10-K 1 svbi10k.htm SVBI10K svbi10k.htm

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

FORM 10-K

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

For the fiscal year ended December 31, 2012
or

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

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

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on which registered
   
Common Stock, par value $.01 per share
 Nasdaq Capital Market

Securities registered pursuant to Section 12(g) of the Act: None


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
                                                                                                                                                                           Yes o No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
                                                                Yes o No þ

Note - Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 of 15(d) of the Exchange Act from their obligations under those Sections.

 
 

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.            Yes o No þ
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
                                                                                                                                                                            Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.      þ   

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
        Large accelerated filer o          Accelerated filer o          Non-accelerated filer o (Do not
                            Smaller reporitng company þ      check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Act).  Yes o No þ


  The aggregate market value of the 6,214,021 shares of common stock held by non-affiliates of the registrant, based on the closing sale price of the registrant’s common stock on June 30, 2012 of $3.12 per share was $19,387,746.

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

Indicate the number of shares outstanding for each of the registrant’s classes of common stock, as of the latest practicable date.

As of March 1, 2013, there were issued and outstanding 10,066,679 shares of the registrant’s common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Definitive Proxy Statement for its 2013 Annual Meeting of Stockholders, which Definitive Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the registrant’s fiscal year-ended December 31, 2012, are incorporated by reference into Part III of this Form 10-K; provided, however, that the Compensation Committee Report, the Audit Committee Report and any other information in such proxy statement that is not required to be included in this Annual Report on Form 10-K, shall not be deemed to be incorporated herein by reference or filed as a part of this Annual Report on Form 10-K.

 
 

 




Table of Contents

Section
 
Page No.
  Explanatory Note Regarding Restatement 1
PART I
 
 
     
Item 1
Business
2
Item 1A
Risk Factors
35
Item 1B
Unresolved Staff Comments
45
Item 2
Properties
45
Item 3
Legal Proceedings
45
Item 4
Mine Safety Disclosures
45
Item 4.1
Executive Officers of the Registrant
45
     
PART II
 
46
     
Item 5
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
46
Item 6
Selected Financial Data
47
Item 7
Management’s Discussion and Analysis of Financial Condition
 
 
and Results of Operations
51
Item 7A
Quantitative and Qualitative Disclosures About Market Risk
60
Item 8
Financial Statements and Supplementary Data
62
Item 9
Changes in and Disagreements with Accountants on
 
 
Accounting and Financial Disclosure
62
Item 9A
Controls and Procedures
62
Item 9B
Other Information
63
     
PART III
 
64
     
Item 10
Directors, Executive Officers  and Corporate Governance
64
Item 11
Executive Compensation
64
Item 12
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
64
Item 13
Certain Relationships and Related Transactions, and Director Independence
65
Item 14
Principal Accounting Fees and Services
65
     
PART IV
 
66
     
Item 15
Exhibits, Financial Statement Schedules
66
     
SIGNATURES
 
68


i
 

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Severn Bancorp, Inc. (“Bancorp”) may from time to time make written or oral “forward-looking statements”, (as defined in the Securities Exchange Act of 1934, as amended, and the regulations thereunder) including statements contained in Bancorp’s filings with the Securities and Exchange Commission (including this Annual Report on Form 10-K and the exhibits thereto), in its reports to stockholders and in other communications by Bancorp, pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements include, but are not limited to:

·  
Statements contained in “Item 1A. Risk Factors;”
 
·  
Statements contained in “Business” concerning strategy, competitive strengths, liquidity and business plans;
 
·  
Statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the notes to Bancorp’s consolidated financial statements, such as statements concerning allowance for loan losses, liquidity, capital adequacy requirements, unrealized losses, guarantees, the Bank being well-capitalized, and impact of accounting pronouncements; and
 
·  
Statements as to trends or Bancorp’s or management’s beliefs, expectations and opinions.
 
The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “will,” “would,” “could,” “should,” “guidance,” “potential,” “continue,” “project,” “forecast,” “confident,” and similar expressions are typically used to identify forward-looking statements.  These statements are based on assumptions and assessments made by management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate.  Any forward-looking statements are not guarantees of Bancorp’s future performance and are subject to risks and uncertainties and may be affected by various factors that may cause actual results, developments and business decisions to differ materially from those in the forward-looking statements.  Some of the factors that may cause actual results, developments and business decisions to differ materially from those contemplated by such forward-looking statements include the risk factors discussed under “Item 1A. Risk Factors” and the following:
 
 
·  
Changes in general economic and political conditions and by governmental monetary and fiscal policies;
 
·  
Changes in the economic conditions of the geographic areas in which Bancorp conducts business;
 
·  
Changes in interest rates;
 
·  
A downturn in the real estate markets in which Bancorp conducts business;
 
·  
The high degree of risk exhibited by Bancorp’s loan portfolio;
 
·  
Environmental liabilities with respect to properties Bancorp has title;
 
·  
Changes in federal and state regulation;
 
·  
The effects of the supervisory agreements entered into by each of  Bancorp and Severn Savings Bank, FSB with their respective federal regulator;
 
·  
Bancorp’s ability to estimate loan losses;
 
·  
Competition;
 
·  
Breaches in security or interruptions in Bancorp’s information systems, including cyber security risks;
 
·  
Bancorp’s ability to timely develop and implement technology;
 
 
ii
 

 
 
·  
Bancorp’s ability to retain its management team;
 
·  
Perception of Bancorp in the marketplace;
 
·  
Bancorp’s ability to maintain effective internal controls over financial reporting and disclosure controls and procedures; and
 
·  
Terrorist attacks and threats or actual war.

Bancorp can give no assurance that any of the events anticipated by the forward-looking statements will occur or, if any of them does, what impact they will have on Bancorp’s results of operations and financial condition.  Bancorp disclaims any intent or obligation to publicly update or revise any forward-looking statements, regardless of whether new information becomes available, future developments occur or otherwise.


  iii
 

 

EXPLANATORY NOTE REGARDING RESTATEMENT

As previously disclosed in our Current Report on Form 8-K dated February 14, 2013, Bancorp’s Board of Directors, upon recommendation of the Audit Committee of the Board of Directors and in consultation with Bancorp’s management, concluded that Bancorp’s previously filed audited consolidated financial statements for fiscal years 2010 and 2011 contained in Bancorp’s Annual Reports on Form 10-K for those years, and unaudited interim consolidated financial statements contained in Bancorp’s Quarterly Reports on Form 10-Q for each of the quarters ended March 31, 2010, 2011 and 2012, June 30, 2010, 2011 and 2012, and September 30, 2010, 2011 and 2012 (collectively the “Restated Periods”) require restatement to correct the method used to amortize a three year prepayment made in 2009 for Bancorp’s FDIC risk-based insurance assessment, and, therefore, should no longer be relied upon.  In 2009, Bancorp paid an estimated FDIC insurance assessment in advance for fiscal years 2010, 2011 and 2012 based on the level of net assets as of June 30, 2009, and began expensing the prepayment evenly over the three year period covered by the prepayment.  During the course of preparation of the 2012 year-end financial statements and audit, management determined that this method of amortization was incorrect and that Bancorp should have amortized the prepayment based on the actual reduced level of net assets over that period.

All applicable amounts relating to this restatement have been reflected in the consolidated financial statements and disclosed in the notes to the consolidated financial statements in this 2012 Form 10-K.  For discussion of the restatement adjustments, see Item 8. Financial Statements and Supplementary Data – Note 2 – Restatement of Consolidated Financial Statements and Note 19 – Quarterly Financial Data (Unaudited).  Additionally, see Item 6. Selected Financial Data and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

As a result of the error detected above, Bancorp is reporting that it had a material weakness in its internal control over financial reporting. A material weakness is a deficiency, or combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.  For a discussion of Bancorp’s controls and procedures, the material weakness identified and actions to remediate such weakness, see Item 9A. Controls and Procedures.
 
We believe that presenting all of this information regarding the Restated Periods in this Annual Report allows investors to review all pertinent data in a single presentation.  We have not filed amendments to (i) our Quarterly Reports on Form 10-Q for the first three quarterly periods in the years ended December 31, 2012, 2011 and 2010, or (ii) our Annual Reports on Form 10-K for the years ended December 31, 2011 and 2010 (collectively, the “Affected Reports”).  Accordingly, investors should rely only on the financial information and other disclosures regarding the Restated Periods in this Annual Report on Form 10-K, and not on the Affected Reports or any reports, earnings releases or similar communications relating to those periods.

 
1

 

PART I

Item 1.  Business

General

Bancorp is a savings and loan holding company chartered as a corporation in the state of Maryland in 1990.  It conducts business primarily through two subsidiaries, Severn Savings Bank, FSB (“Bank”) and SBI Mortgage Company (“SBI”).  The Bank’s principal subsidiary Louis Hyatt, Inc. (“Hyatt Commercial”), conducts business as Hyatt Commercial, a commercial real estate brokerage and property management company.  SBI holds mortgages that do not meet the underwriting criteria of the Bank, and is the parent company of Crownsville Development Corporation (“Crownsville”), which is doing business as Annapolis Equity Group, which acquires real estate for syndication and investment purposes.

The Bank has four branches in Anne Arundel County, Maryland, which offer a full range of deposit products, and originate mortgages in its primary market of Anne Arundel County, Maryland and, to a lesser extent, in other parts of Maryland, Delaware and Virginia.

On December 17, 2004, Bancorp acquired all the common stock of newly formed Severn Capital Trust I, a Delaware business trust.  Severn Capital Trust I issued $20,000,000 of trust preferred securities in a private placement pursuant to an applicable exemption from registration under the Securities Act of 1933, as amended.  Bancorp irrevocably and unconditionally guaranteed the trust preferred securities.  The proceeds of the trust preferred securities were used to purchase Bancorp’s Junior Subordinated Debt Securities due 2035 (the “2035 Debentures”).

On November 15, 2008, Bancorp sold a total of 70 units, at an offering price of $100,000 per unit, for gross proceeds of $7.0 million pursuant to a private placement exempt from registration under the Securities Act of 1933.    Each unit consisted of 6,250 shares of Bancorp's Series A 8.0% Non-Cumulative Convertible Preferred Stock ("Series A Preferred Stock") and Bancorp's Subordinated Notes in the original principal amount of $50,000 ("Subordinated Notes").  In the private placement, Bancorp issued a total of 437,500 shares of its Series A Preferred Stock and $3.5 million aggregate principal amount of its Subordinated Notes.

The Emergency Economic Stabilization Act of 2008 (“EESA”) authorized the U.S. Department of the Treasury (“Treasury Department”) to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in the Troubled Asset Relief Program (“TARP”).  The Treasury Department allocated $250 billion towards the TARP Capital Purchase Program (“CPP”).  Under the CPP, Treasury purchased debt or equity securities from participating institutions.  Bancorp made application to the Treasury Department to participate in this program.  On November 21, 2008, Bancorp entered into a Letter Agreement (the “Purchase Agreement”) with the Treasury Department, pursuant to which Bancorp issued and sold (i) 23,393 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series B, par value $0.01 per share and liquidation preference $1,000 per share, (the “Series B Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 556,976 shares of Bancorp’s common stock at $6.30 per (the “Common Stock”), for an aggregate purchase price of $ 23,393,000 in cash.  Closing of the sale occurred on November 21, 2008.

 On November 23, 2009, Bancorp and the Bank each entered into a supervisory agreement with the Office of Thrift Supervision (“OTS”) which primarily addressed issues identified in the OTS’ reports of examination of Bancorp’s and the Bank’s operations and financial condition conducted in 2009.  The Bank’s supervisory agreement is now enforced by the Office of the Comptroller of the Currency. Bancorp’s supervisory agreement is now enforced by the Federal Reserve.   See “Supervisory Agreements” for more information.

Until recently, Bancorp and the Bank were regulated by the OTS.  As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the OTS was eliminated and, as of July 21, 2011, the regulatory oversight functions and authority of the OTS related to the Bank were transferred to the Office of the Comptroller of the Currency (the “OCC”) and the regulatory oversight functions and authority of the OTS related to Bancorp were transferred to the Board of Governors of the Federal Reserve System (the “Federal Reserve”).  See “Regulation – Regulatory Reform and Legislation.”
 
 
 
2

 

 
As of December 31, 2012, Bancorp had total assets of $852,118,000, total deposits of $599,394,000, and total stockholders’ equity of $108,996,000. Net income of Bancorp for the year ended December 31, 2012 was $3,728,000.  For more information, see “Item 6. Selected Financial Data.”

Bancorp’s internet address is www.severnbank.com.  Bancorp makes available free of charge on www.severnbank.com its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC.

In addition, we will provide, at no cost, paper or electronic copies of our reports and other filings made with the SEC.  Requests should be directed to:

Thomas G. Bevivino
Executive Vice President
Severn Bancorp, Inc.
200 Westgate Circle, Suite 200
Annapolis, Maryland 21401

The information on the website listed above, is not and should not be considered part of this Annual Report on Form 10-K and is not incorporated by reference in this document.  This website is and is only intended to be an inactive textual reference.


 
3

 


Business of the Bank

 
The Bank was organized in 1946 in Baltimore, Maryland as Pompei Permanent Building and Loan Association.  It relocated to Annapolis, Maryland in 1980 and its name was changed to Severn Savings Association.  Subsequently, the Bank obtained a federal charter and changed its name to Severn Savings Bank, FSB.  The Bank operates four full-service branch offices, and one administrative office.  The Bank operates as a federally chartered savings bank whose principal business is attracting deposits from the general public and investing those funds in mortgage and commercial loans.   The Bank also uses advances, or loans, from the Federal Home Loan Bank of Atlanta, (“FHLB-Atlanta”) to fund its mortgage activities.  The Bank provides a wide range of retail and mortgage banking services. Deposit services include checking, savings, money market, time deposit and individual retirement accounts. Loan services include various types of real estate, consumer, and commercial lending. The Bank also provides safe deposit boxes, ATMs, debit cards, and internet and telephone banking.

The Bank’s revenues are derived principally from interest earned on mortgage, commercial and other loans, and fees charged in connection with the loans and banking services.  The Bank’s primary sources of funds are deposits, advances from the FHLB-Atlanta, principal amortization and prepayment of its loans.  The principal executive offices of the Bank are maintained at 200 Westgate Circle, Suite 200, Annapolis Maryland, 21401.  Its telephone number is 410-260-2000 and its e-mail address is mailman@severnbank.com.


The Thrift Industry

Thrift institutions are financial intermediaries which historically have accepted savings deposits from the general public and, to a lesser extent, borrowed funds from outside sources and invested those deposits and funds primarily in loans secured by first mortgage liens on residential and other types of real estate.  Such institutions may also invest their funds in various types of short- and long-term securities.  The deposits of bank and thrift institutions are insured by the Deposit Insurance Fund (“DIF”) as administered by the Federal Deposit Insurance Corporation (“FDIC”), and these institutions are subject to extensive regulations.  These regula­tions govern, among other things, the lending and other investment powers of thrift institutions, including the terms of mortgage instruments these institutions are permitted to utilize, the types of deposits they are permitted to accept, and reserve require­ments.

The operations of thrift institutions, including those of the Bank, are significantly affected by general economic conditions and by related monetary and fiscal policies of the federal government and regulations and policies of financial institution regulatory authorities, including the Federal Reserve and the OCC into which the former OTS was merged.  Lending activities are influenced by a number of factors including the demand for housing, conditions in the construction industry, and availability of funds.  Sources of funds for lending activities include savings deposits, loan principal payments, proceeds from sales of loans, borrowings from the FHLB-Atlanta and other sources.  Savings flows at thrift institutions such as the Bank are influenced by a number of factors including interest rates on competing investments and levels of personal income.

 
4

 

Earnings

The Bank’s earnings depend primarily on the difference between income from interest-earning assets such as loans and investments, and interest paid on interest-bearing liabilities such as deposits and borrowings.  The Bank typically engages in long-term mortgage lending at fixed rates of interest, generally for periods of up to 30 years, while accepting deposits for consider­ably shorter periods.  However, many of the Bank’s long-term fixed-rate loans are sold in the secondary market, typically resulting in net gains on the sale of such loans by the Bank.

Generally, rapidly rising interest rates cause the cost of interest-bearing liabilities to increase more rapidly than yields on interest-earning assets, thereby adversely affecting the earnings of many thrift institutions.  While the industry has received expanded lending and borrowing powers in recent years permitting different types of investments and mortgage loans, including those with floating or adjustable rates and those with shorter terms, earnings and operations are still highly influenced by levels of interest rates and financial market conditions and by substantial investments in long-term mortgage loans.

Competition

The Annapolis, Maryland area has a high density of financial institutions, many of which are significantly larger and have greater financial resources than the Bank, and all of which are competitors of the Bank to varying degrees.  The Bank’s competition for loans comes primarily from savings and loan associations, savings banks, mortgage banking companies, insurance companies, and commercial banks.  Many of the Bank’s competitors have higher legal lending limits than the Bank.  The Bank’s most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks, and credit unions.  The Bank faces additional competition for deposits from short-term money market funds and other corporate and government securities funds.  The Bank also faces increased competition for deposits from other financial institutions such as brokerage firms, insurance companies and mutual funds.  The Bank is a community-oriented financial institution serving its market area with a wide selection of mortgage loans.  Management considers the Bank’s reputation for financial strength and customer service as its major competitive advantage in attracting and retaining customers in its market area.  The Bank also believes it benefits from its community orientation.

Net Interest Income

Net interest income increases during periods when the spread between Bancorp’s weighted average rate at which new loans are originated and the weighted average cost of interest-bearing liabilities widens.  Market factors such as interest rates, competition, consumer preferences, the supply of and demand for housing, and the availability of funds affect the Bank’s ability to originate loans.

Bancorp has supplemented its interest income through purchases of investments when appropriate.  This activity is intended to generate positive interest rate spreads on large principal balances with minimal administrative expense.

Interest Rate and Volume of Interest-Related Assets and Liabilities

Both changes in rate and changes in the composition of Bancorp’s interest-earning assets and interest-bearing liabilities can have a significant effect on net interest income.

For information concerning the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected Bancorp’s interest income and expense during the fiscal years ended December 31, 2012 and 2011, refer to Item 6, “Selected Financial Data - Rate Volume Table”.


 
5

 


Market Area

The Bank’s market area is primarily Anne Arundel County, Maryland and nearby areas, due to its four branch locations, all located in Anne Arundel County.

The Bank continues to expand its business relationship banking department by focusing on the needs of the business community in Anne Arundel County, Maryland.  In addition, the Bank increased its offerings to businesses and consumers, including additional commercial lending products, business internet banking, and an expanded line of consumer deposit products.  The Bank has traditionally focused its lending activities on first mortgage loans secured by real estate for the purpose of purchasing, refinancing, developing and constructing one-to-four family residences and commercial properties in and near Anne Arundel County, Maryland. While first mortgage lending has slowed due to the economic recession, the Bank continues to be a leading mortgage lender in its market area in 2012.  The Bank participates in the secondary market and sells loans it originates either with mortgage servicing rights released or retained.

Supervisory Agreements

On November 23, 2009, Bancorp and the Bank each entered into a supervisory agreement with the OTS, which agreements primarily addressed issues identified in the OTS’ reports of examination of Bancorp’s and the Bank’s operations and financial condition conducted in 2009.  The Supervisory Agreements provide, among other things, that
 
·  
Bancorp and Bank will not make any dividends or capital distributions, and Bancorp will not redeem any Bancorp common  stock, without the prior approval of the OTS;
 
·  
Bancorp will not, and will not permit its subsidiaries to, incur, issue, renew or rollover any debt or debt securities, increase any current lines of credit, guarantee the debt of any entity, or otherwise incur any additional debt, without the prior written non-objection of the OTS;
 
·  
Bancorp and Bank will submit to OTS a business plan for 2010, 2011 and 2012 designed to, among other things, improve operations, earnings and profitability and reduce Bancorp debt and, after OTS approval, implement such plans and review such plans quarterly;
 
·  
Bank will develop and implement: (i) a plan to reduce the level of classified assets, assets designated special mention, all nonperforming assets and all delinquent loans, including specific workout plans for such assets and loans, or groups of such assets and loans, of $1.5 million or more, (ii) revised policies, procedures, and methodology to ensure the timely establishment and maintenance of an adequate allowance for loan and lease loss level in accordance with applicable laws, regulations, and regulatory guidance, (iii) policies and procedures for the use of interest reserves, (iv) a program, subject to OTS approval, for identifying, monitoring, and managing risks associated with concentrations of credit, (v) a loan modification policy subject to OTS approval, (vi) policies and procedures for identifying and classifying problem assets, (vii) a revised liquidity and funds management policy, subject to OTS approval; the Board of Directors of the Bank is required to review these plans, policies and programs at regular intervals and take appropriate action;
 
·  
Bank will not increase the amount of brokered deposits without the prior approval of the OTS;
 
·  
Bank will establish a regulatory compliance committee, consisting of at least three non-employee directors, to monitor compliance with the supervisory agreement and the completion of all corrective action required in the OTS 2009 report of examination;
 
·  
Bank will not enter into any new, or renew, extend, or revise any existing, contractual arrangement relating to compensation or benefits for any senior executive officer or director of the Bank without prior notice to the OTS;
 

 
6

 

·  
Bank will not enter into any new arrangement or contract with a third party service provider outside of the normal course of business or otherwise in excess of $100,000 per arrangement or contract per year without OTS prior non-objection; and
 
·  
Bancorp and Bank will make various periodic reports to the OTS and their respective boards of directors.
 
Due to the passage of the Dodd-Frank Act, effective July 21, 2011, the supervision of the Bank was transferred to the OCC and the supervision of Bancorp was transferred to the Federal Reserve.  As a result, the Supervisory Agreement with the Bank is now enforced by the OCC and the terms will remain in effect until terminated, modified or suspended by the OCC.  The Supervisory Agreement with Bancorp is now enforced by the Federal Reserve and the terms will remain in effect until terminated, modified or suspended by the Federal Reserve. The foregoing summary is qualified by reference to the Supervisory Agreements, copies of which are filed as exhibits to Bancorp’s Annual Report on Form 10-K for fiscal year ended December 31, 2009 and filed with the Securities and Exchange Commission on March 15, 2010.

 
7

 


Loan Portfolio Composition

The following table sets forth the composition of Bancorp’s loan portfolios by type of loan at the dates indicated.  The table includes a reconciliation of total net loans receivable, including loans held for sale, after consideration of undisbursed portion of loans, deferred loan fees and discounts, and allowances for losses on loans as of December 31:
                                                             
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
   
Amount
   
Percent
 
   
(dollars in thousands)
 
                                                             
Residential mortgage
  $ 269,405       38.60 %   $ 295,876       39.78 %   $ 326,255       38.87 %   $ 343,931       37.97 %   $ 355,909       36.55 %
Construction and land acquisition and
                                                                               
    development
    71,523       10.25 %     99,122       13.32 %     144,098       17.17 %     198,933       21.96 %     242,359       24.89 %
Land
    50,900       7.29 %     59,649       8.02 %     63,155       7.52 %     71,772       7.92 %     82,642       8.49 %
Lines of credit
    31,428       4.50 %     34,278       4.61 %     36,642       4.37 %     31,138       3.44 %     34,872       3.58 %
Commercial real estate
    222,038       31.81 %     203,010       27.29 %     212,477       25.32 %     204,596       22.59 %     214,209       22.00 %
Commercial non-real estate
    6,120       0.88 %     5,599       0.75 %     8,434       1.00 %     6,923       0.76 %     3,084       0.32 %
Home equity
    34,609       4.96 %     41,309       5.56 %     43,501       5.18 %     42,365       4.68 %     39,040       4.01 %
Consumer
    858       0.12 %     897       0.12 %     1,302       0.16 %     1,259       0.14 %     1,083       0.11 %
Loans held for sale
    11,116       1.59 %     4,128       0.55 %     3,426       0.41 %     4,845       0.54 %     453       0.05 %
                                                                                 
  Total gross loans
    697,997       100.00 %     743,868       100.00 %     839,290       100.00 %     905,762       100.00 %     973,651       100.00 %
                                                                                 
Deferred loan origination fees and costs, net
    (2,047 )             (2,485 )             (3,205 )             (3,895 )             (4,439 )        
                                                                                 
Loans in process
    (15,647 )             (18,014 )             (23,851 )             (48,095 )             (57,940 )        
                                                                                 
Allowance for loan losses
    (17,478 )             (25,938 )             (29,871 )             (34,693 )             (14,813 )        
                                                                                 
  Total loans net
  $ 662,825             $ 697,431             $ 782,363             $ 819,079             $ 896,459          



 
8

 

Lending Activities

General

The Bank originates mortgage loans of all types, including residential, residential-construction, commercial-construction, commercial, land and residential lot loans.  The Bank also originates non-mortgage loans, which include consumer, business and commercial loans.  These loans constitute a small part of the Bank’s portfolio.

The Bank originated and funded $190,998,000 and $95,586,000 of mortgage loans for the years ended December 31, 2012 and 2011, respectively.

Loan Origination Procedures

The following table contains information on the activity of the Bank’s loans held for sale and its loans held for investment in its portfolio:
   
For the Years Ended December 31,
 
   
2012
   
2011
   
2010
 
   
(dollars in thousands)
 
Held for Sale:
                 
    Beginning balance
  $ 4,128     $ 3,426     $ 4,845  
    Originations
    105,674       43,403       62,654  
    Net sales
    (98,686 )     (42,701 )     (64,073 )
 
                       
         Ending balance
  $ 11,116     $ 4,128     $ 3,426  
                         
                         
Held for investment:
                       
    Beginning balance
  $ 739,740     $ 835,864     $ 900,917  
    Originations and purchases
    85,324       52,183       94,892  
    Transfers to foreclosed real estate
    (16,515 )     (19,820 )     (32,283 )
    Repayments/payoffs
    (121,668 )     (128,487 )     (127,662 )
 
                       
         Ending balance
  $ 686,881     $ 739,740     $ 835,864  

The Bank originates residential mortgage loans that are to be held in the Bank’s loan portfolio as well as loans that are intended for sale in the secondary market.  Loans sold in the secondary market are primarily sold to investors with which the Bank maintains a correspondent relationship.  These loans are made in conformity with standard underwriting criteria to assure maximum eligibility for possible resale in the secondary market, and are approved either by the Bank’s underwriter or the correspondent’s underwriter.  Loans considered for the Bank’s portfolio are approved by the Bank’s loan committee, which includes the Chief Executive Officer, the Chief Operating Officer, the Chief Risk Officer and the Chief Credit Officer.  Meetings of the loan committee are open to attendance by any member of the Bank’s Board of Directors who wishes to attend.  The loan committee reports to and consults with the Board of Directors in interpreting and applying the Bank’s lending policy.  Single loans greater than $2,000,000, or loans to one borrower aggregating more than $4,000,000, up to $18,425,000 (the maximum amount of loans to one borrower as of December 31, 2012), must also have Board of Directors’ approval.

 
9

 

Loans that are sold are typically long-term (15 or more years) loans with fixed interest rates eligible for resale in the secondary market.  Loans retained for Bancorp’s portfolio typically include construction loans, commercial loans and loans that periodically reprice or mature prior to the end of an amortized term.  Loans are sold with either servicing released or retained by the Bank.  As of December 31, 2012, the Bank was servicing $18,961,000 in loans for Federal Home Loan Mortgage Corporation (“FHLMC”), $35,185,000 in loans for Federal National Mortgage Association (“FNMA”) and $41,306,000 in loans for other investors.

The following table contains information, as of December 31, 2012, on the percentage of fixed-rate single-family loans serviced for others by the Bank, by interest rate category.

Interest rate range
 
Percentage of Portfolio
Less than 5.00%
 
96.0%
5.01 – 6.00%
 
3.4%
6.01 – 7.00%
 
0.1%
7.01 – 8.00%
 
0.3%
Over 8.00%
 
0.2%
   
100.0%

The Bank’s mortgage loan approval process is intended to assess the borrower’s ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan.  The authority of the loan committee to approve loans is established by the Board of Directors and currently is commensurate with the Bank’s limitation on loans to one borrower.  The Bank’s maximum amount of loans to one borrower currently is equal to 15% of the Bank’s unimpaired capital, or $18,425,000 as of December 31, 2012.  Loans greater than this amount require participation by one or more additional lenders.  Letters of credit are subject to the same limitations as direct loans.  The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate.  The Bank requires borrowers to maintain fire and casualty insurance on its secured properties.

The procedure for approval of construction loans is the same for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs.  The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer.  In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long-term loan to replace the construction loan upon completion of construction.

Residential Mortgage Loans

At December 31, 2012, Bancorp’s residential mortgage loan portfolio totaled $269,405,000, or 38.6% of Bancorp’s loan portfolio.  All of Bancorp’s residential mortgage loans are secured by one to four family residential properties.  Loans secured by residential properties generally have less risk than other loans because they are generally the primary residence of the borrower.

Commercial Real Estate Loans

At December 31, 2012, Bancorp’s commercial real estate loan portfolio totaled $222,038,000, or 31.8% of Bancorp’s loan portfolio.  All of Bancorp’s commercial real estate loans are secured by improved property such as office buildings, retail strip shopping centers, industrial condominium units and other small businesses, most of which are located in the Bank’s primary lending area.  The largest commercial real estate loan outstanding at December 31, 2012 was a $6,775,000 loan secured by an office building in Annapolis, Maryland.  This loan has consistently performed in accordance with the terms of the debt instrument.

Loans secured by commercial real estate properties generally involve a greater degree of risk than residential mortgage loans.  Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to a greater extent to adverse conditions in the real estate market or the economy.
 
 
 
 
10

 

 
Construction and Land Acquisition and Development Loans

The Bank originates loans to finance the construction of one-to-four family dwellings, and to a lesser extent, commercial real estate.  It also originates loans for the acquisition and development of unimproved property to be used for residential and/or commercial purposes in cases where the Bank is to provide the construction funds to improve the properties.  As of December 31, 2012, Bancorp had 83 construction loans outstanding in the gross aggregate amount of $71,523,000, representing 10.3% of its loan portfolio.  There were also commitments to advance an additional $15,647,000 of which $49,000 is owner funded. 

Construction loan amounts are based on the appraised value of the property and, for builder loans, a feasibility study as to the potential marketability and profitability of the project.  Construction loans generally have terms of up to one year, with reasonable extensions as needed, and typically have interest rates that float monthly at margins ranging from the prime rate to 2 percent above the prime rate.   In addition to builders’ projects, the Bank finances the construction of single family, owner-occupied houses where qualified contractors are involved and on the basis of strict written underwriting and construction loan guidelines.  Construction loans are structured either to be converted to permanent loans with the Bank upon the expiration of the construction phase or to be paid off by financing from another financial institution.

Construction loans afford the Bank the opportunity to increase the interest rate sensitivity of its loan portfolio and to receive yields higher than those obtainable on loans secured by existing residential properties.  These higher yields correspond to the higher risks associated with construction lending.   Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the project under construction that is of uncertain value prior to its completion.  Because of the uncertainties inherent in estimating construction costs as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to value accurately the total funds required to complete a project and the related loan-to-value ratio.  As a result, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the ultimate success of the project rather than the ability of the borrower or guarantor to repay principal and interest.  If the Bank is forced to foreclose on a project prior to or at completion, due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of the loan as well as related foreclosure and holding costs.  In addition, the Bank may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time.  The Bank has attempted to address these risks through its underwriting procedures and its limited amount of construction lending on multi-family and commercial real estate properties.

It is the policy of the Bank to conduct physical inspections of each property secured by a construction or rehabilitation loan for the purpose of reporting upon the progress of the construction of improvements.  These inspections, referred to as “construction draw inspections,” are to be performed at the time of a request for an advance of construction funds.  If no construction advance has been requested, a fee inspector or senior officer of the institution makes an inspection of the subject property at least quarterly.


 
11

 


Land and Residential Building Lots

Land loans include loans to developers for the development of residential subdivisions and loans on unimproved lots primarily to individuals.  At December 31, 2012, Bancorp had outstanding land and residential building lot loans totaling $50,900,000, or 7.3% of the total loan portfolio.  The largest of these loans for $6,486,000, is secured by thirty lots in Davidsonville, Maryland, and has performed in accordance with the terms of the debt instrument.  Land development loans typically are short-term loans; the duration of these loans is typically not greater than three years.  The interest rate on land loans is generally at least 1% or 2% over the prime rate.   The loan-to-value ratio generally does not exceed 75% at the time of loan origination. Land and residential building lot loans typically are made to customers of the Bank and developers and contractors with whom the Bank has had previous lending experience.  In addition to the customary requirements for these types of loans, the Bank may also require a satisfactory Phase I environmental study and feasibility study to determine the profit potential of the development.

Other Business and Commercial Loans

The Bank also offers other business and commercial loans.  These are loans to businesses are typically lines of credit or other loans that are not secured by real estate, although equipment, securities, or other collateral may secure them.  They typically are offered to customers with long-standing relationships with the Bank.  At December 31, 2012, $37,548,000, or 5.4%, of the loan portfolio consisted of lines of credit and other commercial loans.

Home Equity and Other Consumer Loans

The Bank also offers other loans to consumers, including home equity loans, home equity lines of credit and other consumer loans.  At December 31, 2012, $35,467,000, or 5.1% of the loan portfolio consisted of these loans.

Loan Portfolio Cash Flows

The following table sets forth the estimated maturity of Bancorp’s loan portfolios by type of loan at December 31, 2012.  The estimated maturity reflects contractual terms at December 31, 2012.  Contractual principal repayments of loans do not necessarily reflect the actual life of the Bank’s loan portfolios.  The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and because of enforcement of "due on sale" clauses.  The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans.

   
Due
   
Due after
             
   
Within one
   
1 through
   
Due after
       
   
year or less
   
5 years
   
5 years
   
Total
 
   
(dollars in thousands)
 
Residential mortgage
  $ 24,980     $ 61,764     $ 193,777     $ 280,521  
Acquisition and development
    61,456       10,067       -       71,523  
Land
    25,691       15,429       9,780       50,900  
Lines of credit
    26,897       2,368       2,163       31,428  
Commercial real estate
    28,192       81,837       112,009       222,038  
Commercial, non-real estate
    854       3,355       1,911       6,120  
Home equity
    -       -       34,609       34,609  
Consumer
    299       533       26       858  
Total
  $ 168,369     $ 175,353     $ 354,275     $ 697,997  



 
12

 

The following table contains certain information as of December 31, 2012 relating to the loan portfolio of Bancorp with the dollar amounts of loans due after one year that have fixed and floating rates.  All loans are shown maturing based upon contractual maturities and include scheduled payments but not possible prepayments.

   
Fixed
   
Floating
   
Total
 
   
(dollars in thousands)
 
Residential mortgage
  $ 156,020     $ 99,521     $ 255,541  
Home equity
    -       34,609       34,609  
Lines of credit
    -       4,531       4,531  
Commercial real estate
    75,630       118,216       193,846  
Acquisition and development
    1,030       9,037       10,067  
Land
    14,883       10,326       25,209  
Commercial, non-real estate
    4,134       1,132       5,266  
Consumer
    559       -       559  
Total
  $ 252,256     $ 277,372     $ 529,628  

Loans to One Borrower

Under regulatory guidelines, the aggregate amount of loans that the Bank may make to one borrower was $18,425,000 at December 31, 2012, which is 15% of the Bank’s unimpaired capital and unimpaired surplus.  The Bank’s three largest loans at December 31, 2012 were a $6,775,000 loan secured by an office building located in Annapolis, Maryland, a $6,486,000 loan secured by residential lots in Davidsonville, Maryland and a $5,700,000 loan secured by commercial property located in Norfolk, Virginia.  All three loans are performing as agreed.

Origination and Purchase and Sale of Loans

The Bank originates residential loans in conformity with standard underwriting criteria to assure maximum eligibility for possible resale in the secondary market.  Although the Bank has authority to lend anywhere in the United States, it has confined its loan origination activities primarily to the states of Maryland, Virginia and Delaware.

Loan originations are developed from a number of sources, primarily from referrals from real estate brokers, internet leads, builders, and existing and walk-in customers.

The Bank’s mortgage loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan.  The loan committee of the Bank can approve single residential and commercial loans up to $2,000,000, and loans that aggregate up to $4,000,000 to one borrower.  Single loans greater than $2,000,000, or loans to one borrower aggregating more than $4,000,000, up to $18,425,000 (the maximum amount of loans to one borrower as of December 31, 2012), must also have Board of Directors’ approval. The Bank utilizes independent qualified appraisers approved by the Board of Directors to appraise the properties securing its loans and requires title insurance or title opinions so as to insure that the Bank has a valid lien on the mortgaged real estate. The Bank requires borrowers to maintain fire and casualty insurance on its secured properties.

The procedure for approval of construction loans is the same as for residential mortgage loans, except that the appraiser evaluates the building plans, construction specifications, and estimates of construction costs.  The Bank also evaluates the feasibility of the proposed construction project and the experience and track record of the developer.  In addition, all construction loans generally require a commitment from a third-party lender or from the Bank for a permanent long-term loan to replace the construction loan upon completion of construction.


 
13

 

Consumer loans are underwritten on the basis of the borrower's credit history and an analysis of the borrower's income and expenses, ability to repay the loan, and the value of the collateral, if any.

Currently, it is the Bank’s policy to originate both fixed-rate and adjustable-rate loans. The Bank is currently active in the secondary market and sells a portion of its fixed-rate loans.

Interest Rates, Points and Fees

The Bank realizes interest, point, and fee income from its lending activities.  The Bank also realizes income from commitment fees for making commitments to originate loans, and from prepayment and late charges, loan fees, application fees, and fees for other miscellaneous services.

The Bank accounts for loan origination fees in accordance with standards set on the accounting for deferred costs and fees. These standards prohibit the immediate recognition of loan origination fees as revenues and require that such income (net of certain direct loan origination costs) for each loan be amortized, generally by the interest method, over the estimated life of the loan as an adjustment of yield.  The Bank also realizes income from gains on sales of loans, and servicing released fees for loans sold with servicing released.

Delinquencies and Classified Assets and Allowance for Loan Losses

Delinquencies

The Board of Directors reviews delinquencies on all loans monthly.  The Bancorp’s collection procedures include sending a past due notice to the borrower on the 17th day of nonpayment, making telephone contact with the borrower between 20 and 30 days after nonpayment, and sending a letter after the 30th day of nonpayment. A notice of intent to foreclose is generally sent between 60 and 90 days after delinquency.  When the borrower is contacted, Bancorp attempts to obtain full payment of the past due amount.  However, Bancorp generally will seek to reach agreement with the borrower on a payment plan to avoid foreclosure.

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

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

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

 
14

 

For such loans that are classified as impaired, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs is lower than the carrying value of that loan.  For loans that are not solely collateral dependent, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  The general component relates to loans that are classified as substandard or special mention that are not considered impaired, as well as non-classified loans.  The general reserve is based on historical loss experience adjusted for qualitative factors.  These qualitative factors include:
·  
Levels and trends in delinquencies and nonaccruals;
·  
Inherent risk in the loan portfolio;
·  
Trends in volume and terms of the loan;
·  
Effects of any change in lending policies and procedures;
·  
Experience, ability and depth of management;
·  
National and local economic trends and conditions; and
·  
Effect of any changes in concentration of credit.

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

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

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

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

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


 
15

 

The Bank discontinues the accrual of interest on loans 90 days or more past due, at which time all previously accrued but uncollected interest is deducted from income.  $3,148,000 in interest income would have been recorded for the year ended December 31, 2012 if the loans had been current in accordance with their original terms and had been outstanding throughout the year ended December 31, 2012 or since their origination (if held for only part of the fiscal year).  For the year ended December 31, 2012, $1,184,000 in interest income on such loans was actually included in net income.  The following table sets forth information as to non-accrual loans and other non-performing assets.

   
At December 31,
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(dollars in thousands)
 
Loans accounted for on a non-accrual basis:
                             
    Residential mortgage
  $ 14,436     $ 8,912     $ 18,778     $ 33,391     $ 35,829  
    Acquisition and development
    8,564       10,997       15,160       -       -  
    Land
    4,688       6,813       5,890       19,425       15,721  
    Lines of credit
    1,877       2,019       4,265       -       -  
    Commercial real estate
    5,793       2,140       1,927       7,400       3,047  
    Commercial non-real estate
    111       5       -       56       -  
    Home Equity
    2,000       343       118       536       189  
    Consumer
    26       203       26       -       -  
Total non-accrual loans
  $ 37,495     $ 31,432     $ 46,164     $ 60,808     $ 54,786  
Accruing loans greater than 90 days past due
  $ -     $ -     $ -     $ -     $ -  
Foreclosed real-estate
  $ 11,441     $ 19,932     $ 20,955     $ 21,574     $ 6,317  
Total non-performing assets
  $ 48,936     $ 51,364     $ 57,119     $ 82,382     $ 61,103  
Nonaccrual troubled debt restructures (included above)
  $ 5,635     $ 19,351     $ 13,299     $ 13,771     $ -  
Accruing troubled debt restructurings
  $ 56,448     $ 40,424     $ 58,730     $ 30,945     $ 2,142  
Total non-accrual loans to net loans
    5.8 %     4.5 %     5.9 %     7.5 %     6.1 %
Allowance for loan losses to total non-performing loans,
                                       
    including loans contractually past due 90 days or more
    46.6 %     82.5 %     64.7 %     57.1 %     27.0 %
Total non-accrual and accruing loans greater than
                                       
    90 days past due to total assets
    4.4 %     3.5 %     4.8 %     5.7 %     5.5 %
Total non-performing assets to total assets
    5.7 %     5.7 %     7.0 %     8.5 %     6.2 %

Included in non-accrual residential mortgage loans at December 31, 2012 were 32 loans totaling $11,967,000 to consumers and 14 loans totaling $2,469,000 to builders.  Included in non-accrual land loans at December 31, 2012 were 13 loans.

 
16

 

Classified Assets and Allowance for Loan Losses

Federal regulations provide for the classification of loans and other assets, such as debt and equity securities, considered by the OCC to be of lesser quality, as “substandard,” “doubtful” or “loss assets.” An asset is considered substandard if the paying capacity and net worth of the obligor or the collateral pledged, if any, inadequately protects it.  Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected.  Assets classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions, and values.  Assets classified as loss assets are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.  Assets that do not currently expose the insured institution to a sufficient degree of risk to warrant classification in one of these categories but possess credit deficiencies or potential weakness are required to be designated special mention by management.

When an insured institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for losses in an amount deemed prudent by management.  General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets.  When an insured institution classifies problem assets as loss assets, it is to charge-off such amount.  An institution’s determination as to the classification of its assets is subject to scrutiny by the OCC, which can require the establishment of additional general or specific loss allowances.  The Bank reviews monthly the assets in its portfolio to determine whether any assets require classification in accordance with applicable regulations.

Total classified loans as of December 31, 2012 were $77,317,000 of which $77,127,000 were classified substandard and $190,000 were classified doubtful.  The allowance for loan losses as of December 31, 2012 was $17,478,000, which was 2.5% of gross loans receivable and 46.6% of total non-performing loans.

[see table on following page]


 
17

 

The following table summarizes the allocation of the allowance for loan losses by loan type and the percent of loans in each category compared to total loans (excluding loans held for sale) as of December 31,


                                                             
   
2012
   
2011
   
2010
   
2009
   
2008
 
         
Percentage of
         
Percentage of
         
Percentage of
         
Percentage of
         
Percentage of
 
         
Loans in each
         
Loans in each
         
Loans in each
         
Loans in each
         
Loans in each
 
   
Allowance
   
Category to
   
Allowance
   
Category to
   
Allowance
   
Category to
   
Allowance
   
Category to
   
Allowance
   
Category to
 
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
   
Amount
   
Total Loans
 
   
(dollars in thousands)
 
Residential mortgage
  $ 8,418       48.16 %   $ 12,303       40.00 %   $ 16,339       39.03 %   $ 19,621       38.17 %   $ 5,765       36.57 %
Acquisition and development
    2,120       12.13 %     3,916       13.40 %     3,997       17.24 %     1,492       22.08 %     2,559       24.90 %
Land
    2,245       12.85 %     2,405       8.06 %     4,225       7.56 %     5,539       7.97 %     3,286       8.49 %
Lines of credit
    87       0.50 %     725       4.63 %     458       4.38 %     20       3.46 %     -       3.58 %
Commercial real estate
    3,295       18.85 %     4,157       27.44 %     3,949       25.42 %     5,506       22.71 %     3,080       22.01 %
Commercial non-real estate
    46       0.26 %     169       0.76 %     131       1.01 %     82       0.77 %     77       0.32 %
Home equity
    1,254       7.18 %     2,257       5.58 %     762       5.20 %     2,425       4.70 %     42       4.01 %
Consumer
    13       0.07 %     6       0.13 %     10       0.16 %     8       0.14 %     4       0.12 %
     Total
  $ 17,478       100.00 %   $ 25,938       100.00 %   $ 29,871       100.00 %   $ 34,693       100.00 %   $ 14,813       100.00 %



 
18

 

The following table contains information with respect to Bancorp’s allowance for loan losses for the periods indicated:

   
At of or for the Year Ended
 
   
December 31
 
   
2012
   
2011
   
2010
   
2009
   
2008
 
   
(dollars in thousands)
 
Average loans outstanding, net
  $ 692,831     $ 753,926     $ 823,410     $ 878,191     $ 893,030  
Total gross loans outstanding at end of period
  $ 697,997     $ 743,868     $ 839,290     $ 905,762     $ 973,651  
Total net loans outstanding at end of period
  $ 662,825     $ 697,431     $ 782,363     $ 819,079     $ 896,459  
Allowance balance at beginning of period
  $ 25,938     $ 29,871     $ 34,693     $ 14,813     $ 10,781  
                                         
Provision for loan losses
    765       4,612       5,744       31,402       7,481  
Actual charge-offs
                                       
    Residential real estate
    4,299       4,421       6,825       6,761       2,571  
    Acquisition and development
    1,395       1,503       -       -       -  
    Land
    1,624       1,054       3,096       -       -  
    Lines of credit
    182       -       -       -       -  
    Commercial real estate
    416       811       523       -       -  
    Commercial non-real estate
    20       -       -       -       -  
    Home Equity
    1,407       39       217       -       -  
    Consumer
    10       717       5       -       -  
    Other
    -       -       -       4,818       878  
        Total charge-offs
    9,353       8,545       10,666       11,579       3,449  
Recoveries
                                       
    Commercial non-real estate
    110       -       -       -       -  
    Residential real estate
    18       -       100       57       -  
        Total recoveries
    128       -       100       57       -  
           Net charge offs
    9,225       8,545       10,566       11,522       3,449  
                                         
Allowance balance at end of period
  $ 17,478     $ 25,938     $ 29,871     $ 34,693     $ 14,813  
Net charge offs as a percent of average loans
    1.33 %     1.13 %     1.28 %     1.31 %     0.39 %
Allowance for loan losses to total gross loans at end of period
    2.50 %     3.49 %     3.56 %     3.83 %     1.52 %
Allowance for loan losses to net loans at end of period
    2.64 %     3.72 %     3.82 %     4.24 %     1.65 %

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

 
 
19

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

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

 
                For such loans that are classified as impaired, an allowance is established when the current market value of the underlying collateral less its estimated disposal costs is lower than the carrying value of that loan.  For loans that are not solely collateral dependent, an allowance is established when the present value of the expected future cash flows of the impaired loan is lower than the carrying value of that loan.  The general component relates to loans that are classified as doubtful, substandard or special mention that are not considered impaired, as well as non-classified loans.  The general reserve is based on historical loss experience adjusted for qualitative factors.  These qualitative factors include:
 
· Levels and trends in delinquencies and nonaccruals;
· Inherent risk in the loan portfolio;
· Trends in volume and terms of the loan;
· Effects of any change in lending policies and procedures;
· Experience, ability and depth of management;
· National and local economic trends and conditions; and
· Effect of any changes in concentration of credit.
   

A loan is generally considered impaired if it meets either of the following two criteria:
 
·  
Loans that are 90 days or more in arrears (nonaccrual loans); or
·  
Loans where, based on current information and events, it is probable that a borrower will be unable to      pay all amounts due according to the contractual terms of the loan agreement.

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

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

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

 
20

 

Investment Activities

Federal thrift institutions, such as the Bank, have authority to invest in various types of liquid assets, including United States Treasury obliga­tions and securities of various federal agencies, certificates of deposit at insured banks, bankers' acceptances and federal funds.  As a member of the FHLB System, the Bank must maintain minimum levels of liquid assets specified by the OCC, which vary from time to time.  Subject to various regulatory restrictions, federal thrift institutions may also invest a portion of their assets in certain commercial paper, corporate debt securities and mutual funds whose assets conform to the investments that a federal thrift institution is authorized to make directly.

The amortized cost of the Bank’s investment securities held to maturity, as of the dates indicated are presented in the following table:
 
 
   
At December 31,
 
   
2012
   
2011
   
2010
 
   
(dollars in thousands)
 
US Treasury securities
  $ 29,414     $ 34,498     $ 21,104  
US Agency securities
    4,142       5,206       5,233  
US Government sponsored mortgage-backed securities
    510       653       974  
                         
    Total Investment Securities Held to Maturity
  $ 34,066     $ 40,357     $ 27,311  

 
21

 

Investment Scheduled Maturity Table

As of December 31, 2012

               
More than One to
   
More than Five to
   
More than
                   
   
One Year or Less
   
Five Years
   
Ten Years
   
Ten Years
   
Total Investment Securities
 
         
Weighted
         
Weighted
         
Weighted
         
Weighted
         
Weighted
       
   
Amortized
   
Average
   
Amortized
   
Average
   
Amortized
   
Average
   
Amortized
   
Average
   
Amortized
   
Average
   
Fair
 
   
Cost
   
Yield
   
Cost
   
Yield
   
Cost
   
Yield
   
Cost
   
Yield
   
Cost
   
Yield
   
Value
 
   
(dollars in thousands)
 
                                                                   
US Treasury securities
  $ 4,008       1.95 %   $ 22,383       1.69 %   $ 3,023       3.06 %   $ -       -     $ 29,414       1.87 %   $ 30,692  
US Agency securities
    1,001       0.78 %     3,141       1.38 %     -       -       -       -       4,142       1.24 %     4,221  
US Government sponsored mortgage-backed securities*
    120       0.47 %     -       -       2       7.08 %     388       5.29 %     510       5.17 %     550  
    Total securities
  $ 5,129       0.63 %   $ 25,524       1.65 %   $ 3,025       3.07 %   $ 388       5.29 %   $ 34,066       2.03 %   $ 35,463  

* The amortized cost of mortgage-backed securities as of December 31, 2012, by contractual maturity, is shown above.  Expected maturities may differ from contractual maturities because the securities may be called or prepaid with or without prepayment penalties.

 
22

 

Deposits

Deposits are attracted principally from within the Bank’s primary market areas through the offering of a variety of deposit instruments, including passbook and statement accounts and certificates of deposit ranging in terms from three months to five years.  Deposit account terms vary, principally on the basis of the minimum balance required, the time periods the funds must remain on deposit and the interest rate.  The Bank also offers individual retirement accounts.

The Bank’s policies are designed primarily to attract deposits from local residents rather than to solicit deposits from areas outside the Bank’s primary markets.  Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis.  Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations.

Deposits in the Bank as of December 31, 2012, 2011 and 2010 consisted of savings programs described below:

   
2012
   
2011
   
2010
 
   
(dollars in thousands)
 
                   
NOW accounts
  $ 32,140     $ 16,654     $ 13,465  
Money market accounts
    48,252       43,344       41,168  
Passbooks
    176,799       189,696       222,183  
Certificates of deposit
    318,955       383,103       420,133  
Non-interest bearing accounts
    23,248       19,960       17,827  
                         
Total deposits
  $ 599,394     $ 652,757     $ 714,776  

The following table contains information pertaining to the certificates of deposit held by the Bank in excess of $100,000 as of December 31, 2012.

   
Jumbo Certificates
 
   
of Deposit
 
Time Remaining Until Maturity
 
(dollars in thousands)
 
Less than three months
  $ 17,474  
3 months to 6 months
    23,242  
6 months to 12 months
    20,429  
Greater than 12 months
    75,970  
Total
  $ 137,115  


 
23

 

Liquidity and Asset/Liability Management

Two major objectives of asset and liability management are to maintain adequate liquidity and to control the interest sensitivity of the balance sheet.

Liquidity is the measure of a company’s ability to maintain sufficient cash flow to fund operations and to meet financial obligations to depositors and borrowers.  Liquidity is provided by the ability to attract and retain deposits and by principal and interest payments on loans and maturing securities in the investment portfolio.  A strong core deposit base, supplemented by other deposits of varying maturities and rates, contributes to the Bank’s liquidity.

Management believes that funds available through short-term borrowings and asset maturities are adequate to meet all anticipated needs, and management is continually monitoring the Bank’s liquidity position to meet projected needs.

Interest rate sensitivity is maintaining the ability to reprice interest earning assets and interest bearing liabilities in relationship to changes in the general level of interest rates.  Management attributes interest rate sensitivity to a steady net interest margin through all phases of interest rate cycles.  Management attempts to make the necessary adjustments to constrain adverse swings in net interest income resulting from interest rate movements through gap analysis and income simulation modeling techniques.

Borrowings

The Bank’s credit availability under the FHLB of Atlanta’s credit availability program was $171,060,000 at December 31, 2012.  The Bank is able to borrow up to 20% of total assets. The Bank, from time to time, utilizes the line of credit when interest rates under the line are more favorable than obtaining deposits from the public.  There were no short-term borrowings with the FHLB of Atlanta at December 31, 2012.

 
24

 

Employees

As of December 31, 2012, Bancorp and its subsidiaries had approximately 142 full-time equivalent employees.    Bancorp’s employees are not represented by any collective bargaining group.

Hyatt Commercial

Hyatt Commercial is a subsidiary of the bank and is a real estate brokerage company specializing in commercial real estate sales, leasing and property management.  During the quarter ended September 30, 2009, the common stock of Hyatt Commercial was contributed to the Bank from Bancorp.

SBI Mortgage Company

SBI is a subsidiary of Bancorp that has engaged in the origination of mortgages not suitable for the Bank.  It owns subsidiary companies that purchase real estate for investment purposes.  As of December 31, 2012, SBI had $1,948,000 in outstanding mortgage loans and it had $469,000 invested in subsidiaries, which funds were held in cash, pending potential acquisition of investment real estate.

Crownsville Development Corporation

Crownsville, which is doing business as Annapolis Equity Group, is a subsidiary of SBI and is engaged in the business of acquiring real estate for investment and syndication purposes.

HS West, LLC

HS West, LLC (“HS”) is a subsidiary of the Bank, and constructed a building in Annapolis, Maryland that serves as Bancorp’s and the Bank’s administrative headquarters. A branch office of the Bank is also located in the building.  In addition, HS leases space to four unrelated companies and to a law firm of which the President of Bancorp and the Bank is a partner.

Severn Financial Services Corporation

Severn Financial Services Corporation is a subsidiary of the Bank that is part of a joint venture with a local insurance agency to provide various insurance products to customers of Bancorp.
 
Homeowners Title and Escrow Corporation

Homeowners Title and Escrow Corporation, is a subsidiary of the Bank, that was engaged in the business of conducting loan settlements for the Bank.  During 2008, Homeowners Title and Escrow Corporation ceased operations.

 
25

 

Regulation

The financial services industry in the Bank’s market area is highly competitive, including competition from commercial banks, savings banks, credit unions, finance companies and non-bank providers of financial services. Several of the Bank’s competitors have legal lending limits that exceed that of the Bank’s, as well as funding sources in the capital markets that exceeds the Bank’s availability. The increased competition has resulted from a changing legal and regulatory climate, as well as from the economic climate.
 
 
General

Savings and loan holding companies and savings associations are extensively regulated under both federal and state law.  This regulation is intended primarily to protect depositors and the Deposit Insurance Fund (“DIF”), and not the stockholders of Bancorp.  The summary below describes briefly the regulation that is applicable to Bancorp and the Bank, does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.

Regulatory Reform and Legislation
 
On July 21, 2010, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act has significantly changed the bank regulatory structure and significantly impacted the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies have been given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and future impact of the Dodd-Frank Act may not be known for many months or years. The discussion below generally discusses the material provisions of the Dodd-Frank Act applicable to Bancorp and the Bank and is not complete or meant to be an exhaustive discussion.

Certain provisions of the Dodd-Frank Act have already affected Bancorp.  Effective July 21, 2011, the OTS, which was the primary federal regulator for Bancorp and the Bank, was abolished and replaced by the FRB with respect to savings and loan holding companies and their non-depository institution subsidiaries, including Bancorp, and the OCC with respect to federal savings associations, including the Bank.

The Dodd-Frank Act also created a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The Consumer Financial Protection Bureau has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Savings institutions with $10 billion or less in assets, such as the Bank, continue to be examined for compliance with the consumer laws by their primary bank regulators.

Effective July 21, 2011, the federal prohibitions on paying interest on demand deposits were eliminated, thus allowing businesses to have interest bearing checking accounts.

The Dodd-Frank Act weakened the federal preemption rules applicable to national banks and federal savings associations, allowing federal law to preempt state law only where state law (i) would have a discriminatory effect on federal savings associations, (ii) would prevent or significantly interfere with the exercise by a federal savings association of its powers or (iii) is preempted by other federal law.  The OCC has the authority to make preemption determinations and must make each determination on a case by case basis.

The Dodd-Frank Act directed the FDIC to redefine the base for deposit insurance assessments paid by banks. Assessments will now be based on the average consolidated total assets less tangible equity of a financial institution. This change may proportionally shift deposit insurance funding away from banks that rely primarily on deposits for funding operations, like the Bank. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, and extended the FDIC’s program of insuring non-interest bearing transaction accounts on an unlimited basis until December 31, 2012.  The minimum reserve ratio for the Deposit Insurance Fund has been increased from 1.15% to 1.35% of estimated insured deposits.
 
 
 
26

 

The Dodd-Frank Act amended the Home Owners Loan Act (HOLA) to require that leverage capital requirements and risk based capital requirements applicable to depository and bank holding companies be extended to thrift holding companies.  It also applied the Federal Reserve Board’s “source of strength” doctrine, which has long applied to bank holding companies, to savings and loan holding companies. Pursuant to the doctrine, regulatory agencies must issue regulations requiring holding companies to act as a source of strength to their subsidiary depository institutions by providing capital, liquidity and other support in times of financial stress.

The Dodd-Frank Act also included several provisions regarding executive compensation.  Publically traded companies must give stockholders a non-binding vote on executive compensation and so called “golden parachute” payments.  Companies will be required to disclose the relationship between executive compensation and financial performance of the issuer in annual proxy materials.

It is difficult to predict the exact impact the Dodd-Frank Act and the implementing rules and regulations will have on savings and loan holding companies and banks. The Dodd-Frank Act and resulting rules and regulations may impact the profitability of our business or change certain of our business practices, including our ability to offer new products, make loans and achieve satisfactory interest spreads, and could expose us to additional costs, including increased regulatory compliance costs.  The changes also may require us to invest significant management attention and resources to make any necessary changes to our operations in order to comply, and could materially adversely affect our business, results of operations and financial condition.  The following provides a description of the current regulations that are applicable to Bancorp and the Bank and selected changes to be implemented pursuant to the Dodd-Frank Act, all of which are subject to further change as additional provisions of the Dodd-Frank Act are implemented.

Regulation of Bancorp
 
General.  As previously noted, the Dodd-Frank Act eliminated the OTS and transferred supervision of savings and loan holding companies to the FRB on July 21, 2011.  As a unitary savings and loan holding company, Bancorp is now required to register and file reports with the FRB and is subject to regulation and examination by the FRB.  In addition, the FRB has enforcement authority over Bancorp and its subsidiaries, which permits the FRB to restrict or prohibit activities determined to be a serious risk to the subsidiary savings association.

Activities Restriction Test.  As a unitary savings and loan holding company, Bancorp generally is not subject to activity restrictions, provided the Bank satisfies the Qualified Thrift Lender (“QTL”) test. The termination of the “unitary thrift holding company exemption” in 1999 did not affect Bancorp because Bancorp was grandfathered under the law.  Under certain circumstances, Bancorp could lose its grandfathered status.  If the Bank failed to meet the QTL test, then Bancorp would become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the Bank qualified as a QTL within one year thereafter, Bancorp would be required to register as, and would become subject to the restrictions applicable to, a bank holding company. Additionally, if Bancorp acquired control of another savings association, either through merger or other combination with the Bank, other than in a supervisory acquisition where the acquired association also met the QTL test, Bancorp would thereupon become a multiple savings and loan holding company and thereafter be subject to further restrictions on its activities.  Bancorp presently intends to continue to operate as a unitary savings and loan holding company.

Restrictions on Acquisitions.  Except under limited circumstances, savings and loan holding companies, such as Bancorp, are prohibited from (i) acquiring, without prior approval of the FRB, more than 5% of the voting shares of a savings association or a holding company which is not a subsidiary thereof or (ii) acquiring control of an uninsured institution, or retaining, for more than one year after the date of any savings association becomes uninsured, control of such association.  In evaluating proposed acquisitions of savings institutions by holding companies, the FRB considers the financial and managerial resources and future prospects of the holding company and the target institution, the effect of the acquisition on the risk to the DIF, the convenience and the needs of the community and competitive factors.
 
 
 
27

 

No director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company’s stock, may acquire control of any savings association, other than a subsidiary savings association, or of any other savings and loan holding company, without written approval of the FRB. Certain individuals, including Alan J. Hyatt, Louis Hyatt, and Melvin Hyatt, and their respective spouses (“Applicants”), filed an Application for Notice of Change In Control (“Notice”) in April 2001 pursuant to 12 CFR Section 574.3(b).  The Notice permitted the Applicants to acquire up to 32.32% of Bancorp’s issued and outstanding shares of stock of Bancorp by April 16, 2002.  The OTS approved requests by the Applicants to extend the time to consummate such acquisition of shares to December 16, 2011. The Applicants currently own approximately 29.67% of the total outstanding shares of Bancorp as of December 31, 2012.

The FRB is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies; and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions.  The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.

Federal Securities Law.  Bancorp’s securities are registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended.  As such, Bancorp is subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Securities Exchange Act of 1934.

Financial Services Modernization Legislation.  In November 1999, the Gramm-Leach-Bliley Act of 1999 (“GLBA”) was enacted. The GLBA generally permits banks, other depository institutions, insurance companies and securities firms to enter into combinations that result in a single financial services organization to offer customers a wider array of financial services and products provided that they do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

The GLBA resulted in increased competition for Bancorp and the Bank from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than Bancorp and the Bank.

Troubled Assets Relief Program.  During the fourth quarter of 2008, the U.S. Department of the Treasury (the “Treasury”) instituted the Troubled Assets Relief Program (the “TARP”) pursuant to the Emergency Economic Stabilization Act of 2008 (the “EESA”) in an effort to stabilize the nation’s capital markets.  To carry out the TARP, the Treasury established the Capital Purchase Program (the “CPP”) which financial institutions may participate in on a voluntary basis.
 
Bancorp elected to participate in the CPP and entered into agreements to sell certain securities to the Treasury on November 21, 2008 (the “CPP Agreements”).  As a result of the CPP Agreements, Bancorp is subject to certain restrictions, requirements and limitations related to executive compensation, dividend payments and stock repurchase activities. 

The American Recovery and Reinvestment Act of 2009 (“ARRA”) and the regulations adopted thereunder have imposed additional compensation restrictions on companies participating in the TARP. As directed by ARRA, the Department of the Treasury has adopted standards for executive compensation that include limits on compensation that exclude incentives to take unnecessary and excessive risks that threaten the value of the participant, provision for recovery by the participant of any bonus, retention award or incentive compensation paid to any senior executive office and up to 20 next mostly highly compensated employees of the participant based on statements of earnings, revenues, gains or other criteria that are later found to be materially inaccurate, and prohibitions on bonus, retention awards or incentive compensation to certain senior employees, among other provisions. TARP participants are required to annually allow shareholders to have a separate non-binding vote on executive compensation while a TARP investment is outstanding.
 
 
 
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Maryland Corporation Law.  Bancorp is incorporated under the laws of the State of Maryland, and is therefore subject to regulation by the state of Maryland.  The rights of Bancorp’s stockholders are governed by the Maryland General Corporation Law.
 
Regulation of the Bank
 
General.  As noted above, the Dodd-Frank Act transferred supervision of savings associations like the Bank to the OCC, the agency that regulates national banks, on July 21, 2011.  As a federally chartered, DIF-insured savings association, the Bank is subject to extensive regulation by the OCC and the FDIC.  Lending activities and other investments of the Bank must comply with various statutory and regulatory requirements.  The Bank is also subject to certain reserve requirements promulgated by the FRB.  The OCC, in conjunction with the FDIC, regularly examines the Bank and prepares reports for the consideration of the Bank’s Board of Directors on any deficiencies found in the operations of the Bank.  The relationship between the Bank and depositors and borrowers is also regulated by federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents utilized by the Bank.

The Bank must file reports with the OCC and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions.

Regulatory Capital Requirements.  OCC regulations require the Bank to maintain minimum levels of regulatory capital including: (i) tangible capital equal to at least 1.5% of adjusted total assets; (ii) a leverage ratio consisting of Tier 1 or “core” capital equal to at least 4% (or 3%, if the Bank receives the highest CAMELS rating under the Uniform Financial Institutions Rating System) of adjusted total assets; and (iii) risk-based capital equal to at least 8% of total risk-weighted assets.  

Tier 1, or core capital includes common stockholder’s equity (including retained earnings), non-cumulative perpetual preferred stock and related surplus, minority interests in the equity accounts of consolidated subsidiaries and certain non-withdrawable accounts or pledged deposits. Tier 1 (Core) capital is generally reduced by the amount of the saving’s institution’s intangible assets. Limited exceptions to the deduction of intangible assets exist for certain mortgage servicing rights and credit card relationships and qualifying supervisory goodwill.

Tangible capital is generally defined the same as core capital but does not include an exception for qualifying supervisory goodwill and is reduced by the amount of all the savings association’s intangible assets with only limited exceptions, including certain mortgage servicing rights.  Both core and tangible capital are further reduced by an amount equal to a savings institution’s debt and equity investments in subsidiaries engaged in activities not permissible for national banks (other than subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities and subsidiary depository institutions or their holding companies).  Investments in and extensions of credit to such subsidiaries are required to be fully netted against tangible and core capital.  At December 31, 2012, the Bank had no such investments.

Total capital equals the sum of Tier 1 (Core) capital and supplementary capital, to the extent that supplementary capital does not exceed Tier 1 (Core) capital.  Supplementary capital includes, among other items, cumulative perpetual preferred stock, long-term preferred stock, subordinated debt, mandatory convertible securities, intermediate-term preferred stock, the portion of allowance for loan losses not designated for specific loan losses (up to 1.25% of risk-weighted assets) and up to 45% of unrealized gains on available-for-sale equity securities.

A savings institution’s risk based capital requirement is measured against risk-weighted assets, which equal the sum of each on-balance sheet asset and the credit-equivalent amount of each off-balance-sheet item after each is multiplied by an assigned risk weight.  These risk weights range from 0% for cash to 100% for consumer or commercial loans, home equity loans, repossessed assets or assets that are more than 90 days past due.
 
 
 
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In addition to requiring institutions to meet the applicable capital standards for savings institutions, the OCC may require institutions to meet capital standards in excess of the prescribed standards as the OCC determines necessary or appropriate for such institution in light of the particular circumstances of the institution. Such circumstances would include a high degree of exposure to interest rate risk, concentration of credit risk and certain risks arising from non-traditional activity. The OCC may treat the failure of any savings institution to maintain capital at or above such level as an unsafe or unsound practice and may issue a directive requiring any savings institution which fails to maintain capital at or above the minimum level required by the OCC to submit and adhere to a plan for increasing capital.

As shown below, the Bank’s regulatory capital exceeded all minimum regulatory capital requirements applicable to it as of December 31, 2012 and 2011.

   
 
Actual
   
Required For Capital
Adequacy Purposes
   
Required To Be Well Capitalized Under Prompt Corrective Action Provisions
 
   
Amount
   
%
   
Amount
   
%
   
Amount
   
%
 
   
(dollars in thousands)
 
December 31, 2012
                                   
Tangible (1)
  $ 122,836       14.6 %   $ 12,6201       1.50 %     N/A       N/A  
Tier 1 capital (2)
    122,836       19.6 %     N/A       N/A     $ 37,656       6.00 %
Core (1)
    122,836       14.6 %     33,653       4.00 %     42,066       5.00 %
Total (2)
    130,592       20.8 %     50,209       8.00 %     62,761       10.00 %
                                                 
December 31, 2011
                                               
(restated)
                                               
Tangible (1)
  $ 115,321       13.0 %   $ 13,351       1.50 %     N/A       N/A  
Tier 1 capital (2)
    115,321       17.2 %     N/A       N/A     $ 40,292       6.00 %
Core (1)
    115,321       13.0 %     35,603       4.00 %     44,504       5.00 %
Total (2)
    123,771       18.4 %     53,750       8.00 %     67,187       10.00 %
  
(1)  To adjusted total assets.
(2)  To risk-weighted assets.

    Proposed Changes to Regulatory Capital Requirement. In June 2012, the FDIC and other federal banking agencies issued a series of proposed rules to conform U.S. regulatory capital rules with the international regulatory standards agreed to by the Basel Committee on Banking Supervision in the international accord referred to as “Basel III”.  The proposed revisions, if adopted, would establish new higher capital ratio requirements, narrow the definitions of capital, impose new operating restrictions on banking organizations with insufficient capital buffers and increase the risk weighting of certain assets.  The proposed new requirements would apply to all banks and savings associations, bank holding companies with more than $500 million in assets and all savings and loan holding companies regardless of size.  The comment period for the notices of proposed rulemakings ended on October 22, 2012.  Under the proposed rules, Basel III would be implemented beginning January 1, 2013 and fully phased in by January 1, 2019.

Under the proposed rules, a new capital measure would be established, “Common Equity Tier 1 Capital,” consisting of common stock and related surplus, retained earnings, accumulated other comprehensive income and, subject to certain adjustments, minority common equity interests in subsidiaries.  Depository institutions and their holding companies would be required to maintain Common Equity Tier 1 Capital equal to 4.5% of risk-weighted assets by 2015.  The proposed rules would also increase the Tier 1 capital ratio to 6% from 4% and impose a minimum Tier 1 leverage ratio of 4% for all institutions.  Trust preferred securities and cumulative perpetual preferred securities generally would not qualify for inclusion in Tier 1 Capital.  The minimum required ratio of total capital would remain at 8%.  The proposed rules would also implement a capital buffer of at least 2.5% which would be phased in beginning on January 1, 2016 through January 1, 2019.  If the capital level of an institution were to fall below the buffer amount, the institutions would be subject to progressively more stringent limitations on the percentage of earnings than can be paid out in dividends, used in share repurchase and used in the payment of discretionary bonuses to executive officers.  The proposed rules would also revise the prompt corrective action framework discussed below by incorporating the new regulatory capital minimums and updating the definition of tangible common equity and would change the risk weightings of assets used to determine required capital ratios.  The U.S. federal banking agencies announced on November 9, 2012 that they did not expect the proposed rules to become effective on January 1, 2013 and did not indicate the likely new effective date.
 
 
 
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       Enforcement. The OCC has primary enforcement responsibility over federal savings institutions and has the authority to bring enforcement action against the institution and all “institution-affiliated parties,” including stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution.  Formal enforcement actions by the OCC may range from issuance of a capital directive or cease and desist order, to removal of officers or directors of the institution and the appointment of a receiver or conservator.  The FDIC also has the authority to terminate deposit insurance or recommend to the director of the OCC that enforcement action be taken with respect to a particular savings institution.  If action is not taken by the director of the OCC, the FDIC has authority to take action under specific circumstances.

Safety and Soundness Standards.  Federal law requires each federal banking agency, including the OCC, to prescribe to certain standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, fees and benefits.  In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines.  The guidelines further provide that savings institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions.  If the OCC determines that a savings institution is not in compliance with the safety and soundness guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines.  A savings institution must submit an acceptable compliance plan to the OCC within 30 days of receipt of a request for such a plan. If the institution fails to submit an acceptable plan, the OCC must issue an order directing the institution to correct the deficiency.  Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions.

Prompt Corrective Action.  Under the prompt corrective action regulations, the OCC is required and authorized to take supervisory actions against undercapitalized savings associations.  The leverage ratio, risk-based capital ratio and total risk-based capital ratio are used to determine an institution’s capital classification.  For this purpose, a savings association is placed into one of the following five categories dependent on their respective capital ratios:

·  
“well capitalized” (at least 5% leverage ratio, 6% Tier 1 risk-based capital ratio and 10% total risk-based capital ratio);
·  
“adequately capitalized” (at least 4% leverage ratio (or 3% if the savings association is assigned a composite rating of 1), 4% Tier 1 risk-based capital ratio and 8% total risk-based capital ratio);
·  
“undercapitalized” (less than 4% leverage ratio (or 3% if the savings association is assigned a composite rating of 1), 4% Tier 1 risk-based capital ratio or 8% total risk-based capital ratio);
·  
“significantly undercapitalized” (less than 3% leverage ratio, 3% Tier 1 risk-based capital ratio or 6% total risk-based capital ratio); and
·  
“critically undercapitalized” (less than 2% ratio of tangible equity to total assets).

Generally, the Federal Deposit Insurance Act requires the OCC to appoint a receiver or conservator for an institution within 90 days of that institution becoming “critically undercapitalized”.  The regulation also provides that a capital restoration plan must be filed with the OCC within 45 days after an institution receives notice that it is “undercapitalized”, “significantly undercapitalized” or “critically undercapitalized”.  In addition, numerous mandatory supervisory actions become immediately applicable to the institution, including, but not limited to, restrictions on growth, investment activities, payment of dividends and other capital distributions, and affiliate transactions.  The OCC may also take any one of a number of discretionary supervisory actions against the undercapitalized institutions, including the issuance of a capital directive and, in the case of an institution that fails to file a required capital restoration plan, the replacement of senior executive officers and directors.
 
 
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As of December 31, 2012, the Bank met the capital requirements of a “well capitalized” institution under applicable OCC regulations.

Proposed Changes to Prompt Corrective Action.  The proposed rules issued in connection with implementation of Basel III international standards discussed in the Proposed Changes to Regulatory Capital Requirements section above would revise the adequately capitalized and well-capitalized categories.  Under the proposed rules, to be well-capitalized, a savings association would be required to have at least a 10% total risk-based capital ratio, an 8% Tier 1 risk-based capital ratio, a 6.5% common equity Tier 1 risk-based capital ratio and a 5% Tier 1 leverage ratio.  To be adequately capitalized, a savings association would be required to have at least an 8% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio, a 4.5% common equity Tier 1 risk based capital ratio and a 4% Tier 1 leverage ratio.

Premiums for Deposit Insurance.  The Bank’s deposits are insured up to applicable limits by the DIF of the FDIC and are backed by the full faith and credit of the United States government.

The FDIC regulations assess insurance premiums based on an institution’s risk.  Under this assessment system, the FDIC evaluates the risk of each financial institution based on its supervisory rating, financial ratios, and long-term debt issuer rating. In 2010, the assessment ranged from 7 to 77.5 basis points of an institution's deposits, depending on its risk category.  On February 7, 2011, the FDIC issued final rules, effective April 1, 2011, implementing changes to the assessment rules as mandated by the Dodd-Frank Act.  The final rules redefined the assessment base used for calculating deposit insurance assessments.  Specifically, the rules base assessments on an institution’s total assets less tangible capital, as opposed to total deposits.  The base assessment rates range from 2.5 to 9 basis points for the least risky institutions to 30 to 45 basis points for the riskiest.  The rate schedules will automatically adjust in the future as the DIF reaches certain milestones.

On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution was limited to 10 basis points times the institution’s assessment base for the second quarter 2009, payable on September 30, 2009. On November 12, 2009, the FDIC amended its regulations to require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012. For purposes of determining the prepayment, the FDIC used the institution’s assessment rate in effect on September 30, 2009. The prepayment amount for the Bank was approximately $5,838,000.

As discussed above, the Dodd-Frank Act made permanent the maximum deposit insurance amount of $250,000 per depositor, and non-interest-bearing transaction accounts had unlimited deposit insurance until December 31, 2012.

 
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The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.  The termination of deposit insurance for the Bank could have a material adverse effect on Bancorp’s earnings, depending on the collective size of the particular institutions involved.

All FDIC-insured depository institutions pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board.  The bonds, commonly referred to as Financing Corporation (“FICO”) bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation.  For the quarter ended September 30, 2011, the annualized FICO assessment rate equaled 1.0 basis point for each $100 in domestic deposits maintained at an institution.  Beginning with the fourth quarter of 2011, the FICO assessment was based on total assets less tangible capital instead of deposits. The fourth quarter 2012 FICO assessment rate was 0.66 basis points and the first quarter 2013 FICO assessment rate was 0.64 basis points.  FICO assessments will continue until the bonds mature in 2017 through 2019.

The FDIC has authority to increase insurance assessments.  A significant increase in insurance premiums would likely have an adverse effect on the operating expenses of the Bank.

Privacy.  Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties.  Pursuant to these rules, financial institutions must provide:
 
·  
initial and annual notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; and
·  
a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.

Since the GLBA’s enactment, a number of states have implemented their own versions of privacy laws.  The Bank has implemented its privacy policies in accordance with applicable law.

Loans-to-One Borrower Limitations.  With certain limited exceptions, the maximum amount that a savings association or a national bank may lend on an unsecured basis to any borrower (including certain related entities of the borrower) may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral.
 
 
At December 31, 2012, the Bank’s loans-to-one-borrower limit was $18,425,000 based upon the 15% of unimpaired capital and surplus measurement.  At December 31, 2012, the Bank’s three largest loans were a $6,775,000 loan secured by an office building located in Annapolis, Maryland, a $6,486,000 loan secured by residential lots in Davidsonville, Maryland and a $5,700,000 loan secured by commercial residential property located in Norfolk, Virginia.  These loans were performing in accordance with their terms.

Qualified Thrift Lender Test. Savings associations must meet a QTL test, which may be met either by maintaining, on average, at least 65% of its portfolio assets in qualified thrift investments in at least nine of the most recent twelve month period, or meeting the definition of a “domestic building and loan association” as defined in the Code.  “Portfolio Assets” generally means total assets of a savings institution, less the sum of (i) specified liquid assets up to 20% of total assets, (ii) goodwill and other intangible assets, and (iii) the value of property used in the conduct of the savings association’s business.  Qualified thrift investments are primarily residential mortgages and related investments, including certain mortgage-related securities.  Associations that fail to meet the QTL test must either convert to a bank charter or operate under specified restrictions. As of December 31, 2012, the Bank was in compliance with its QTL requirement and met the definition of a domestic building and loan association.
 
Affiliate Transactions. Transactions between savings associations and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act as made applicable to savings associations by Section 11 of the Home Owners’ Loan Act (HOLA).  A savings association affiliate includes any company or entity which controls the savings institution or that is controlled by a company that controls the savings association.  For example, the holding company of a savings association and any companies which are controlled by such holding company are affiliates of the savings association.  Generally, Section 23A limits the extent to which the savings association or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such association’s capital stock and surplus, as well as contains an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus.  Section 23B applies to “covered transactions,” as well as certain other transactions and requires that all transactions be on terms substantially the same, or at least as favorable, to the savings association as those provided to a non-affiliate.  “Covered transaction” include the making of loans to, purchase of assets from and issuance of a guarantee to an affiliate and similar transactions.  Section 23B transactions also include the provision of services and the sale of assets by a savings association to an affiliate.  In addition to the restrictions imposed by Sections 23A and 23B, Section 11 of the Home Owners’ Loan Act prohibits a savings association from (i) making a loan or other extension of credit to an affiliate, except for any affiliate which engages only in certain activities which are permissible for bank holding companies, or (ii) purchasing or investing in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which are subsidiaries of the savings association.
 
 
 
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The Bank’s authority to extend credit to executive officers, directors, trustees and 10% stockholders, as well as entities under such person’s control, is currently governed by Section 22(g) and 22(h) of the Federal Reserve Act and Regulation O promulgated by the FRB.  Among other things, these regulations generally require such loans to be made on terms substantially similar to those offered to unaffiliated individuals, place limits on the amounts of the loans the Bank may make to such persons based, in part, on the Bank’s capital position, and require certain board of directors’ approval procedures to be followed.
 
Capital Distribution Limitations. OCC regulations impose limitations upon all capital distributions by savings associations, such as cash dividends, payments to repurchase or otherwise acquire its shares, payments to shareholders of another institution in a cash-out merger and other distributions charged against capital.

The OCC regulations require a savings association to file an application for approval of a capital distribution if:
 
·  
the association is not eligible for expedited treatment of its filings with the OCC;
·  
the total amount of all of capital distributions, including the proposed capital distribution, for the applicable calendar year exceeds its net income for that year to date plus retained net income for the preceding two years;
·  
the association would not be at least adequately capitalized following the distribution; or
·  
the proposed capital distribution would violate any applicable statute, regulation, agreement between the association and the OCC or OTS, or an OCC or OTS imposed condition.

In addition, a savings association must give the OCC notice of a capital distribution if the savings association is not required to file an application, but:

·  
would not be well capitalized following the distribution;
·  
the proposed capital distribution would reduce the amount of or retire any part of the savings association's common or preferred stock or retire any part of debt instruments like notes or debentures included in capital, other than regular payments required under a debt instrument; or
·  
the savings association is a subsidiary of a savings and loan holding company and is not otherwise required to file a notice regarding the proposed distribution with the Federal Reserve, in which case an information copy of the notice filed with the Federal Reserve needs to be simultaneously provided to the OCC.

The OCC may prohibit a proposed capital distribution that would otherwise be permitted if the OCC determines that the distribution would constitute an unsafe or unsound practice.  In addition, the Federal Deposit Insurance Act provides that an insured depository institution shall not make any capital distribution, if after making such distribution the institution would be undercapitalized.

 
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Branching.  Under OCC branching regulations, the Bank is generally authorized to open branches within or beyond the State of Maryland if the Bank (1) qualifies as a “domestic building and loan association” under the Code, which qualification requirements are similar to those for a Qualified Thrift Lender under the Home Owners’ Loan Act, and (2) publishes public notice at least 30 days before opening a branch and no one opposes the branch.  If a comment in opposition to a branch opening is filed and the OCC determines the comment to be relevant to the approval process standards, and to require action in response, the OCC may, among other things, require a branch application or elect to hold a meeting with the Bank and the person who submitted the comment.  The OCC authority preempts any state law purporting to regulate branching by federal savings banks.
 
Community Reinvestment Act and the Fair Lending Laws.  Savings associations have a responsibility under the Community Reinvestment Act and related regulations of the OCC to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities and the denial of applications. In addition, an institution's failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in the OCC, other federal regulatory agencies as well as the Department of Justice taking enforcement actions.  Based on an examination conducted August 9, 2012, the Bank received a satisfactory rating.

Federal Home Loan Bank System. The Bank is a member of the FHLB-Atlanta. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB.
 
Under the capital plan of the FHLB-Atlanta as of December 31, 2012, the Bank was required to own at least $6,520,000 of the capital stock of the FHLB-Atlanta.  As of such date, the Bank owned $6,520,000 of the capital stock of the FHLB-Atlanta and was in compliance with the capital plan requirements.

Federal Reserve System.  The FRB requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts (primarily checking, NOW, and Super NOW checking accounts) and non-personal time deposits.  At December 31, 2012, the Bank was in compliance with these requirements.

Activities of Subsidiaries. A savings association seeking to establish a new subsidiary, acquire control of an existing company or conduct a new activity through a subsidiary must provide 30 days prior notice to the FDIC and the FRB and conduct any activities of the subsidiary in compliance with regulations and orders of the FRB. The FRB has the power to require a savings association to divest any subsidiary or terminate any activity conducted by a subsidiary that the FRB determines to pose a serious threat to the financial safety, soundness or stability of the savings association or to be otherwise inconsistent with sound banking practices.
 
Tying Arrangements. Federal savings associations are prohibited, subject to some exceptions, from extending credit to or offering any other services, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.

Item 1A.  Risk Factors

Unless the context indicates otherwise, all references to “we,” “us,” “our” in this subsection “Risk Factors” refer to Bancorp and its subsidiaries.  You should carefully consider the risks and uncertainties described below as well as elsewhere in this Annual Report on Form 10-K. If any of the risks or uncertainties actually occurs, our business, financial condition or results of future operations could be materially adversely affected. The risks and uncertainties described in this Form 10-K are not the only ones we face.  Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us.  This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of many factors, including the risks faced by us described below and elsewhere in this Annual Report on Form 10-K.
 
 
 
35

 

We may be adversely affected by changes in economic and political conditions and by governmental monetary and fiscal policies.

The thrift industry is affected, directly and indirectly, by local, domestic, and international economic and political conditions, and by governmental monetary and fiscal policies.  Conditions such as inflation, recession, unemployment, volatile interest rates, tight money supply, real estate values, international conflicts and other factors beyond our control may adversely affect our potential profitability.  Any future rises in interest rates, while increasing the income yield on our earning assets, may adversely affect loan demand and the cost of funds and, consequently, our profitability.  Any future decreases in interest rates may adversely affect our profitability because such decreases may reduce the amounts that we may earn on our assets.  Economic downturns have resulted and may continue to result in the delinquency of outstanding loans.  We do not expect any one particular factor to materially affect our results of operations.  However, downtrends in several areas, including real estate, construction and consumer spending, have had and may continue to have a material adverse impact on our ability to remain profitable.  Further, there can be no assurance that the asset values of the loans included in our loan portfolio, the value of properties and other collateral securing such loans, or the value of foreclosed real estate will remain at current levels.

The changing economic environment poses significant challenges for Bancorp.

Negative developments in the financial services industry from 2008 into 2012 have resulted in uncertainty in the financial markets in general and a related general economic downturn globally.  While we are beginning to experience modest improvement in performance, we may experience similar negative conditions in 2013.  In addition, as a consequence of the United States recession, business activity across a wide range of industries face serious difficulties due to the decline in the housing market and lack of consumer spending. Unemployment continues to be higher than historical averages.

As a result of these financial economic crises, many lending institutions, including us, have experienced declines in the performance of their loans, including residential, construction, land and residential building lots, multi-family, commercial and consumer loans.  Moreover, competition among depository institutions for deposits and quality loans has increased significantly while the significant decline in economic growth has led to a slowdown in banking related activities.  In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline.  A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial services industry.

As a result, there is a potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be very aggressive in responding to concerns and trends identified in examinations, including the expected issuance of many formal or informal enforcement actions or orders. The impact of new legislation in response to those developments may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance or our stock price.

We are operating in a challenging economic environment, including generally uncertain national and local market conditions.  Negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses.  Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses and other factors, could have adverse effects on our borrowers, which could adversely affect our financial condition and results of operations.  For instance, because payments on loans secured by commercial real estate properties are often dependent upon the successful operation of management of the properties, repayment of these loans are subject to adverse conditions in the economy.  If consumer spending decreases, businesses located in commercial real estate property may close, reducing the rental income of the Bank’s borrower.  The reduction in rental income may result in the borrower being unable to make payments on the loan.  The deterioration in economic conditions could drive losses beyond that which is provided for in our allowance for loan losses and could result in the following:

 
36

 

·  
an increase in loan delinquencies, problem assets and foreclosures;
 
·  
a decline in demand for our products and services;
 
·  
a decrease in low cost or non-interest-bearing deposits; and
 
·  
a decline in the value of the collateral for our loans, which in turn may reduce customers’ borrowing capacities, and reduce the value of assets and collateral supporting our existing loans.
 

During the past year, we continued to experience higher than normal levels of non-performing loans.  No assurance can be given that these conditions will improve in the near term or will not worsen.  Moreover, such conditions may result in a further increase in loan delinquencies, causing a decrease in our interest income, and may continue to have an adverse impact on our loan loss experience, possibly requiring us to add to our allowance for loan losses.  Until conditions improve, we expect our business, financial condition and results of operations to be adversely affected.

Changes in interest rates could adversely affect our financial condition and results of operations.

The operations of financial institutions, such as ours, are dependent to a large degree on net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings. Our net interest income is significantly affected by market rates of interest that in turn are affected by prevailing economic conditions, fiscal and monetary policies of the federal government and the policies of various regulatory agencies. Like all financial institutions, our balance sheet is affected by fluctuations in interest rates. Volatility in interest rates can also result in disintermediation, which is the flow of funds away from financial institutions into direct investments, such as U.S. Government bonds, corporate securities and other investment vehicles, including mutual funds, which, because of the absence of federal insurance premiums and reserve requirements, generally pay higher rates of return than those offered by financial institutions such as ours.

We expect to experience continual competition for deposit accounts which may make it difficult to reduce the interest paid on some deposits.

We believe that, in the current market environment, we have adequate policies and procedures for maintaining a conservative interest rate sensitive position.   However, there is no assurance that this condition will continue.  A sharp movement up or down in deposit rates, loan rates, investment fund rates and other interest-sensitive instruments on our balance sheet could have a significant, adverse impact on our net interest income and operating results.

Most of our loans are secured by real estate located in our market area.  If there is a continuing downturn in the real estate market, additional borrowers may default on their loans and we may not be able to fully recover our loans.

A continuing downturn in the real estate market could adversely affect our business because most of our loans are secured by real estate.  Substantially all of our real estate collateral is located in the states of Maryland, Virginia and Delaware.  Real estate values and real estate markets are generally affected by changes in national, regional or local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies and acts of nature.

In addition to the risks generally present with respect to mortgage lending activities, our operations are affected by other factors affecting our borrowers, including:

·  
the ability of our mortgagors to make mortgage payments,
 
·  
the ability of our borrowers to attract and retain buyers or tenants, which may in turn be affected by local conditions such as an oversupply of space or a reduction in demand for rental space in the area, the attractiveness of properties to buyers and tenants, and competition from other available space, or by the ability of the owner to pay leasing commissions, provide adequate maintenance and insurance, pay tenant improvements costs and make other tenant concessions,
 
·  
interest rate levels and the availability of credit to refinance loans at or prior to maturity, and
 

 
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increased operating costs, including energy costs, real estate taxes and costs of compliance with environmental controls and regulations.
 
       As of December 31, 2012, approximately 99% of the book value of our loan portfolio consisted of loans collateralized by various types of real estate.  If real estate prices decline, the value of real estate collateral securing our loans will be reduced.   Our ability to recover defaulted loans by foreclosing and selling the real estate collateral would then be diminished, and we would be more likely to incur financial losses on defaulted loans.  

In addition, approximately 49% of the book value of our loans consisted of construction, land acquisition and development loans, commercial real estate loans and land loans, which present additional risks described in “Item 1. Business - Construction Loans” of this Form 10-K.

Our loan portfolio exhibits a high degree of risk.

We have a significant amount of nonresidential loans, as well as construction and land loans granted on a speculative basis. Although permanent single-family, owner-occupied loans represent the largest single component of assets and currently impaired loans, a significant level of nonresidential loans, construction loans, and land loans, results in an above-average risk exposure.  Our monitoring of higher risk loans may be inadequate and the internal asset review function may be inadequate in view of current real estate market weaknesses.

At December 31, 2012 and December 31, 2011, our nonperforming loans (those loans 90 or more days in arrears) equaled $37.5 million and $31.4 million, respectively. There were 87 residential loans (including acquisition and development and land loans) in non-accrual status totaling $29.7 million and 17 commercial loans in non-accrual status totaling $7.8 million at December 31, 2012 compared to 53 residential loans in non-accrual status totaling $27.0 million, ten commercial loans in non-accrual status totaling $4.2 million and four consumer loans in non-accrual status totaling $0.2 million at December 31, 2011. For the years ended December 31, 2012 and December 31, 2011, there were $9.3 million and $8.5 million of loan charge-offs, respectively. At December 31, 2012, the total allowance for loan losses was $17.5 million, which was 2.68% of total net loans, compared with $25.9 million, which was 3.72% of total net loans, as of December 31, 2011.

We are exposed to risk of environmental liabilities with respect to properties to which we take title.

In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties.  We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property.  The costs associated with investigation or remediation activities could be substantial.  In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.  If we become subject to significant environmental liabilities, our business, financial condition, results of operations and cash flows could be materially and adversely affected.

Our operations are located in Anne Arundel County, Maryland, which makes our business highly susceptible to local economic conditions.  An economic downturn or recession in this area may adversely affect our ability to operate profitably.

Unlike larger banking organizations that are geographically diversified, our operations are concentrated in Anne Arundel County, Maryland.  In addition, nearly all of our loans have been made to borrowers in the states of Maryland, Virginia and Delaware.  As a result of this geographic concentration, our financial results depend largely upon economic conditions in our market area.  A deterioration or recession in economic conditions in this market could result in one or more of the following:

·  
a decrease in deposits;
 

 
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·  
an increase in loan delinquencies;
 
·  
an increase in problem assets and foreclosures;
 
·  
a decrease in the demand for our products and services; and
 
·  
a decrease in the value of collateral for loans, especially real estate, and reduction in customers’ borrowing capacities.
 

Any of the foregoing factors may adversely affect our ability to operate profitably.

Failure to comply with the Supervisory Agreements could adversely affect our business, financial condition and operating results.

On November 23, 2009, we and the Bank each entered into a supervisory agreement with the OTS, which agreements primarily addressed issues identified in the OTS’ reports of examination of our and the Bank’s operations and financial condition conducted in 2009. These supervisory agreements are now being overseen by the OCC and FRB. Although we and the Bank each intend to take such actions as may be necessary to enable us to comply with our respective requirements, there can be no assurance that we will be able to comply fully with the provisions of the Supervisory Agreements, or to do so within the timeframes required. Moreover, there can be no assurance that compliance with such requirements will not be more time consuming or more expensive than anticipated, or that efforts to comply with such requirements will not have adverse effects on the operations and financial condition of us or the Bank. Failure to comply with the Supervisory Agreements, or other supervisory directives, could subject us to significant civil monetary penalties, orders to cease and desist or other regulatory or enforcement actions. Accordingly, any material failure to comply with the Supervisory Agreements could have a material adverse effect on our business, financial condition and operating results.

We are subject to federal and state regulation and the monetary policies of the FRB.  Such regulation and policies can have a material adverse effect on our earnings and prospects.

Our operations are heavily regulated and will be affected by present and future legislation and by the policies established from time to time by various federal and state regulatory authorities.  In particular, the monetary policies of the FRB have had a significant effect on the operating results of banks in the past, and are expected to continue to do so in the future.  Among the instruments of monetary policy used by the FRB to implement its objectives are changes in the discount rate charged on bank borrowings and changes in the reserve requirements on bank deposits.  It is not possible to predict what changes, if any, will be made to the monetary polices of the FRB or to existing federal and state legislation or the effect that such changes may have on our future business and earnings prospects.

If the Bank becomes “undercapitalized” as determined under the “prompt corrective action” initiatives of the federal bank regulators, such regulatory authorities will have the authority to require the Bank to, among other things, alter, reduce or terminate any activity that the regulator determines poses an excessive risk to the Bank.  The Bank could further be directed to take any other action that the regulatory agency determines will better carry out the purpose of prompt corrective action. The Bank could be subject to these prompt corrective action restrictions if federal regulators determine that the Bank is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. Some or all of the foregoing actions and restrictions could have a material adverse effect on our operations.

The Dodd-Frank Act, which is still being implemented, may have a material impact on our operations.

On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  The Dodd-Frank Act restructures the regulation of depository institutions.  Under the Dodd-Frank Act, the OTS was merged into the OCC, which regulates national banks.  Savings and loan holding companies are now regulated by the FRB.  Also, included was the creation of a new federal agency to administer consumer protection and fair lending laws, a function that was previously performed by the depository institution regulators.  The federal preemption of state laws currently accorded federally charted depository institutions was reduced as well.  The Dodd-Frank Act also will impose consolidated capital requirements on savings and loan holding companies effective in five years, which will limit our ability to borrow at the holding company and invest the proceeds from such borrowings as capital in the Bank that could be leveraged to support additional growth.  The Dodd-Frank Act contains various other provisions designed to enhance the regulation of depository institutions and prevent the recurrence of a financial crisis such as occurred in 2008-2009.  The full impact of the Dodd-Frank Act on our business and operations may not be known for years until all regulations implementing the statute are written, adopted and implemented.  The Dodd-Frank Act may have a material impact on operations, particularly through increased regulatory burden and compliance costs.
 
 
 
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Bancorp may become subject to more stringent capital requirements, which may have a material adverse effect on Bancorp’s operations.

The Dodd-Frank Act requires federal banking agencies to establish more stringent risk-based capital requirements and leverage limits applicable to banks, savings associations and their holding companies.  Under the legislation, federal banking agencies are required to develop capital requirements that address systemically risky activities.  In June 2012, the FRB, FDIC and OCC issued a series of proposed rules that would revise and replace their current capital rules in a manner consistent both with relevant provisions of the Dodd-Frank Act as well as the implementation of Basel III.  The proposed revisions, if adopted, would establish new higher capital ratio requirements, narrow the definitions of capital, impose new operating restrictions on banking organizations with insufficient capital buffers and increase the risk weighting of certain assets.  These requirements, and any other new regulations, including those that have been proposed but not yet implemented as a result of the requirements established by the Basel Committee on Banking Supervision, could require Bancorp to reduce business levels or to raise capital, including in ways that may adversely affect its results of operations or financial condition.  In addition, the costs associated with complying with more stringent capital requirements could have a material adverse effect on Bancorp.

We have established an allowance for loan losses based on our management's estimates.  Actual losses could differ significantly from those estimates. If the allowance is not adequate, it could have a material adverse effect on our earnings and the price of our common stock.

We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management's best estimate of probable incurred losses within the existing portfolio of loans.  The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio.  The level of the allowance reflects management's continuing evaluation of specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; industry concentrations and other unidentified losses inherent in the current loan portfolio.  The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses.  Increases in nonperforming loans have a significant impact on our allowance for loan losses.  Generally, our non-performing loans and assets reflect operating difficulties of individual borrowers resulting from weakness in the economy of our market area.  While Bancorp is experiencing better performance results from those experienced in 2009 and 2008, loan delinquencies remain higher than usual, particularly with respect to residential construction, land and residential building lots, multi-family, commercial and consumer loans.  Bancorp has seen a slight increase in troubled debt restructurings balances in 2012 compared to 2011, and the balances are still high compared to historical averages.
 
In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  If charge-offs in future periods exceed the allowance for loan losses, we may need additional provisions to increase the allowance for loan losses.  Furthermore, growth in the loan portfolio would generally lead to an increase in the provision for loan losses.

Any increases in the allowance for loan losses will result in a decrease in net income and capital, and may have a material adverse effect on our financial condition, results of operations and cash flows.
 
 
 
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We compete with a number of local, regional and national financial institutions for customers.

We face strong competition from savings and loan associations, banks, and other financial institutions that have branch offices or otherwise operate in our market area, as well as many other companies now offering a range of financial services. Many of these competitors have substantially greater financial resources and larger branch systems than us. In addition, many of our competitors have higher legal lending limits than us.  Particularly intense competition exists for sources of funds including savings and retail time deposits as well as for loans and other services offered by us.  In addition, over the last several years, the banking industry has undergone substantial consolidation, and this trend is expected to continue.  Significant ongoing consolidation in the banking industry may result in one or more large competitors emerging in our primary target market.  The financial resources, human capital and expertise of one or more large institutions could threaten our ability to maintain our competitiveness.
 
During the past several years, significant legislative attention has been focused on the regulation and deregulation of the financial services industry.  Non-bank financial institutions, such as securities brokerage firms, insurance companies and mutual funds, have been permitted to engage in activities that compete directly with traditional bank business.  Competition with various financial institutions could hinder our ability to maintain profitable operations and grow our business.

We face intense competitive pressure on customer pricing, which may materially and adversely affect revenues and profitability.
 
We generate net interest income, and charge our customers fees, based on prevailing market conditions for deposits, loans and other financial services.  In order to increase deposit, loan and other service volumes, enter new market segments and expand our base of customers and the size of individual relationships, we must provide competitive pricing for such products and services.  In order to stay competitive, we have had to intensify our efforts around attractively pricing our products and services.  To the extent that we must continue to adjust our pricing to stay competitive, we will need to grow our volumes and balances in order to offset the effects of declining net interest income and fee-based margins.  Increased pricing pressure also enhances the importance of cost containment and productivity initiatives, and we may not succeed in these efforts.

Our brand, reputation and relationship with our customers are key assets of our business and may be affected by how we are perceived in the marketplace.
 
Our brand and its attributes are key assets of our business.  The ability to attract and retain customers to  Bancorp’s products and services is highly dependent upon the external perceptions of us and the industry in which we operate.  Our business may be affected by actions taken by competitors, customers, third party providers, employees, regulators, suppliers or others that impact the perception of the brand, such as creditor practices that may be viewed as “predatory,” customer service quality issues, and employee relations issues.  Adverse developments with respect to our industry may also, by association, impair our reputation, or result in greater regulatory or legislative scrutiny.