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SVBI > SEC Filings for SVBI > Form 10-K on 15-Mar-2013All Recent SEC Filings

Show all filings for SEVERN BANCORP INC | Request a Trial to NEW EDGAR Online Pro

Form 10-K for SEVERN BANCORP INC


15-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Bancorp has restated its 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 to correct the method used to amortize a three year prepayment made in 2009 for Bancorp's FDIC risk-based insurance assessment. In 2009, Bancorp paid an estimated 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. Management determined that this method of amortization was incorrect and that it should have amortized the prepayment based on the actual reduced level of net assets over that period. This error was discovered by management during the course of its preparation of the 2012 year-end financial statements and audit. For more information, see "Explanatory Note Regarding Restatement" above and Note 2 - Restatement of Financial Statements in the accompanying consolidated financial statements. For information regarding the restated quarterly financial data for Bancorp for each of the quarters in the 2012, 2011 and 2010 fiscal years, see Note 19 to the accompanying consolidated financial statements.

Bancorp provides a wide range of personal and commercial banking services. Personal services include various lending services as well as deposit products such as checking accounts, individual retirement accounts, money market accounts, and savings and time deposit accounts. Commercial services include commercial secured and unsecured lending services as well as business internet banking, corporate cash management services and deposit services. Bancorp also provides ATMs, debit cards, internet banking including on-line bill pay, mortgage lending, safe deposit boxes, and telephone banking, among other products and services.


Bancorp has experienced improved earnings from those experienced during the second half of 2008 and all of 2009 as it continues to see some improvement in the national and local economic environment. Management believes that Bancorp's 2012, 2011 and 2010 results, while significantly better than 2009, do not mean that it will not continue to experience the challenges it and many other financial institutions faced in 2008 and 2009 as a result of the economic recession. Those challenges, including increased loan delinquencies and a decrease in the demand for certain loan products including construction, development, and land acquisition loans, continue to show signs of improvement from 2008 and 2009. However, continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the recession, including job losses and other factors, have continued to affect Bancorp's borrowers. Management believes that this economic deterioration has continued to be stable in 2012 since having stabilized somewhat in 2010 which has resulted in stabilization in loan delinquencies from 2009 levels. While the interest rate spread between Bancorp's cost of funds and what it earns on loans has increased from 2009 levels, competition for new loans and deposits remains strong. The slight decrease in interest rate spread in 2012 compared to 2011 was caused in part by the decrease in interest rates earned on loans outpacing the decrease in interest rates paid on deposits and other borrowings.

Bancorp's total loan portfolio has decreased from 2011 and Bancorp has experienced a modest decrease in loan delinquencies, which resulted in the allowance for loan losses decreasing from 2011. The decrease in the allowance was primarily due to $4.4 million charge offs of impaired collateral dependent loans. Bancorp has seen a decrease in the level of foreclosed real estate expenses in 2012 as compared to 2011 due to fewer loans going to foreclosure.

Bancorp expects to experience continued improvement in market conditions in 2013, as the effects of the economic downturn continue to improve and as the employment environment in its market improves. However, if interest rates increase, demand for borrowing may remain low and Bancorp's interest rate spread could decrease. Bancorp will continue to manage loan and deposit pricing against the risks of rising costs of its deposits and borrowings. Interest rates are outside the control of Bancorp, so it must attempt to balance its pricing and duration of its loan portfolio against the risks of rising costs of its deposits and borrowings.

The continued success and attraction of Anne Arundel County, Maryland, and vicinity, will also be important to Bancorp's ability to originate and grow its mortgage loans and deposits, as will Bancorp's continued focus on maintaining a low overhead.

If the volatility in the market and the economy continues or worsens, our business, financial condition, results of operations, access to funds and the price of our stock could be materially and adversely impacted.

On November 23, 2009, Bancorp and the Bank each entered into a supervisory agreement with the OTS which primarily addressed the issues identified in the OTS' reports of examination of Bancorp's and the Bank's operations and financial condition in 2009. The Bank's supervisory agreement is now enforced by the OCC and Bancorp's by FRB. See "Item 1. Business - Supervisory Agreements" for more information.

Critical Accounting Policies and Recent Accounting Pronouncements

Bancorp's significant accounting policies and recent accounting pronouncements are set forth in Note 1 of the consolidated financial statements which are included elsewhere in this Form 10-K. Of these significant accounting policies, Bancorp considers the policies regarding the allowance for loan losses and valuation of foreclosed real estate to be its most critical accounting policies, given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio and the material effect that such judgments can have on the results of operations. In addition, changes in economic conditions can have a significant impact on real estate values of underlying collateral affecting the allowance for loan losses and therefore the provision for loan losses and results of operations as well as the valuation of foreclosed real estate. Bancorp has developed policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. Bancorp's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers that is not known to management at the time of the issuance of the consolidated financial statements.


Financial Condition

Total assets decreased by $49,045,000, or 5.4%, at December 31, 2012 to $852,118,000, compared to the restated amount of $901,163,000 at December 31, 2011. The following discusses the material changes between the December 31, 2012 and 2011 statements of financial condition.

Cash

Cash and cash equivalents increased by $6,002,000, or 6.9%, at December 31, 2012 to $93,392,000, compared to $87,390,000 at December 31, 2011. This increase was primarily due to management's decision to increase liquidity to offset any potential decreases in customer deposits due to the low interest rate environment. This was achieved by retaining more customer deposits than necessary given the lower loan demand and loan payoffs.

Investments

Investment securities held to maturity decreased by $6,291,000, or 15.6%, at December 31, 2012 to $34,066,000, compared to $40,357,000 at December 31, 2011. This decrease was primarily due to management's decision to not purchase US Treasury and agency securities to replace securities which matured in 2012.

Loans

Loans Held For Sale. Loans held for sale increased by $6,988,000, or 169.3% at December 31, 2012 to $11,116,000, compared to $4,128,000 at December 31, 2011. This increase was primarily due to the increased volume of loans originated to be sold and to the timing of loans pending sale as of December 31, 2012 compared to as of December 31, 2011.

Loans Receivable. Total loans receivable, net decreased by $41,594,000, or 6.0% at December 31, 2012, to $651,709,000, compared to $693,303,000 at December 31, 2011. The decrease in the loan portfolio was a result of decreased loan demand from the economic slowdown. In addition, the allowance for loan losses decreased by $8,460,000, or 32.6%, at December 31, 2012 to $17,478,000, compared to $25,938,000 at December 31, 2011. The decrease in the allowance was primarily due to $4.4 million charge offs of impaired collateral dependent loans and a decrease in loans receivable and an improvement in loan delinquencies.

Foreclosed Real Estate

Foreclosed real estate decreased by $8,491,000, or 42.6%, at December 31, 2012 to $11,441,000, compared to $19,932,000 at December 31, 2011. This decrease was primarily due to foreclosed properties being sold and additional write downs taken partially offset by new loan foreclosures.

Premises and Equipment

Premises and equipment decreased by $770,000, or 2.8%, at December 31, 2012 to $26,448,000, compared to $27,218,000 at December 31, 2011. This decrease was primarily due to the annual depreciation of the premises and equipment with minimal new fixed assets added throughout 2012.

Other Assets

Other assets decreased by $4,466,000, or 20.4%, at December 31, 2012 to $17,426,000, compared to the restated amount of $21,892,000 at December 31, 2011. This decrease was primarily due to decreases in net deferred income taxes of $2,204,000 and accrued interest receivable of $910,000 in 2012.

Liabilities

Deposits. Total deposits decreased by $53,363,000, or 8.2%, at December 31, 2012 to $599,394,000, compared to $652,757,000 at December 31, 2011. This decrease was primarily attributable to decreases in certificates of deposits of $64,148,000 and passbooks of $12,897,000 partially offset by increases in NOW accounts of $15,486,000 due to management's decision to actively promote its demand deposits.


FHLB-Atlanta Advances. FHLB-Atlanta advances at December 31, 2012 were $115,000,000, which was unchanged from December 31, 2011. There were no contractual advance payoffs scheduled during 2012 and no additional advances were needed as cash increased during the year from the proceeds from loan payoffs.

During the third quarter 2012, the Bank restructured a portion of its FHLB Atlanta borrowings by repaying $65 million of existing advances and replacing them with $65 million of lower cost advances. The transaction resulted in $5.3 million in prepayment penalties that were deferred and will be recognized in interest expense through yield adjustments on the new borrowings in future periods. The existing borrowings had an average cost of 3.87%. The new borrowings had an average cost of 2.72% including the deferred adjustment. The relevant accounting treatment for this transaction was provided in ASC 470-50. This transaction was executed as an earnings strategy.

Junior Subordinated Debt Securities Due 2035. As of December 31, 2012, Bancorp had outstanding approximately $20,619,000 principal amount of Junior Subordinated Debt Securities Due 2035 (the "2035 Debentures"). The 2035 Debentures were issued pursuant to an Indenture dated as of December 17, 2004 (the "2035 Indenture") between Bancorp and Wells Fargo Bank, National Association as Trustee. The 2035 Debentures pay interest quarterly at a floating rate of interest of 3-month LIBOR (0.34% December 31, 2012) plus 200 basis points, and mature on January 7, 2035. Payments of principal, interest, premium and other amounts under the 2035 Debentures are subordinated and junior in right of payment to the prior payment in full of all senior indebtedness of Bancorp, as defined in the 2035 Indenture. The 2035 Debentures became redeemable, in whole or in part, by Bancorp on January 7, 2010.

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

Subordinated Notes and Series A Preferred Stock. On November 15, 2008, Bancorp completed a private placement offering consisting of a total of 70 units, at an offering price of $100,000 per unit, for gross proceeds of $7,000,000. Each unit consists of 6,250 shares of Bancorp's Series A 8.0% Non-Cumulative Convertible Preferred Stock and Bancorp's Subordinated Note in the original principal amount of $50,000. The Subordinated Notes earn interest at an annual rate of 8.0%, payable quarterly in arrears on the last day of March, June, September and December commencing December 31, 2008. The Subordinated Notes are redeemable in whole or in part at the option of Bancorp at any time beginning on December 31, 2009 until maturity, which is December 31, 2018. As permitted under the terms of the Subordinated Notes, Bancorp has deferred three interest payments on the Subordinated Notes. As of December 31, 2012, the cumulative amount of interest in arrears not paid, including interest on unpaid interest, was $381,000.

Troubled Asset Relief Program. On November 21, 2008, Bancorp closed on an agreement with the United States Department of the Treasury ("Treasury"), pursuant to which Bancorp issued and sold (i) 23,393 shares of its Series B Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share and liquidation preference $1,000 per share, (the "Series B Preferred Stock") and
(ii) a warrant (the "Warrant") to purchase 556,976 shares of Bancorp's common stock, par value $0.01 per share, for an aggregate purchase price of $23,393,000.

The Series B Preferred Stock qualifies as Tier 1 capital and will pay cumulative compounding dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series B Preferred Stock may be redeemed by Bancorp.


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

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

The Warrant has a 10-year term and is immediately exercisable at an exercise price of $6.30 per share of Common Stock. The exercise price and number of shares subject to the Warrant are both subject to anti-dilution adjustments. Pursuant to the Purchase Agreement, Treasury has agreed not to exercise voting power with respect to any shares of Common Stock issued upon exercise of the Warrant.

Off-Balance Sheet Arrangements. Bancorp has certain outstanding commitments and obligations that could impact Bancorp's financial condition, liquidity, revenues or expenses. These commitments and obligations include standby letters of credit, home equity lines of credit, loan commitments, lines of credit, and loans sold and serviced with limited repurchase provisions.

Standby letters of credit, which are obligations of Bancorp to guarantee performance of borrowers to governmental entities, increased $990,000, or 6.5%, as of December 31, 2012 to $16,309,000, compared to $15,319,000 as of December 31, 2011. In 2012, Bancorp experienced an increase in demand from its borrowers for letter of credit requirements.

Unadvanced construction loans decreased $2,416,000, or 13.4%, as of December 31, 2012 to $15,598,000, compared to $18,014,000 as of December 31, 2011. This decrease was primarily the result of the funding of existing construction loan obligations outpacing new construction loan originations.

Home equity lines of credit decreased $1,598,000, or 10.9%, as of December 31, 2012 to $13,025,000, compared to $14,623,000 as of December 31, 2011. This decrease was primarily due to lower customer demand for home equity loans in 2012. Home equity lines of credit allow the borrowers to draw funds up to a specified loan amount, from time to time. Bancorp's management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans.

Mortgage loan commitments increased $12,542,000, or 1,184.3%, as of December 31, 2012 to $13,601,000, compared to $1,059,000 as of December 31, 2011. This increase was primarily due to the timing of loan commitments booked at year end. Loan commitments are obligations of Bancorp to provide loans, and such commitments are made in the usual course of business.

Lines of credit, which are obligations of Bancorp to fund loans made to certain borrowers, decreased $45,000, or 0.1%, to $31,480,000 as of December 31, 2012, compared to $31,525,000 as of December 31, 2011. The decrease was a result of slightly lower demand for this type of loan product during 2012. Bancorp's management believes it has sufficient liquidity resources to have the funding available as these borrowers draw on these loans.

Loans sold and serviced with limited repurchase provisions increased $14,033,000, or 79.9% as of December 31, 2012 to $31,591,000, compared to $17,558,000 as of December 31, 2011. This increase was the result of a greater volume of loans sold in the secondary market in 2012.

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


Comparison of Results of Operations for the Years Ended December 31, 2012 and 2011.

General. Bancorp's net income for the year ended December 31, 2012 was $3,728,000, or income of $0.22 per share diluted after giving effect to dividends paid on preferred stock and amortization of discount on preferred stock. This compared to net income of $1,552,000, or a loss of $(0.02) per share diluted in 2011. This increase of $2,176,000 was primarily the result of the economic environment Bancorp experienced in 2012 compared to 2011, including an increase in total other income, a decrease in net interest income, a decrease in the provision for loan losses, an increase in mortgage banking activities and an increase in income tax provision.

Net Interest Income. Net interest income (interest earned net of interest charges) decreased $2,359,000, or 8.2%, to $26,555,000 for the year ended December 31, 2012, compared to $28,914,000 for the year ended December 31, 2011. This decrease was primarily due to a decrease in Bancorp's loan volume and to a decrease in the interest rate spread. Bancorp's interest rate spread decreased by 0.07% to 3.27% for the year ended December 31, 2012, compared to 3.34% for the year ended December 31, 2011. This decrease was the result of interest rates earned on Bancorp's loan portfolio decreasing faster than the decrease in interest rates paid on Bancorp's interest bearing liabilities. In addition, Bancorp's non-accrual loans increased from $31,432,000 at December 31, 2011 to $37,495,000 at December 31, 2012. This resulted in $1,964,000 of interest income not recorded on non-accrual loans in 2012, compared to $2,083,000 of unrecorded interest in 2011. Bancorp discontinues the accrual of interest on all non-accrual loans, at which time all previously accrued but uncollected interest is deducted from income. Bancorp is uncertain whether it will be able to further reduce the interest rate paid on its interest bearing liabilities by attracting lower cost deposits, due to the general expectation of continued increased competition for deposit accounts.

Provision for Loan Losses. Bancorp's loan portfolio is subject to varying degrees of credit risk and an allowance for loan losses is maintained to absorb losses inherent in its loan portfolio. Credit risk includes, but is not limited to, the potential for borrower default and the failure of collateral to be worth what the Bank determined it was worth at the time of the granting of the loan. The Bank monitors its loan portfolio loan delinquencies at least as often as monthly. All loans that are delinquent and all loans within the various categories of the Bank's portfolio as a group are evaluated. The Bank's Board, with the advice and recommendation of the Bank's loss mitigation committee, estimates an allowance to be set aside for loan losses. Included in determining the calculation are such factors as historical losses for each loan portfolio, current market value of the loan's underlying collateral, inherent risk contained within the portfolio after considering the state of the general economy, economic trends, consideration of particular risks inherent in different kinds of lending and consideration of known information that may affect loan collectibility. A decrease in the loan loss provision from the beginning of the year to the end of a year is the result after an analysis of the aforementioned factors and applying that rationale to the total portfolio.

The total allowance for loan losses decreased $8,460,000, or 32.6%, to $17,478,000 as of December 31, 2012, compared to $25,938,000 as of December 31, 2011. The decrease in the allowance was due to a modification of the Bank's loan classification and charge off practice to more closely align it to those of other institutions regulated by the OCC which caused the Bank to charge off loans earlier than it previously had done. The classification of loan impairment as "loss" is now based upon a confirmed expectation for loss, rather than simply equating impairment with a "loss" classification by default. For loans primarily secured by real estate, the expectation for loss is generally confirmed when:
(a) impairment is identified on a loan individually evaluated in the manner described below and, (b) the loan is presumed to be collateral-dependent such that the source of loan repayment is expected to arise solely from sale of collateral securing the application loan. Impairment identified on non-collateral-dependent loans may or may not be eligible for a "loss" classification depending upon the other salient facts and circumstances that affect the manner and likelihood of loan repayment. However, loan impairment that is classified as "loss" is now charged off against the allowance for loan losses concurrent with that classification rather than deferring the charge off of confirmed losses until they are "realized". During the year ended December 31, 2012, the provision for loan losses was $765,000 compared to $4,612,000 for the year ended December 31, 2011. This decrease of $3,847,000, or 83.4%, was a result of management's decision that less of a provision for loan losses was needed for the level of inherent risk in its portfolio as of December 31, 2012 as compared to December 31, 2011.

Bancorp's total loan portfolio has decreased from 2011. In addition, Bancorp has experienced a modest decrease in loan delinquencies, which contributed to the decision to reduce the provision for loan losses from 2011. Management believes that Bancorp will continue to experience improvement in the challenges faced by many financial institutions resulting from the slowdown in the economy and real estate markets.


Other Income and Non Interest Expenses. Total other income increased $1,733,000, or 69.0%, to $4,243,000 for 2012 compared to $2,510,000 for 2011.

Revenues from mortgage banking activities increased $1,489,000, or 258.5%, to $2,065,000 for the year ended December 31, 2012, compared to $576,000 for the year ended December 31, 2011. This increase was primarily a result of the market conditions which affected our ability to originate loans to be sold in the secondary market.

Real estate commissions decreased $13,000, or 2.0%, to $644,000 for the year ended December 31, 2012, compared to $657,000 for the year ended December 31, 2011. This decrease was primarily the result of a slight decrease in commercial sales and leasing in 2012 compared to 2011.

Real estate management fees increased $30,000, or 4.8%, to $655,000 for the year ended December 31, 2012, compared to $625,000 for the year ended December 31, 2011. This increase was primarily due to an increase in properties managed in 2012 compared to 2011.

Other non-interest income increased $227,000, or 34.8%, to $879,000 for the year ended December 31, 2012, compared to $652,000 for the year ended December 31, 2011. This increase was primarily due to higher credit report fees partially offset by lower ATM surcharges fees, letter of credit fees, savings charges, and NSF fees.

Total non-interest expense decreased $403,000, or 1.7%, to $23,647,000 for 2012 compared to $24,050,000 for 2011.

Compensation and related expenses increased $1,751,000, or 17.2%, to $11,906,000 for the year ended December 31, 2012, compared to $10,155,000 for the year ended December 31, 2011. This increase was primarily the result of the hiring additional personnel in 2012 and the resulting compensation for these employees in 2012 compared to 2011. As of December 31, 2012, Bancorp had 142 full-time equivalent employees compared to 127 at December 31, 2011.

Occupancy expense decreased $507,000, or 40.7%, to $740,000 for the year ended December 31, 2012, compared to $1,247,000 for the year ended December 31, 2011. This decrease was primarily due to lower maintenance costs incurred at Bancorp's headquarters.

Foreclosed real estate expenses, net decreased $2,090,000, or 38.6%, to $3,319,000 for the year ended December 31, 2012, compared to $5,409,000 for the year ended December 31, 2011. This decrease was primarily due to a decrease in loans foreclosed on, lower write downs taken on foreclosed property and lower expenses associated with the maintenance of foreclosed properties in 2012 compared to 2011.

Legal fees decreased $159,000, or 17.6%, to $746,000 for the year ended December 31, 2012, compared to $905,000 for the year ended December 31, 2011. This decrease was primarily due to a decrease in fees associated with loan foreclosures and loan collections in 2012 compared to 2011.

The FDIC assessment decreased $226,000, or 13.5%, to $1,444,000 for the year . . .

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