30, 2019 and $8.0 million at December 31, 2018. Any changes in the Allowance from period to period reflect management’s ongoing application of its methodologies to establish the Allowance, which, for the nine months ended September 30, 2019, resulted in increased allocated Allowances for residential mortgage, commercial real estate, ADC loans, and home equity/2nds. The Allowance for commercial loans decreased due to a large favorable resolution to a credit with an allocated reserve in previous periods of $430,000 and due to a high charge-off year rolling out of our lookback period.

At December 31, 2018, due to a re-evaluation of our qualitative factors, we changed our estimates of the Allowance relative to historical loss experience within specific loan portfolio segments in order to better align our qualitative factors with historical losses experienced over a longer period of time, relative to those specific loan segments. The result of this change in estimate did not result in a material increase in the Allowance compared to the year ended December 31, 2017, however there were material changes to the Allowance between loan segments. Due to the change in accounting estimate, the Allowance allocated to commercial loans and ADC loans increased approximately $2.2 million and $1.1 million, respectively, while the Allowance allocated to residential mortgage loans and commercial real estate loans decreased approximately $600,000 and $2.7 million, respectively, as of December 31, 2018. This change in accounting estimate had no impact on earnings or diluted earnings per share.

As result of our Allowance analysis, we recorded a reversal of the provision for loan losses of $500,000 for the three and nine months ended September 30, 2019. We recorded net charge-offs of $162,000 and $113,000, respectively, during the three and nine months ended September 30, 2019 and net recoveries of $99,000 and 301,000, respectively, during the three and nine months ended September 30, 2018.  During the three and nine months ended September 30, 2019, annualized net charge-offs as a percentage of average loans outstanding amounted to 0.09% and 0.02%, respectively, compared to net recoveries as a percentage of average loans outstanding of 0.06% for both the three and nine months ended September 30, 2018. The Allowance as a percentage of outstanding loans was 1.12% as of September 30, 2019 compared to 1.18% as of December 31, 2018. 

Although management uses available information to establish the appropriate level of the Allowance, future additions or reductions to the Allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions, and other factors. As a result, our Allowance may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect our operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our Allowance and related methodology. Such agencies may require us to recognize adjustments to the Allowance based on their judgments about information available to them at the time of their examination. Management believes the Allowance is adequate as of September 30, 2019 and is sufficient to address the credit losses inherent in the current loan portfolio.

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Nonperforming Assets (“NPAs”)

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

NPAs, expressed as a percentage of total assets, totaled 0.75% at September 30, 2019 and 0.64% at December 31, 2018. The ratio of the Allowance to nonperforming loans was 171.5% at September 30, 2019 and 172.8% at December 31, 2018.  

The distribution of our NPAs is illustrated in the following table. We did not have any loans greater than 90 days past due and still accruing at September 30, 2019 or December 31, 2018.

	September 30, 2019		December 31, 2018
Nonaccrual Loans:	(dollars in thousands)
Residential mortgage	$	3,386	$	2,580
Commercial		—		430
Commercial real estate		692		660
ADC		99		558
Home equity/2nds		156		428
		4,333		4,656
Real Estate Acquired Through Foreclosure:
Residential mortgage		1,315		1,366
ADC		558		171
		1,873		1,537
Total Nonperforming Assets	$	6,206	$	6,193

Nonaccrual loans totaled $4.3 million, or 0.66% of total loans, at September 30, 2019 and $4.7 million, or 0.68% of total loans at December 31, 2018. Significant activity in nonaccrual loans during the nine months ended September 30, 2019 included the addition of six loans in the amount of $1.7 million to nonaccrual loans, the transfer of three loans to real estate acquired through foreclosure for $707,000 (net of write downs of $20,000), and payoffs of $1.1 million in nonaccrual loans that existed at December 31, 2018.

Real estate acquired through foreclosure increased $336,000 to $1.9 million at September 30, 2019 compared to $1.5 million at December 31, 2018 due to three property additions, partially offset by write downs on properties existing at December 31, 2018.

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The activity in our real estate acquired through foreclosure was as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(dollars in thousands)
Balance at beginning of period	$	1,430	$	295	$	1,537	$	403
Real estate acquired in satisfaction of loans		516		—		687		—
Write-downs and losses on real estate acquired through foreclosure		(73)		(10)		(244)		(54)
Proceeds from sales of real estate acquired through foreclosure		—		—		(107)		(64)
Balance at end of period	$	1,873	$	285	$	1,873	$	285

Troubled Debt Restructures (“TDRs”)

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

The composition of our TDRs is illustrated in the following table:

	September 30, 2019		December 31, 2018
Residential mortgage:	(dollars in thousands)
Nonaccrual	$	292	$	446
<90 days past due/current		7,828		9,469
Commercial real estate:
Nonaccrual		—		—
<90 days past due/current		993		1,019
ADC:
Nonaccrual		—		—
<90 days past due/current		131		134
Consumer:
Nonaccrual		—		—
<90 days past due/current		71		76
Totals:
Nonaccrual		292		446
<90 days past due/current		9,023		10,698
	$	9,315	$	11,144

See additional information on TDRs in Note 3 to the Consolidated Financial Statements herein.

Deposits

Deposits totaled $657.2 million at September 30, 2019  and  $779.5 million at December 31, 2018. The $122.4 million decrease was primarily the result of short-term medical-use cannabis related funds (funds that have not actually been used in the medical-use cannabis industry yet) that account holders relocated to investment opportunities outside of the Bank. Management was aware of the short-term nature of certain medical-use cannabis related deposits and offset those funds by maintaining short-term liquidity to meet any deposit outflows.

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The deposit breakdown is as follows:

	September 30, 2019				December 31, 2018
			Percent				Percent
	Balance		of Total		Balance		of Total
	(dollars in thousands)
NOW	$	92,804	14.1	%	$	106,508	13.7	%
Money market		147,849	22.5	%		203,351	26.1	%
Savings		64,583	9.8	%		75,692	9.7	%
Certificates of deposit		222,141	33.8	%		247,351	31.7	%
Total interest-bearing deposits		527,377	80.2	%		632,902	81.2	%
Noninterest-bearing deposits		129,777	19.8	%		146,604	18.8	%
Total deposits	$	657,154	100.0	%	$	779,506	100.0	%

Borrowings

Our borrowings consist of advances from the FHLB and a term loan from a commercial bank.

The FHLB advances are available under a specific collateral pledge and security agreement, which requires that we maintain collateral for all of our borrowings equal to 30% of total assets. Our advances from the FHLB may be in the form of short-term or long-term obligations. Short-term advances have maturities for one year or less and may contain prepayment penalties. Long-term borrowings through the FHLB have original maturities up to 15 years and generally contain prepayment penalties.

At September 30, 2019, our total credit line with the FHLB was  $257.5 million. The Bank, from time to time, utilizes the line of credit when interest rates are more favorable than obtaining deposits from the public. Our outstanding FHLB advance balance at September 30, 2019 and December 31, 2018 was $35.0 million and $70.0 million, respectively. 

On September 30, 2016, we entered into a loan agreement with a commercial bank whereby we borrowed $3.5 million for a term of 8 years. The unsecured note bears interest at a fixed rate of 4.25% for the first 36 months then, at the option of the Company, converts to either (1) floating rate of the Wall Street Journal Prime plus 50 basis points or (2) fixed rate at two hundred seventy five (275) basis points over the five year amortizing FHLB rate for the remaining five years. Repayment terms are monthly interest only payments for the first 36 months, then quarterly principal payments of $175,000 plus interest. The loan is subject to a prepayment penalty of 1% of the principal amount prepaid during the first 36 months. If we elect the 5 year fixed rate of 275 basis points over the FHLB rate (“FHLB Rate Period”), the loan will be subject to a prepayment penalty of 2% during the first and second years of the FHLB Rate Period and 1% of the principal repaid during the third, fourth, and fifth years of the FHLB Rate Period. We may make additional principal payments from internally generated funds of up to $875,000 per year during any fixed rate period without penalty. There is no prepayment penalty during any floating rate period. As of September 30, 2019, we have elected the option of the floating rate of the Wall Street Journal Prime plus 50 basis points.

The following table sets forth information concerning the interest rates and maturity dates of the advances from the FHLB as of September 30, 2019:

Principal
Amount (in thousands)		Rate	Maturity
$	25,000	1.75% to 1.92%	2020
	10,000	2.19%	2022
$	35,000

Subordinated Debentures

As of both September 30, 2019 and December 31, 2018, the Company had outstanding $20.6 million in principal amount of Junior Subordinated Debt Securities, due in 2035 (the “2035 Debentures”). The 2035 Debentures were issued pursuant

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to an Indenture dated as of December 17, 2004 (the “2035 Indenture”) between the Company and Wells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3‑month LIBOR plus 200 basis points, and mature on January 7, 2035. Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of the Company, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by the Company on January 7, 2010.

The 2035 Debentures were issued and sold to Severn Capital Trust I (the “Trust”), of which 100% of the common equity is owned by the Company. The Trust was formed for the purpose of issuing corporation-obligated mandatorily redeemable Capital Securities (“Capital Securities”) to third-party investors and using the proceeds from the sale of such Capital Securities to purchase the 2035 Debentures. The 2035 Debentures held by the Trust are the sole assets of the Trust. Distributions on the Capital Securities issued by the Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Trust on the 2035 Debentures. The Capital Securities are subject to mandatory redemption, in whole or in part, upon repayment of the 2035 Debentures. We have entered into an agreement which, taken collectively, fully and unconditionally guarantees the Capital Securities subject to the terms of the guarantee.

Under the terms of the 2035 Debentures, we are permitted to defer the payment of interest on the 2035 Debentures for up to 20 consecutive quarterly periods, provided that no event of default has occurred and is continuing. As of September 30, 2019, we were current on all interest due on the 2035 Debentures.

Capital Resources

Total stockholders’ equity increased $6.2 million to $104.6 million at September 30, 2019 compared to $98.5 million as of December 31, 2018. The increase was principally the result of 2019 net income to date, partially offset by dividends paid to stockholders during the nine months ended September 30, 2019.

Series A Preferred Stock

On November 15, 2008, the Company completed a private placement offering consisting of a total of 70 units, at an offering price of $100,000 per unit, for gross proceeds of $7.0 million. Each unit consisted of 6,250 shares of the Company’s Series A 8.0% Non-Cumulative Convertible Preferred Stock. On March 13, 2018, the Company notified holders of its Series A preferred stock that the Company had exercised its option to convert each of the 437,500 outstanding shares of Series A preferred stock for one share of common stock. The Company converted the Series A preferred stock on April 2, 2018.  As of that date, the Series A preferred stock was no longer deemed outstanding, and all rights with respect to such stock have ceased and terminated. 

Capital Adequacy

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. As of September 30, 2019 and December 31, 2018, the Bank exceeded all capital adequacy requirements to which it is subject and meets the qualifications to be considered “well capitalized.”  See details of our capital ratios in Note 4 of the Consolidated Financial Statements.

Liquidity

Liquidity describes our ability to meet financial obligations, including lending commitments and contingencies, which arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers, to fund the operations of our mortgage-banking business, as well as to meet current and

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planned expenditures. These cash requirements are met on a daily basis through the inflow of deposit funds, the maintenance of short-term overnight investments, maturities and calls in our securities portfolio, and available lines of credit with the FHLB, which requires pledged collateral. Fluctuations in deposit and short-term borrowing balances may be influenced by the interest rates paid, general consumer confidence, and the overall economic environment. There can be no assurances that deposit withdrawals and loan fundings will not exceed all available sources of liquidity on a short-term basis. Such a situation would have an adverse effect on our ability to originate new loans and maintain reasonable loan and deposit interest rates, which would negatively impact earnings.

Our principal sources of liquidity are loan repayments, maturing investments, deposits, borrowed funds, and proceeds from loans sold on the secondary market. The levels of such sources are dependent on the Bank’s operating, financing, and investing activities at any given time. We consider core deposits stable funding sources and include all deposits, except time deposits of $100,000 or more. The Bank’s experience has been that a substantial portion of certificates of deposit renew at time of maturity and remain on deposit with the Bank. Additionally, loan payments, maturities, deposit growth, and earnings contribute to our flow of funds.

In addition to our ability to generate deposits, we have external sources of funds, which may be drawn upon when desired. The primary source of external liquidity is an available line of credit with the FHLB. The Bank’s total credit availability under the FHLB’s credit availability program was $257.5 million at September 30, 2019, of which $35.0 million was outstanding.

The borrowing requirements of customers include commitments to extend credit and the unused portion of lines of credit (collectively “commitments”), which totaled $120.4 million at September 30, 2019. Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements. We expect to fund these commitments from the sources of liquidity described above.

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

In addition to the foregoing, the payment of dividends is a use of cash, but is not expected to have a material effect on liquidity. As of September 30, 2019, we had no material commitments for capital expenditures.

Our ability to acquire deposits or borrow could be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole. At September 30, 2019, management considered the Company’s liquidity level to be sufficient for the purposes of meeting our cash flow requirements. We are not aware of any undisclosed known trends, demands, commitments, or uncertainties that are reasonably likely to result in material changes in our liquidity.

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

Off-Balance Sheet Arrangements and Derivatives

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

Credit Commitments

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

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

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

Derivatives

We maintain and account for derivatives, in the form of interest-rate lock commitments (“IRLCs”) and mandatory forward contracts, in accordance with the Financial Accounting Standards Board guidance on accounting for derivative instruments and hedging activities. We recognize gains and losses on IRLCs, mandatory forward contracts, and best effort forward contracts on the loan pipeline through mortgage-banking revenue in the Consolidated Statements of Income.

IRLCs on mortgage loans that we intend to sell in the secondary market are considered derivatives. We are exposed to price risk from the time a mortgage loan closes until the time the loan is sold. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 14 days to 60 days. For these IRLCs, we attempt to protect the Bank from changes in interest rates through the use of best efforts and mandatory forward contracts.

Information pertaining to the carrying amounts of our derivative financial instruments follows:

	September 30, 2019				December 31, 2018
	Notional		Estimated		Notional		Estimated
	Amount		Fair Value		Amount		Fair Value
	(dollars in thousands)
Asset - IRLCs	$	9,680	$	180	$	3,710	$	100
Asset - mandatory forward contracts		17,104		46		—		—
Asset - best effort forward contracts		9,680		26		3,710		—
Liability - mandatory forward contracts		—		—		9,363		16

Inflation

The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with GAAP and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. As a financial institution, virtually all of our assets and liabilities are monetary in nature and interest rates have a more significant impact on our performance than the effects of general levels of inflation. A prolonged period of inflation could cause interest rates, wages, and other costs to increase and could adversely affect our results of operations unless mitigated by a corresponding increase in our revenues. However, we believe that the impact of inflation on our operations was not material for the three or nine months ended September 30, 2019 and 2018.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

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

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environment even though we generally borrow at short-term interest rates and lend at longer-term interest rates. This is because loans and other interest-earning assets may be prepaid and replaced with lower yielding assets before the supporting interest-bearing liabilities reprice downward. Our interest rate margin may also be negatively impacted in a flat or inverse-yield curve environment. Mortgage origination activity tends to increase when interest rates trend lower and decrease when interest rates rise.

Our primary strategy to control interest rate risk is to strive to balance our loan origination activities with the interest rate market. We attempt to maintain a substantial portion of our loan portfolio in short-term loans such as construction loans. This has proven to be an effective hedge against rapid increases in interest rates as the construction loan portfolio reprices rapidly.

The matching of maturity or repricing of interest-earning assets and interest-bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring the Bank’s interest rate sensitivity gap. An interest-earning asset or interest-bearing liability is interest rate sensitive within a specific time period if it will mature or reprice within that time period. The difference between rate sensitive assets and rate sensitive liabilities represents the Bank’s interest sensitivity gap. At  September 30, 2019, we had a one-year cumulative negative gap of $39.3 million.

Exposure to interest rate risk is actively monitored by management. The objective is to maintain a consistent level of profitability within acceptable risk tolerances across a broad range of potential interest rate environments. We use the PROFITstar® model to monitor our exposure to interest rate risk, which calculates changes in the economic value of equity (“EVE”).

The following table represents our EVE as of September 30, 2019:

Change in Rates		Amount		$ Change		% Change
		(dollars in thousands)
+400	bp	$	144,265	$	5,230	3.76	%
+300	bp		146,459		7,424	5.34	%
+200	bp		148,186		9,151	6.58	%
+100	bp		146,248		7,213	5.19	%
0	bp		139,035
(100)	bp		120,958		(18,077)	(13.00)	%
(200)	bp		88,749		(50,286)	(36.17)	%

The preceding income simulation analysis does not represent a forecast of actual results and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, which are subject to change, including: the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. Also, as market conditions vary, prepayment/refinancing levels, the varying impact of interest rate changes on caps and floors embedded in adjustable-rate loans, early withdrawal of deposits, changes in product preferences, and other internal/external variables will likely deviate from those assumed.

Item 4.     Controls and Procedures

Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities and Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s (“SEC”) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.

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The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC. As of September 30, 2019, the Company’s management, including the Company’s CEO and CFO, have evaluated the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15 and 15d-15(e) under the Exchange Act. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must necessarily reflect the fact that there are resource constraints and that management is required to apply its judgement in evaluating the benefits of possible controls and procedures relative to their costs. Based on this evaluation, the Company's CEO and CFO concluded that, as of the end of the period covered by this quarterly report, the Company's disclosure controls and procedures were not effective because of the material weakness described below.

A material weakness is a deficiency or combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's quarterly financial statements will not be prevented or detected on a timely basis. The identification of the material weaknesses did not impact any of our consolidated financial statements for any prior annual or interim periods, other than as described in our Annual Report on Form 10-K as of and for the year ended December 31, 2018. Accordingly, management believes that the financial statements included in this Quarterly Report on Form 10-Q present fairly in all material respects the Company's financial condition, results of operations and cash flows for the periods presented.

The Company has identified a material weakness in its internal control over financial reporting, specifically related to both management’s review controls and risk rating controls over the Company’s Allowance. The material weakness in internal control over financial reporting resulted from a lack of sufficient management review controls over the development and monitoring of qualitative factors used in calculating the general component of the Allowance, a lack of sufficient management review controls over the relevant inputs and assumptions used to measure the fair value of impaired loans, lack of controls to identify the completeness of TDRs, and review over the completeness of changes to loans’ risk ratings that are required to be modified within the Company’s loan accounting system.

Management has been actively engaged in developing remediation plans to address the above control deficiencies. The Company has enhanced its management review controls over the development and monitoring of qualitative factors and other relevant assumptions used in calculating the general component of the Allowance. The Company has also enhanced its current review process over impaired loans to ensure a timely review is being performed at an appropriate level of precision as it pertains to the relevant inputs and assumptions to measure the fair value of impaired loans, including appraisal review controls. The Company has also implemented a process to ensure the completeness and accuracy of the population to provide assurance that all required loans are properly evaluated for TDR classification. Finally, the Company has enhanced controls over the review of the completeness of changes to loans’ risk ratings that are required to be modified within the Company’s loan accounting system.

The Company had also previously identified a material weakness in its internal control over financial reporting, specifically related to its reconciliation controls relating to LHFS. The material weakness in internal control over financial reporting resulted from a 2018 material reclassification entry identified during the audit. The impact of this reclassification was corrected on the consolidated statement of financial condition as of December 31, 2018. Management has since remediated this material weakness by incorporating stronger internal controls over the LHFS, including strengthening the reconciliation process to ensure accuracy of LHFS and the reflection of all loan sales.

Although the Company’s remediation efforts are well underway and are expected to be fully completed in the near future, the Company’s material weakness will not be considered remediated until new internal controls are operational for a period of time and are tested, and management concludes that these controls are operating effectively.

Other than the remediation described above, there has been no change in the Company’s internal control over financial reporting during the quarter ended September 30, 2019 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1.     Legal Proceedings

In the normal course of business, we are party to litigation arising from the banking, financial, and other activities we conduct. Management, after consultation with legal counsel, does not anticipate that the ultimate liability, if any, arising from these matters will have a material effect on the Company’s financial condition, operating results, or liquidity as of September 30, 2019.

Item 1A.  Risk Factors

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of the Annual Report on Form 10‑K of Severn Bancorp as of and for the year ended December 31, 2018. There have been no material changes in our risk factors since the filing of our December 31, 2018 Annual Report on Form 10‑K.

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

None.

Item 3.     Defaults Upon Senior Securities

None.

Item 4.     Mine Safety Disclosures

Not applicable.

Item 5.     Other Information

None.

Item 6.     Exhibits

Exhibit No.	Description
31.1	Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101	The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10‑Q as of September 30, 2019 and for the three and nine months ended September 30, 2019, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Income; (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Changes in Stockholders’ Equity; (v) the Consolidated Statements of Cash Flows; and (vi) the Notes to Consolidated Financial Statements.

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EXHIBIT INDEX

Exhibit No.	Description
31.1	Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002
32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101	The following financial statements from the Severn Bancorp, Inc. Quarterly Report on Form 10‑Q as of September 30, 2019 and for the three and nine months ended September 30, 2019, formatted in XBRL (Extensible Business Reporting Language): (i) the Consolidated Statements of Financial Condition; (ii) the Consolidated Statements of Income; (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Changes in Stockholders’ Equity; (v) the Consolidated Statements of Cash Flows; and (vi) the Notes to Consolidated Financial Statements.

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SIGNATURES

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

	SEVERN BANCORP, INC.
November 12, 2019	/s/ Alan J. Hyatt
	Alan J. Hyatt, Chairman of the Board, President and Chief Executive Officer
	(Principal Executive Officer)
November 12, 2019	/s/ Vance W. Adkins
	Vance W. Adkins, Chief Financial Officer
	(Principal Financial and Accounting Officer)

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