INDEPENDENT AUDITOR'S REPORT
 
 To the Stockholders and Board of Directors
 Severn Bancorp, Inc.
 Annapolis, Maryland
 
 We have audited the accompanying consolidated statements of financial condition of Severn Bancorp, Inc. and Subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
 We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
 In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Severn Bancorp, Inc. and Subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
  
 March 11, 2004
 Baltimore, Maryland
 
 
 F-1
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
 
 ASSETS
December 31,2003


2002Cash and due from banks
$
4,054,869

$
3,756,640Interest bearing deposits in other banks

457,825


4,190,768Federal funds

3,913,688


10,712,827Investment securities held to maturity

6,000,000


4,000,000Mortgage backed securities held to maturity

6,721,175


5,661,304Loans held for sale, net of unrealized loss of$ -0- in 2003 and 2002

3,174,954


17,481,301Loans receivable, net of allowance for loan lossesof $4,832,446 and $3,990,600, respectively

502,851,450


401,343,360Accrued interest receivable

2,701,718


2,549,425Foreclosed real estate, net

-


223,911Premises and equipment, at cost, lessaccumulated depreciation

5,327,313


4,737,936Mortgage servicing rights

12,740


19,340Federal Home Loan Bank of Atlanta stock at cost

3,250,000


1,900,000Deferred income taxes

1,276,800


1,090,356Income taxes receivable

-


164,255Goodwill

333,569


333,569Prepaid expenses and other assets

395,132


249,517Total assets
$
540,471,233

$
458,414,509
 
 The accompanying notes to consolidated financial statements
 are an integral part of these statements.
 
 
 
 
 
 F-2a
 
  
 
 
 LIABILITIES AND STOCKHOLDERS' EQUITY
December 31,2003


2002LiabilitiesDeposits
$
419,726,185

$
377,925,041Federal Home Loan Bank of Atlanta advances

65,000,000


34,000,000Advance payments by borrowers for expenses

901,520


1,049,408Accounts payable and accrued expenses

1,873,335


2,258,683Total liabilities

487,501,040


415,233,132Commitments - (Notes 4 and 5)Minority interest  preferred securities of subsidiary

4,000,040


4,000,040Stockholders' EquityCommon stock, $.01 par value, 20,000,000 sharesauthorized; 4,159,092 and 4,142,592 issued andoutstanding in 2003 and 2002, respectively

41,591


41,426Additional paid-in capital

11,516,495


11,425,910Retained earnings

37,412,067


27,714,001Total stockholders' equity

48,970,153


39,181,337Total liabilities and stockholders' equity
$
540,471,233

$
458,414,509
 
 
 
 
 
 
 
 
 
 
 
 F-2b
 
  SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 CONSOLIDATED STATEMENTS OF OPERATIONS
 
 Years Ended December 31,Interest Income

2003


2002


2001Interest on loans
$
36,403,402

$
32,722,911

$
28,617,342Interest on securities available for sale

-


-


43,809Interest on securities held to maturity

242,983


361,908


406,117Interest on mortgage backed securities

209,706


53,808


18,042Other interest income

230,915


263,372


403,914Total interest income

37,087,006


33,401,999


29,489,224Interest ExpenseInterest on deposits

10,961,224


12,300,081


13,591,440Interest on short term borrowings

9,239


155,249


1,178,202Interest on long term borrowings

1,370,614


1,343,947


1,324,368Total interest expense

12,341,077


13,799,277


16,094,010Net interest income

24,745,929


19,602,722


13,395,214Provision for loan losses

900,000


670,000


708,669Net interest income after provision for loan losses

23,845,929


18,932,722


12,686,545Other IncomeLoss on sale of investments

-


-


(145,529
)Gain on sale of foreclosed real estate

169,095


-


-Gain on sale of loans

1,563,105


1,263,736


982,778Real estate commissions

1,159,755


1,236,973


499,256Real estate management fees

368,900


383,117


213,102Mortgage processing and servicing fees

927,594


723,702


606,587All other income

485,189


525,157


414,089Net other income

4,673,638


4,132,685


2,570,283Non-Interest ExpensesCompensation and related expenses

6,975,540


6,064,850


4,572,101Occupancy

533,756


487,891


465,628Net expense of foreclosed real estate

-


11,053


30,786Other

2,106,276


1,882,839


1,519,537Total non-interest expenses

9,615,572


8,446,633


6,588,052Income before income tax provision

18,903,995


14,618,774


8,668,776Income tax provision

7,574,857


5,670,554


3,413,206Net income
$
11,329,138

$
8,948,220

$
5,255,570Basic earnings per common share
$
2.68

$
2.13

$
1.38Diluted earnings per common share
$
2.67

$
2.13

$
1.37
 
 The accompanying notes to consolidated financial statements
 are an integral part of these statements.
 
 F-3
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 Years Ended December 31, 2003, 2002, and 2001
 
 Common Stock


Additional Paid-InCapital


Retained
Earnings


Accumulated ComprehensiveIncome (Loss)


Total StockholdersEquityBalance - January 1, 2001

$
10,798

$
5,720,300

$
15,684,650

$
(86,903
)
$
21,328,845Comprehensive IncomeNet income


-


-


5,255,570


-


5,255,570Reclassification for gainsIncluded in net incomenet of taxes of $54,162


-


-


-


86,903


86,903Total comprehensive income














5,342,473Exercise of 13,000 options


130


214,370


-


-


214,500Exercise of 199,592 warrants


1,996


3,282,817


-


-


3,284,813Issuance of 60,000 shares ofcommon stock


600


1,599,400


-


-


1,600,000Other


-


-


(220,971
)

-


(220,971
)Dividends on common stock($.56 per share)


-


-


(718,818
)

-


(718,818
)Balance - December 31, 2001


13,524


10,816,887


20,000,431


-


30,830,842Comprehensive IncomeNet income


-


-


8,948,220


-


8,948,220Three-for-one stock split in theform of a 200% dividend


27,047


-


(27,047
)

-


-Exercise of 85,500 options


855


479,295


-


-


480,150Tax benefit of exercised options


-


129,728


-


-


129,728Other


-


-


(220,972
)

-


(220,972
)Dividends on common stock($.24 per share)


-


-


(986,631
)

-


(986,631
)Balance - December 31, 2002


41,426


11,425,910


27,714,001


-


39,181,337Comprehensive IncomeNet income


-


-


11,329,138


-


11,329,138Exercise of 16,500 options


165


90,585


-


-


90,750Other


-


-


(220,971
)

-


(220,971
)Dividends on common stock($.34 per share)


-


-


(1,410,101
)

-


(1,410,101
)Balance - December 31, 2003

$
41,591

$
11,516,495

$
37,412,067


-

$
48,970,153
 
 The accompanying notes to consolidated financial statements
 are an integral part of these statements.
 
 
 
 
 
 
 F-4
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 Cash Flows from Operating Activities

2003


2002


2001Net income
$
11,329,138

$
8,948,220

$
5,255,570Adjustments to Reconcile Net Income to NetCash Provided by Operating ActivitiesAmortization of deferred loan fees

(2,417,135
)

(2,122,685
)

(1,530,021
)Net (accretion) amortization of discounts andPremiums

78,038


(3,982
)

(8,068
)Provision for loan losses

900,000


670,000


708,669Provision for losses on foreclosed real estate

-


-


20,000Provision for depreciation

290,591


260,232


227,331Loss (gain) on sale of foreclosed real estate

(169,095
)

-


2,769Gain on disposal of premises and equipment

-


-


(5,656
)Loss on sale of available for sale securities

-


-


145,529Gain on sale of loans

(1,563,105
)

(1,263,736
)

(982,778
)Proceeds from loans sold to others

135,435,272


101,798,171


61,258,782Loans originated for sale

(119,660,304
)

(110,564,769
)

(63,564,893
)Principal collected on loans originated for sale

94,484


47,967


(40,961
)Tax effect of exercised options

-


129,728


-(Increase) decrease in accrued interest

(152,293
)

(352,612
)

69,553Decrease in mortgage servicing rights

6,600


6,600


6,600Increase in deferred taxes

(186,444
)

(276,870
)

(260,702
)Decrease (increase) in income taxes receivable

164,255


(163,305
)

21,477(Increase) decrease in prepaid expensesand other assets

(145,615
)

(77,435
)

105,349Decrease in accrued interest payable

(4,704
)

(8,152
)

(8,445
)(Decrease) increase in other liabilities

(541,494
)

410,821


187,326(Decrease) increase in income taxes payable

(64,825
)

290,408


79,717Net cash provided (used) by operating activities

23,393,364


(2,271,399
)

1,687,148
 
 
 
 
 
 
 
 
 
 
 
 
 F-5
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 **Years Ended Decmeber 31,**Cash Flows from Investing Activities

2003


2002


2001Cash consideration Louis Hyatt, Inc.acquisition, net

-


-

$
(31,340
)Purchase of investment securities
$
(10,000,000
)
$
(4,000,000
)

(4,000,000
)Proceeds from maturing investment securities

8,000,000


7,000,000


6,497,754Proceeds from sale of available for sale securities

-


-


854,471Purchase of mortgage backed securities

(4,484,726
)

(5,759,846
)

-Principal collected on mortgage backed securities

3,317,530


307,829


67,507Net increase in loans

(99,715,668
)

(64,543,724
)

(60,404,624
)Loans purchased

(246,000
)

(197,000
)

(3,551,316
)Proceeds from sale of foreclosed real estate

393,006


88,207


103,941Investment in premises and equipment

(879,968
)

(355,687
)

(2,097,708
)Proceeds from disposal of premises and equipment

-


-


15,029Purchase of Federal Home Loan Bank ofAtlanta stock

(1,350,000
)

-


(700,000
)Redemption of Federal Home Loan Bank ofAtlanta stock

-


600,000


-Net cash used by investing activities

(104,965,826
)

(66,860,221
)

(63,246,286
)Cash Flows from Financing ActivitiesNet increase in demand deposits, moneymarket, passbook accounts and advancesby borrowers for taxes and insurance

25,592,459


70,812,416


44,777,862Net increase in certificates of deposit

16,065,501


20,245,549


13,424,172Decrease in checks outstandingin excess of bank balance

-


(798,088
)

(2,500,270
)Additional borrowed funds

56,000,000


37,000,000


47,000,000Repayment of borrowed funds

(25,000,000
)

(45,000,000
)

(39,000,000
)Common stock dividends

(1,410,101
)

(986,631
)

(718,818
)Proceeds from exercise of options

90,750


480,150


214,500Proceeds from exercise of warrants

-


-


3,393,064Net cash provided by financing activities

71,338,609


81,753,396


66,590,510
 
 
 
 
 
 
 
 
 F-6
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
 Years Ended December 31,2003


2002


2001(Decrease) increase in cash and cashequivalents
$
(10,233,853
)
$
12,621,776

$
5,031,372Cash and cash equivalents at beginning of year

18,660,235


6,038,459


1,007,087Cash and cash equivalents at end of year
$
8,426,382

$
18,660,235

$
6,038,459The Following is a Summary of Cash andCash EquivalentsCash
$
4,054,869

$
3,756,640

$
1,030,867Interest bearing deposits in other banks

457,825


4,190,768


1,058,692Federal funds

3,913,688


10,712,827


3,948,900Cash and cash equivalents reflected on thestatement of cash flows
$
8,426,382

$
18,660,235

$
6,038,459Supplemental Disclosure of Cash Flows Information:Cash Paid During Year For:Interest
$
12,432,679

$
13,804,867

$
16,094,010Income taxes
$
7,576,913

$
5,556,478

$
3,282,444Transfer from loans to foreclosed real estate
$
-

$
-

$
485,210Transfer from foreclosed real estate to loans
$
223,911

$
-

$
358,500Common stock issued for acquired company
$
-

$
-

$
1,600,000
 
 The accompanying notes to consolidated financial statements
 are an integral part of these statements.
 
 
 
 
 F-7
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 1 - Summary of Significant Accounting Policies
 
 A.  Principles of Consolidation - The consolidated financial statements include the accounts of Severn Bancorp, Inc. ("the Corporation"), and its wholly-owned subsidiaries, Louis Hyatt, Inc., SBI Mortgage Company and SBI Mortgage Company's subsidiary, Crownsville Development Corporation, and its subsidiary, Crownsville Holdings I, LLC, and Severn Savings Bank, FSB ("the Bank"), and the Bank's subsidiaries, Homeowners Title and Escrow Corporation, Severn Financial Services Corporation, Creekside Commons, LLC, SSB Realty Holdings, LLC, SSB Realty Holdings II, LLC, HS West, LLC and Severn Preferred Capital Corporation ("the Company"). All intercompany accounts and transactions have been eliminated in the accompanying financial statements.
 
 Severn Preferred Capital Corporation was organized on April 29, 1997 and commenced operations of July 22, 1997. The Company qualifies as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended.
  B. Business - The Bank's primary business activity is the acceptance of deposits  from the general public and the use of the proceeds for investments and loan originations. The Bank is subject to competition from other financial institutions. The Bank is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities.
 
 The corporation has no reportable segments. Management does not separately allocate expenses, including the cost of funding loan demand, between the retail and real estate operations of the Corporation.
 
 C.  Estimates - The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses and the valuation of foreclosed real estate. See Notes H and K below for a discussion of the determination of that estimate.
 
 D.  Investment Securities Available for Sale  Securities classified as available for sale are those debt securities that the Corporation intends to hold for an indefinite period of time, but not necessarily to maturity. Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of shareholders' equity until realized. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Gains and losses are determined using the specific identification method. The Corporation had no securities classified as available for sale at December 31, 2003 and 2002.
 
 F-8
 
  
 SEVERN BANCORP, INC.  AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 1 - Summary of Significant Accounting Policies - Continued
 
 E.  Investments and Mortgage Backed Securities Held to Maturity - Investments and mortgage backed securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity.
 
 F. Loans Held for Sale - Loans held for sale are carried at lower of cost or market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income.
 
 G. Loans - Loans are carried at cost since management has the ability and intention to hold them to maturity.
 
 H.  Allowance for Loan Losses - An allowance for loan losses is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based on evaluations of the collectibility 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 allowances for losses on loans. Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Statement of Financial Accounting Standards ("SFAS") No. 114, as amended by SFAS No. 118, addresses the accounting by creditors for impairment of certain loans. It is generally applicable for all loans except large groups of smaller balance homogeneous loans that are collectively evaluated for impairment, including residential mortgage loans and consumer installment loans. It also applies to all loans that are restructured in a troubled debt restructuring involving a modification
 
 
 
 
 
 F-9
 
  
 SEVERN BANCORP, INC.  AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 1 - Summary of Significant Accounting Policies - Continued
 
 H. Allowance for Loan Losses - Continued
 
 of terms. SFAS No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.
 
 Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of interest is doubtful. When a payment is received on a loan on non-accrual status, the amount received is allocated to principal and interest in accordance with the contractual terms of the loan.
 
 I.  Loan Origination Fees - Loan origination fees and certain direct loan origination costs are deferred and recognized over the contractual life of the related loan as an adjustment of yield using the level-yield method.
 
 J.  Discounts or Premiums - Discounts received or premiums paid in connection with loans purchased are amortized into income over an average loan life using the interest method.
 
 K.  Foreclosed Real Estate - Real estate acquired through or in the process of foreclosure is recorded at the lower of cost or fair value. Management periodically evaluates the recoverability of the carrying value of the real estate acquired through foreclosure using estimates as described under the caption "Allowance for Loan Losses". In the event of a subsequent decline, management provides an additional allowance, to reduce real estate acquired through foreclosure to fair value less estimated disposal cost. Expenses incurred on foreclosed real estate prior to disposition are charged to expense. Gains on the sale of foreclosed real estate are recognized upon disposition of the property.
 
 
 
 
 
 
 
 
 F-10
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 1 - Summary of Significant Accounting Policies - Continued
 
 L. Loan Servicing - The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using pricing sheets from correspondent purchasers. For purposes of measuring impairment, the rights are stratified based on the following predominant risk characteristics of the underlying loans: fixed rate loans with similar terms (i.e.; fifteen years, twenty years or thirty years amortization) all originated within the same fiscal year. The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceed their fair value.
 
 M. Transfers of Financial Assets  Transfers of financial assets, including loan and loan participation sales, are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
 
 N.  Premises and Equipment - Premises and equipment are carried at cost less accumulated depreciation. Depreciation and amortization of premises and equipment is accumulated by the use of the straight-line method over the estimated useful lives of the assets. Additions and improvements are capitalized, and charges for repairs and maintenance are expensed when incurred. The related cost and accumulated depreciation are eliminated from the accounts when an asset is sold or retired and the resultant gain or loss is credited or charged to income.
 
 O.  Income Taxes - Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities based on enacted tax rates expected to be in effect when such amounts are realized or settled. Deferred tax assets are recognized only to the extent that is more likely than not that such amounts will be realized based on consideration of available evidence. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
 
 P.  Statement of Cash Flows - In the statement of cash flows, cash and cash equivalents include cash, amounts due from banks, Federal Home Loan Bank of Atlanta overnight deposits, federal funds and certificates of deposit with an original maturity date less than ninety days.
 
 Q.  Goodwill - During the year ended December 31, 2001, the Corporation recorded goodwill in the amount of $333,569 as the result of the purchase of Louis Hyatt, Inc. There were no other changes in the carrying amount of goodwill for the years ended December 31, 2003, 2002, and 2001. The Corporation tests the goodwill for impairment in accordance with SFAS 142.
 
 F-11
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 1 - Summary of Significant Accounting Policies - Continued
 
 R.  Earnings Per Share - Basic earnings per share of common stock for the years ended December 31, 2003, 2002 and 2001 is computed by dividing net income less preferred stock dividend net of tax by 4,146,566, 4,092,188 and 3,647,451, respectively, the weighted average number of shares of common stock outstanding for each year. Diluted earnings per share of common stock for the years ended December 31, 2003, 2002 and 2001, is computed by dividing net income for each year by 4,157,302, 4,103,223 and 3,683,346, respectively, the weighted average number of diluted shares of common stock. (See Note 12) The above amounts have been retroactively adjusted to give effect to a 3-for-1 stock split in the form of a 200% stock dividend declared in 2002. (See Note 11)
 
 S.  Employee Stock Ownership Plan - The Corporation accounts for its Employee Stock Ownership Plan ("ESOP") in accordance with Statement of Position 93-6 of the Accounting Standards Division of the American Institute of Certified Public Accountants. The Corporation records compensation expense equal to the cash contribution called for under the Plan. All ESOP shares are included in the weighted average shares outstanding for earnings per share computations. All dividends paid on ESOP shares are charged to retained earnings. (See Note 9)
 
 T.  Advertising Cost - Advertising cost is expensed as incurred. For the years ended December 31, 2003, 2002, and 2001 advertising expenses were $131,014, $131,298 and $112,214, respectively.
 
 U.  Reclassification - Certain prior year's amounts have been reclassified to conform to the current year's method of presentation. These reclassifications had no effect on net income.
  V.  Cash Concentrations - The Bank has a demand deposit account and federal funds with another financial institution in the amount of $6,859,294 and $13,709,768 at December 31, 2003 and 2002, respectively. The balance exceeds the Federal Deposit Insurance Corporation (FDIC) insurance level of $100,000 and constitutes a concentration of credit risk.
 
 
 
 
 
 
 
 
 F-12
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 2 - Investment Securities
 
 The amortized cost and fair values of investment securities held to maturity are as follows:
  AmortizedCost


Gross Unrealized Gains


Gross Unrealized Losses


Fair
ValueDecember 31, 2003:Federal Home Loan Bank(FHLB) Notes
$
6,000,000

$
-

$
77,600

$
5,922,400December 31, 2002:Federal Home Loan Bank(FHLB) Notes
$
4,000,000

$
48,400

$
-

$
4,048,400
 
 FHLB Notes in the amount of $2,000,000 are pledged as collateral for its standby letters of credit issued on behalf of various borrowers and developers in favor of Anne Arundel County.
  The scheduled maturities of investment securities are as follows at December 31, 2003:
 
 Held To
Maturity SecuritiesAmortized
Cost


Fair
ValueDue after one year through five years

$
4,000,000

$
3,933,000More than five to ten years


2,000,000


1,989,400$
6,000,000

$
5,922,400
 
 
 
 
 F-13
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 2 - Investment Securities - Continued
 
 Gross losses of $145,529 and no gross gains were realized on proceeds of $854,471 during the year ended December 31, 2001 on sales of securities available for sale. No gains or losses were realized during the years ended December 31, 2002 and December 31, 2003.
 
 Below is a schedule of securities with unrealized losses as of December 31, 2003. There are no continuous unrealized losses existing for greater than twelve months on any security at December 31, 2003. Unrealized losses are the result of interest rate levels differing from those existing at the time of purchase of the securities and, as to mortgage backed securities, actual and estimated prepayment speeds. These unrealized losses are considered temporary as they reflect market values on December 31, 2003 and are subject to change daily as interest rates fluctuate.
 
 
 Continuous Unrealized Losses forLess than 12 monthsFair Value


Unrealized LossesInvestment Securities:FHLB Notes (three securities)
$
5,922,400

$
77,600Mortgage Backed Securities:FNMA (two securities)

2,397,735


20,342FHLMC Gold (two securities)

4,041,440


24,933Total Mortgage Backed Securities

6,439,175


45,275Total
$
12,361,575

$
122,875
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-14
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 
 Note 3 - Mortgage Backed Securities
 
 The amortized cost and fair values of mortgage backed securities held to maturity are as follows as of December 31:
  
 Gross Amortized Cost


Gross Unrealized Gains


Gross Unrealized Losses


Fair
Value**2003**FNMA
$
2,417,735


-

$
20,342

$
2,397,393FHLMC GOLD

4,303,440

$
17,701


24,933


4,296,208$
6,721,175

$
17,701

$
45,275

$
6,693,6012002FHLMC GOLD
$
5,661,304

$
13,559

$
5,223

$
5,669,640
 
 
 FHLMC GOLD in amount of $2,833,966 is pledged as collateral for its standby letters of credit on behalf of various borrowers and developers in favor of Anne Arundel County.
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-15
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 4 - Loans Receivable
 
 Loans receivable consist of the following:
 
 December 31,2003


2002Residential mortgage loans
$
187,497,605

$
142,341,868Construction, land acquisition anddevelopment loans

240,756,886


191,196,444Land loans

25,820,590


20,109,481Lines of credit

19,580,722


12,472,108Commercial real estate loans

106,823,141


90,861,798Commercial non-real estate loans

3,813,271


3,444,297Second mortgage loans

1,220,025


3,108,961Home equity loans

18,391,185


11,196,706Consumer loans

783,048


425,001Loans secured by deposits

360,891


444,597605,047,364


475,601,261LessLoans in process

(94,020,135
)

(67,593,187
)Allowance for loan losses

(4,832,446
)

(3,990,600
)Unearned discount on loans purchased

-


(29,287
)Deferred loan origination fees

(3,343,333
)

(2,644,827
)(102,195,914
)

(74,257,901
)$
502,851,450

$
401,343,360
 
 Residential lending is generally considered to involve less risk than other forms of lending, although payment experience on these loans is dependent to some extent on economic and market conditions in the Bank's lending area. Multifamily residential, commercial, construction and other loan repayments are generally dependent on the operations of the related properties or the financial condition of its borrower or guarantor. Accordingly, repayment of such loans can be more susceptible to adverse conditions in the real estate market and the regional economy.
 
 
 A substantial portion of the Bank's loans receivable are mortgage loans secured by residential and commercial real estate properties located in the State of Maryland. Loans are extended only after evaluation by management of customers' creditworthiness and other relevant factors on a case-by-case basis. The Bank generally does not lend more than 90% of the appraised value
 
 
 F-16
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 4 - Loans Receivable - Continued
 
 of a property and requires private mortgage insurance on residential mortgages with loan-to-value ratios in excess of 80%. In addition, the Bank generally obtains personal guarantees of repayment from borrowers and/or others for construction, commercial and multifamily residential loans and disburses the proceeds of construction and similar loans only as work progresses on the related projects.
 
 The following is a summary of the allowance for loan losses for the three years ended December 31:
 
 2003


2002


2001Balance at beginning of year
$
3,990,600

$
3,353,375

$
2,728,004Provision for loan losses

900,000


670,000


708,669Recoveries

-


-


-Charge-offs

(58,154
)

(32,775
)

(83,298
)Balance at end of year
$
4,832,446

$
3,990,600

$
3,353,375
 
 There were no Impaired loans as defined by SFAS No. 114 as of December 31, 2003. Impaired loans are summarized as follows for the years ended December 31:
 
 2003


2002


2001Recorded investment
$
-

$
252,780

$
300,000Average balances

21,065


371,725


542,628Allowance for loan losses

-


-


-
 
 Impaired loans as defined by SFAS No. 114 for which interest income has been reduced are as follows for the year ended December 31:
 
 2003


2002


2001Interest income that would have beenrecorded
$
-

$
29,779

$
32,909Interest income recognized
$
-


21,335


25,159Interest income not recognized
$
-

$
8,444

$
7,750
 
 
 
 F-17
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 4 - Loans Receivable - Continued
 
 Nonaccrual loans not subject to SFAS No. 114 amounted to approximately $468,864 and $1,504,706 at December 31, 2003 and 2002, respectively. The Bank had no loans greater than ninety days past due and still accruing at December 31, 2003 and 2002.
 
 Interest income that would have been recorded under the original terms of such loans and the interest income actually recognized for the years ended December 31, are summarized below:
 
 2003


2002


2001Interest income that would havebeen recorded
$
27,878

$
126,263

$
190,279Interest income recognized

16,787


59,152


145,199Interest income not recognized
$
11,091

$
67,111

$
45,080
 
 Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of these loans at December 31 are summarized as follows:
 
 2003


2002Mortgage Loan Portfolio Serviced For:FHLMC
$
2,531,476

$
5,758,947Other investors

21,484,664


18,175,891$
24,016,140

$
23,934,838
 
 Custodial escrow balances maintained in connection with the foregoing loan servicing were approximately $18,659 and $53,749 at December 31, 2003 and 2002, respectively.
 
 The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of financial position. The contract amounts of these instruments express the extent of involvement the Bank has in each class of financial instruments.
 
 
 
 
 
 F-18
 
  SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 4 - Loans Receivable - Continued
 
 The Bank's exposure to credit loss from non-performance by the other party to the above mentioned financial instruments is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
 
 Unless otherwise noted, the Bank requires collateral or other security to support financial instruments with off-balance-sheet credit risk.
 
 Financial Instruments Whose Contract
Amounts Represent Credit Risk
Contract Amount
At December 31,2003


2002Standby letters of credit
$
7,981,976

$
6,693,732Home equity lines of credit
$
12,142,164

$
8,014,492Loan commitments
$
24,520,151

$
24,771,785Lines of credit
$
20,435,779

$
22,368,021Loans sold and serviced with limitedrepurchase provisions
$
32,876,896

$
10,162,735
 
 Standby letters of credit are conditional commitments issued by the Bank guaranteeing performance by a customer to various municipalities. These guarantees are issued primarily to support performance arrangements, limited to real estate transactions. The majority of these standby letters of credit expire within the next twelve months. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Bank requires collateral supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of December 31, 2003 for guarantees under standby letters of credit issued is not material.
 
 Home equity lines of credit are loan commitments to individuals as long as there is no violation of any condition established in the contract. Commitments under home equity lines expire ten years after the date the loan closes and are secured by real estate. The Bank evaluates each customer's credit worthiness on a case-by-case basis.
 
 Mortgage loan commitments not reflected in the accompanying statements at December 31, 2003 include $19,007,934 at fixed rates ranging from 4.25% to 9.00% and $5,512,217 at rates ranging from prime to prime plus 1.5%.
 
 Lines of credit are loan commitments to individuals and companies as long as there is no violation of any condition established in the contract. Lines of credit have a fixed expiration date. The Bank evaluates each customer's credit worthiness on a case-by-case basis.
 
 F-19
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 4 - Loans Receivable - Continued
 
 The Bank has entered into several agreements to sell mortgage loans to third parties. These agreements contain limited provisions that require the Bank to repurchase a loan if the loan becomes delinquent within the terms specified by the agreement.
 
 The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. No amount has been recognized in the statement of financial condition at December 31, 2003, as a liability for credit loss.
 
 Note 5 - Premises and Equipment
 
 Premises and equipment at December 31, 2003 and 2002 are summarized by major classification as follows:
 
 December 31,

Estimated Useful Lives2003


2002Land
$
1,923,960

$
1,923,960


-Building

2,642,664


2,188,696


39 YearsLeasehold improvements

574,153


535,016


15-27.5 YearsFurniture, fixtures and equipment

1,758,717


1,756,898


3-10 YearsTotal at cost

6,899,494


6,404,570Accumulated depreciation

(1,572,181
)

(1,666,634
)$
5,327,313

$
4,737,936
  Depreciation expense for the years ended December 31, 2003, 2002 and 2001 was $290,591, $260,232, and $227,331, respectively.
 
 HS West, LLC will construct a building in the Annapolis, Maryland area to serve as the administrative headquarters. A branch office will be included. To date, HS West , LLC has incurred approximately $1,701,854 of costs, which are included in premises and equipment above. The total cost is expected to be approximately $17,000,000, with completion in November 2005.
 
 Interest capitalized during the period ended December 31, 2003 was $38,812. There was no interest capitalized during 2002 and 2001.
 
 The Bank and a subsidiary are obligated under long term leases for their administrative offices. The minimum annual rental payments are as follows:
 
 Years Ended December 31,2004
$
72,5332005

46,3542006

25,652
 
 F-20
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 5 - Premises and Equipment - Continued
 
 Homeowners Title and Escrow Corporation and Louis Hyatt, Inc. are also obligated under a month-to-month lease with no obligation to renew, but they anticipate that they will continue to do so.
 
 Total rent expense was $77,599, $64,853, and $106,868 for the years ended December 31, 2003, 2002 and 2001, respectively.
 
 Note 6 - Investment in Federal Home Loan Bank of Atlanta Stock
 
 The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank of Atlanta ("FHLB") in an amount equal to at least 1% of the unpaid principal balances of the Bank's residential mortgage loans or 1/20 of its outstanding advances from the FHLB, whichever is greater. Purchases and sales of stock are made directly with the FHLB at par value.
 
 Note 7 - Deposits
 
 Deposits in the Bank as of December 31, 2003 and 2002 consisted of the savings programs described below:
 
 2003
2002Category

Amount


Percent


Amount


PercentNOW accounts
$
21,219,969


5.06
%
$
15,980,589


4.23
%Money market accounts

152,412,884


36.31


132,767,052


35.13Passbooks

19,190,968


4.57


18,189,610


4.81Certificates

226,832,739


54.04


210,913,461


55.81419,656,560


99.98


377,850,712


99.98Accrued interest

69,625


.02


74,329


.02Total savings
$
419,726,185


100.00
%
$
377,925,041


100.00
%
 
 
 
 
 
 
 F-21
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 
 Note 7 - Deposits - Continued
 
 At December 31, scheduled maturities of certificates of deposit are as follows:
 
 
 2003Amount


**%**One year or less
$
125,650,800


55.39More than 1 year to 2 years

30,261,890


13.34More than 2 years to 3 years

39,724,600


17.51More than 3 years to 4 years

19,889,201


8.77More than 4 years to 5 years

11,306,248


4.99More than 5 years

-


-$
226,832,739


100.00
 
 Interest expense on deposits is summarized as follows:
 
 For Years Ended December 31,2003


2002


2001NOW accounts

$
65,297

$
74,814

$
66,785Money market accounts


2,595,448


2,853,484


1,579,829Passbooks


336,359


556,444


775,017Certificates


7,964,120


8,815,339


11,169,809$
10,961,224

$
12,300,081

$
13,591,440
 
 The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100,000 was approximately $57,879,113 and $50,837,141 at December 31, 2003 and 2002.
 
 
 
 
 
 
 
 
 
 
 
 F-22
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 
 Note 8 - Federal Home Loan Bank Advances and Loan Payable
 
 During 1994, the Federal Home Loan Bank of Atlanta established a Credit Availability Program. The Bank's Credit Availability under the program at December 31, 2003 and 2002 was $134,687,519 and $113,884,235, respectively. Advances outstanding at December 31, 2003 and 2002 were $65,000,000 and $34,000,000, respectively. The maturities of these advances at December 31, 2003 are as follows:
 
 Description

Rate


Amount


MaturityFHLB advances

1.15% to 3.64
%
$
11,000,000


2004FHLB advances

4.52
%

2,000,000


2005FHLB advances

2.99% to 3.24
%

10,000,000


2006FHLB advances

3.55% to 4.01
%

10,000,000


2007FHLB advances

3.33
%

5,000,000


2008FHLB advances

2.57% to 4.48
%

27,000,000


Thereafter$
65,000,000
 
 
 The Bank's stock in the Federal Home Loan Bank of Atlanta is pledged as security for the advances and under a blanket floating lien security agreement with the Federal Home Loan Bank of Atlanta, the Bank is required to maintain as collateral for its advances, qualified home mortgage loans in an amount equal to 175% of the advances.
 
 Note 9  Employee Benefit Plans
 
 The Bank has a Supplemental Executive Retirement Plan covering selected officers which is funded by life insurance policies. The Bank owns the policies and is the beneficiary. The amount of cost recognized for the years ended December 31, 2003, 2002 and 2001 was $11,753 per year.
 
 The Bank has a 401(k) Retirement Savings Plan. Employees may contribute a percentage of their salary up to a maximum of $12,000 for 2003. The Bank is obligated to contribute 50% of the employee's contribution, not to exceed 6% of the employee's annual salary. All employees who have completed one year of service with the Bank are eligible to participate. The Bank's contribution to this plan was $78,564, $93,415 and $75,174 for the years ended December 31, 2003, 2002 and 2001, respectively.
 
 
 
 F-23
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 
 Note 9- Employee Benefit Plans - Continued
 
 The Bank has an Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of participating employees. During the years ended December 31, 2003, 2002 and 2001, the Bank recognized ESOP expense of $140,400, $140,400 and $120,000, respectively.
 
 Note 10- Minority Interest
 
 Minority interest represents the equity attributable to that portion of a consolidated subsidiary (Severn Preferred Capital Corporation) that is owned by parties independent of the Corporation.
 
 Severn Preferred Capital Corporation issued 200,002 shares of preferred stock at $20.00 per share, together with warrants to purchase 200,002 shares of the Corporations common stock at $17.00 per share and 200,000 shares of its common stock for $20 per share, par value of $1 per share for gross proceeds of $8,000,080 and net proceeds of $7,891,829. The Bank purchased all of the outstanding common stock. All of the warrants were exercised as of December 31, 2001.
 
 Note 11- Stockholders Equity
 
 In 1984, the Bank converted from a state chartered mutual savings and loan to a state chartered stock savings and loan association. At the time of conversion, the Bank established a liquidation account in an amount equal to the Bank's retained earnings as of September 30, 1983. The liquidation account is maintained for the benefit of eligible savings account holders who maintained their savings account in the Bank after conversion. In the event of a complete liquidation (and only in such event), each eligible savings account holder would be entitled to receive a liquidation distribution from the liquidation account in an amount equal to the account holder's then interest in the liquidation account before any liquidation distribution may be made with respect to capital stock. At December 31, 2003 and 2002, the balance of the liquidation account is included in retained earnings.
 
 The shareholders of the Corporation voted to approve an amendment to the corporate charter to increase the number of Common shares authorized to 20,000,000 and increased the authorized number Serial Preferred shares to 1,000,000.
 
 On February 19, 2002, the Corporations Board of Directors declared a 3-for-1 stock split in the form of a 200% stock dividend, which was effective for shares outstanding as of March 1, 2002 to be paid March 15, 2002. All per share data in the accompanying financial statements and all share and per share data in the footnotes have been adjusted to give retroactive effect to this transaction.
 
 F-24
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 11- Stockholders Equity - Continued
 
 The Banks Stock Option Plan (Plan) provides for the granting of options to acquire common stock to directors and key employees. Option prices are equal to or greater than fair market value of the common stock at the date of the grant. The Bank granted options to purchase 156,000 shares. The Plan provides for options granted to directors (60,000 shares) to be immediately exercisable for a period of five years from the effective date of November 25, 1997. Additionally, the Plan provides for one-fifth of the remaining options granted to be exercisable on each of the first five anniversaries of the effective date. As of December 31, 2003 all options have been granted. If the participant in the Plan terminates employment for reasons other than death or disability, he or she forfeits all rights to unvested shares.
 
 The following table summarizes the status of and changes in the Banks stock option plan.
 
 
 Shares


Weighted AverageExercise PriceOutstanding at January 1, 2001

144,000

$
5.57Exercised in 2001

39,000


5.50Outstanding at December 31, 2001

105,000


5.59Exercised in 2002

85,500


5.62Forfeited in 2002

1,500


5.50Outstanding at December 31, 2002

18,000


5.50Exercised in 2003

16,500


5.50Forfeited in 2003

1,500


5.50Outstanding at December 31,2003

-


-Exercisable at December 31, 2002

18,000Exercisable at December 31, 2003

-
 
 All share and per share amounts have been retroactively adjusted for the 2002 3-for-1 stock split in the form of a 200% stock dividend.
 
 F-25
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 12- Earnings Per Share
 
 Basic EPS is computed based upon income available to common shareholders and the weighted average number of common shares outstanding for the period. Diluted EPS is to reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Corporation.
 
 For Years Ended December 31,2003


2002


2001Net income

$
11,329,138

$
8,948,220

$
5,255,570Less  minority interest preferredstock dividends, net of tax


(220,972
)

(220,972
)

(220,971
)Net income available to shareholders

$
11,108,166

$
8,727,248

$
5,034,599Weighted average shares outstandingbasic EPS


4,146,566


4,092,188


3,647,451Effect of Dilutive SharesStock options


10,736


11,035


35,895Adjusted weighted average sharesused for dilutive EPS


4,157,302


4,103,223


3,683,346
 
 All share and per share amounts have been retroactively adjusted for the 2002 3-for-1 stock split in the form of a 200% stock dividend. (See Note 11)
 
 Note 13- Regulatory Matters
 
 The Bank is required to maintain an average daily balance with the Federal Reserve Bank in a non-interest bearing account. The amount in such account at December 31, 2003 was $300,000.
 
 The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on the Banks financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Banks assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Banks capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
 F-26
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 13- Regulatory Matters - Continued
 
 Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) and risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2003, that the Bank meets all capital adequacy requirements to which it is subject.
 
 As of December 31, 2003, the most recent notification from the Office of Thrift Supervision categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Banks category. The Banks actual capital amounts and ratios are also presented in the table.
 
 The following table presents the Bank's capital position based on the financial statements.
 
 
 Actual
For CapitalAdequacy Purposes

To Be Well
Capitalized Under
Prompt Corrective
Action ProvisionsAmount


%


Amount


%


Amount


%December 31, 2003Tangible (1)
$
49,568,918


9.2
%
$
8,095,323


1.50
%

N/A


N/ATier I capital (2)

49,568,918


12.0
%

N/A


N/A

$
24,692,400


6.00
%Core (1)

49,568,918


9.2
%

21,587,529


4.00
%

26,984,411


5.00
%Risk-weighted (2)

54,313,918


13.2
%

32,923,200


8.00
%

41,154,000


10.00
%December 31, 2002Tangible (1)
$
39,898,384


8.8
%
$
6,837,788


1.50
%

N/A


N/ATier I capital (2)

39,898,384


12.1
%

N/A


N/A

$
19,768,800


6.00
%Core (1)

39,898,384


8.8
%

18,234,100


4.00
%

22,792,625


5.00
%Risk-weighted (2)

43,781,865


13.3
%

26,358,400


8.00
%

32,948,000


10.00
%
 
 
 (1) To adjusted total assets.
 (2) To risk-weighted assets.
 
 F-27
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 13- Regulatory Matters - Continued
 
 The Corporation has no significant source of income other than dividends from the Bank. As a result, the Corporation's dividends will depend primarily upon receipt of dividends from the Bank.
 
 OTS regulations limit the payment of dividends and other capital distributions by the Bank. The Bank is able to pay dividends during a calendar year without regulatory approval to the extent of the greater of (i) an amount which will reduce by one-half its surplus capital ratio at the beginning of the year plus all its net income determined on the basis of generally accepted accounting principles for that calendar year or (ii) 75% of net income for the last four calendar quarters.
 
 The Bank is restricted in paying dividends on its stock to the greater of the restrictions described in the preceding paragraph, or an amount that would reduce its retained earnings below its regulatory capital requirement, the accumulated bad debt deduction, or the liquidation account described in Note 11.
 
 The Bank was allowed a special bad debt deduction at various percentages of otherwise taxable income for various years effectively through December 31, 1987. If the amounts which qualified as deductions for federal income tax purposes prior to December 31, 1987 are later used for purposes other than to absorb loan losses, including distributions in liquidations, they will be subject to federal income tax at the then current corporate rate. Retained earnings at December 31, 2003 and 2002 include $482,000, for which no provision for federal income tax has been provided. The unrecorded deferred income tax liability on the above amount was approximately $186,000.
 
 
 
 
 
 
 
 
 
 
 
 
 F-28
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 14- Income Taxes
 
 The income tax provision consists of the following for the years ended December 31:
 
 For Years Ended December 31,2003


2002


2001CurrentFederal
$
6,322,163

$
4,754,616

$
2,891,156State

1,300,105


1,053,776


643,7197,622,268


5,808,392


3,534,875DeferredFederal

(152,650
)

(226,686
)

(213,450
)State

(33,793
)

(50,184
)

(47,252
)(186,443
)

(276,870
)

(260,702
)OtherFederal

113,832


113,832


113,833State

25,200


25,200


25,200139,032


139,032


139,033$
7,574,857

$
5,670,554

$
3,413,206
 
 Other income tax provision consists of income tax from preferred stock dividends.
 
 The amount computed by applying the statutory federal income tax rate to income before federal taxes is greater than the taxes provided for the following reasons:
 
 2003
2002
2001Amount


Percent of PretaxIncome


Amount


Percent of PretaxIncome


Amount


Percent of PretaxIncomeStatutory federalincome tax / rate

$
6,427,358


34.00
%
$
4,970,383


34.00
%
$
2,947,384


34.00
%State tax net offederal incometax benefit


839,483


4.44


689,291


4.72


410,300


4.73Other adjustments


308,016


1.63


10,880


.07


55,522


.64$
7,574,857


40.07
%
$
5,670,554


38.79
%
$
3,413,206


39.37
%
 
 F-29
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 14- Income Taxes - Continued
 
 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 are presented below:
 
 2003


2002Deferred Tax Assets:Allowances for losses

$
1,863,607

$
1,541,170Reserve for uncollected interest


4,283


29,179Total gross deferred tax assets


1,867,890


1,570,349Deferred Tax Liabilities:Federal Home Loan Bank of Atlantastock dividends


(79,976
)

(79,976
)Mortgage servicing rights


(4,920
)

(7,469
)Accelerated depreciation


(506,194
)

(392,548
)Total gross deferred tax liabilities


(591,090
)

(479,993
)Net deferred tax assets

$
1,276,800

$
1,090,356
 
 
 
 Note 15- Related Party Transactions
 
 During the years ended December 31, 2003, 2002 and 2001, the Bank engaged in the transactions described below with parties that may be deemed affiliated.
 
 The land and building for the office where the Bank's primary operating activities are conducted were leased from a stockholder of the Bank. Rent paid on this property was $ -0-, $ -0- and $32,012 for 2003, 2002 and 2001, respectively. Additionally, two subsidiaries rent property from a director of the Bank. Rent paid on these properties was $49,105, $38,562 and $32,010 for 2003, 2002 and 2001, respectively.
 
 A director of the Bank is a member of a law firm that represents the Bank in certain legal matters. The fees for services rendered by that firm were $166,816, $161,890 and $80,866 for the years ended December 31, 2003, 2002 and 2001, respectively.
 
 
 
 F-30
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 15- Related Party Transactions - Continued
 
  In June, 2001 the Corporation purchased Louis Hyatt, Inc. (see Note 17) from Louis Hyatt who is a stockholder of the Corporation and a relative of the Chairman of the Board.
 
 The Corporation purchased HS West, LLC from Louis Hyatt who is a stockholder of the Corporation and a relative of the Chairman of the Board. HS West, LLC had no income or expenses and consisted only of land.
 
 Management believes that the terms in the above mentioned transactions were no less favorable to the Bank than the terms that would have been obtained in transactions with non-affiliated persons or entities.
 
 Note 16- Disclosure About Fair Value of Financial Instruments
 
 The estimated fair values of the Bank's financial instruments are summarized below. The fair values of a significant portion of these financial instruments are estimates derived using present value techniques prescribed by the FASB and may not be indicative of the net realizable or liquidation values. Also, the calculation of estimated fair values is based on market conditions at a specific point in time and may not reflect current or future fair values.
 
 The carrying amount is a reasonable estimate of fair value for cash, federal funds, interest-bearing deposits in other banks, accrued interest receivable, and accrued interest payable due to the short-term nature of these investments. Fair value is based upon market prices quoted by dealers for investment securities and estimates using bid prices published in financial newspapers for mortgage backed securities. The carrying amount of Federal Home Loan Bank of Atlanta stock is a reasonable estimate of fair value. Loans receivable were discounted using a single discount rate, comparing the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
 
 
 
 
 
 
 
 
 
 
 
 F-31
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 16- Disclosure About Fair Value of Financial Instruments - Continued
 
 These rates were used for each aggregated category of loans as reported on the Office of Thrift Supervision Quarterly Report. The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered on deposits of similar remaining maturities.
 
 The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business, including loan commitments. The loan commitments were a blended rate based on the relative risk of the properties involved and the lines of credit are at adjustable rates.
 
 The estimated fair values of the Bank's financial instruments are as follows:
 
 December 31, 2003
December 31, 2002Carrying
Value


Fair
Value


Carrying
Value


Fair
ValueFinancial AssetsCash, interest bearing deposits in otherbanks and federal funds

$
8,426,382

$
8,426,382

$
18,660,235

$
18,660,235Investment securities


6,000,000


5,922,400


4,000,000


4,048,400Mortgage backedsecurities


6,721,175


6,693,601


5,661,304


5,669,640FHLB of Atlanta stock


3,250,000


3,250,000


1,900,000


1,900,000Loans held for sale


3,174,954


3,174,954


17,481,301


17,481,301Loans receivable, net


502,851,450


457,887,000


401,343,360


373,532,000Accrued interest receivable


2,701,718


2,701,718


2,549,425


2,549,425Financial LiabilitiesDeposits

$
419,656,560

$
421,557,000

$
377,850,712

$
380,038,000FHLB advances


65,000,000


63,595,276


34,000,000


33,783,262Accrued interest payable


69,625


69,625


74,329


74,329Commitments


-


-


-


-
 
 
 
 
 F-32
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 
 Note 17- Merger
 
 On July 1, 2001, the Corporation acquired Louis Hyatt, Inc. (LHI) a real estate sales and management company (see Note 15). LHI was 100% owned by Louis Hyatt. The Corporation issued 60,000 shares new shares and transferred 20,000 shares that were previously owned by LHI for all the outstanding stock of LHI.
 
 The combination was accounted for under the purchase method of accounting, and accordingly, the net assets were recorded at their estimated fair values at the date of acquisition. LHIs assets consisted primarily of fixed assets and, accordingly, the fair market value adjustment of $1,415,829 will be depreciated over the estimated lives of the assets. The excess of the purchase price over the estimated fair value of the underlying net assets of $333,569 was allocated to goodwill.
 
 Unaudited proforma condensed financial statements are not presented because the amounts are not material to the consolidated financial statements.
 
 Note 18- Condensed Financial Information (Parent Company Only)
 
 Information as to the financial position of Severn Bancorp, Inc. as of December 31, 2003 and 2002 and results of operations and cash flows for each of the years ended December 31, 2003, 2002 and 2001 is summarized below.
 
 
 December 31,2003


2002Statement of Financial ConditionCash

$
464,505

$
363,279Equity in net assets of subsidiaries


48,835,478


39,061,475Taxes receivable


49,539


11,064$
49,349,522

$
39,435,818
 
 
 
 
 
 
 
 
 
 F-33
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 18- Condensed Financial Information (Parent Company Only) - Continued
 
 
 December 31,2003


2002Taxes payable

$
-

$
5,925Accounts payable and accrued expenses


379,369


248,556379,369


254,481Common stock


41,591


41,426Additional paid-in capital


11,516,495


11,425,910Retained earnings


37,412,067


27,714,00148,970,153


39,181,337$
49,349,522

$
39,435,818
 
 For the Years Ended December 31,2003


2002


2001Statement of OperationsDividends received from subsidiaries

$
1,410,102

$
986,631

$
718,818General and administrative expenses


95,450


137,961


27,569Net Income before income taxes and equity in undistributed netincome of subsidiaries


1,314,652


848,670


691,249Income tax benefit


(19,512
)

(56,564
)

(9,373
)Equity in undistributed net income ofsubsidiaries


9,994,974


8,042,986


4,554,948Net income

$
11,329,138

$
8,948,220

$
5,255,570
 
 December 31,2003


2002


2001Statement of Cash FlowsCash Flows from Operating Activities:Net income

$
11,329,138

$
8,948,220

$
5,255,570Adjustments to Reconcile Net Income to NetCash Provided by Operating Activities:Equity in undistributed earnings ofsubsidiaries


(9,994,974
)

(8,042,986
)

(4,554,948
)Increase in taxes receivable


(38,475
)

(11,064
)

-Decrease (increase) in other assets


-


9,550


14,824Decrease (increase) in taxes payable


(5,925
)

511


(9,298
)Increase in accounts payable andaccrued expenses


130,813


57,300


53,684Tax benefit of exercised options


-


129,728


-Net cash provided by operating activities


1,420,577


1,091,259


759,832
 
 
 F-34
   
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 
 Note 18- Condensed Financial Information (Parent Company Only) - Continued
 
 
 December 31,2003


2002


2001Cash Flows From Investing ActivitiesInvestment in subsidiaries

$
-

$
(587,878
)
$
(3,299,313
)Cash consideration Louis Hyatt, Inc.acquisition - net


-


-


(31,340
)Cash provided by (used) investingactivities


-


(587,878
)

(3,330,653
)Cash Flows from Financing ActivitiesDividends paid on capital stock


(1,410,101
)

(986,631
)

(718,818
)Proceeds from exercise of options


90,750


480,150


214,500Proceeds from exercise of warrants


-


-


3,284,813Net cash (used) provided by financingactivities


(1,319,351
)

(506,481
)

2,780,495(Decrease) increase in cash andcash equivalents

$
101,226

$
(3,100
)
$
209,674Cash and cash equivalents at beginningof year


363,279


366,379


156,705Cash and cash equivalents at end of year

$
464,505

$
363,279

$
366,379Supplemental Disclosures of Cash Flows Information:Common stock issued foracquired Company

$
-

$
-

$
1,600,000
  
 There was no cash paid during the years ended December 31, 2003, 2002 and 2001 for income taxes or interest.
 
 
 
 
 
 
 F-35
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 19- Recent Accounting Pronouncements
 
 In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This Interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under certain specified guarantees. Under FIN 45, the Bank does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit, as discussed in Note 4. Adoption of FIN 45 did not have a significant impact on the Banks financial condition or results of operations.
 
 In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 was revised in December 2003. This Interpretation provides new guidance for the consolidation of variable interest entities (VIEs) and requires such entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among parties involved. The interpretation also adds disclosure requirements for investors that are involved with unconsolidated VIEs. The disclosure requirements apply to all financial statements issued after December 31, 2003. The consolidation requirements apply to companies that have interests in special-purpose entities for periods ending after December 15, 2003. Consolidation of other types of VIEs is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation did not have and is not expected to have an impact on the Corporations financial condition or results of operations.
 
 In April 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement clarifies the definition of a derivative and incorporates certain decisions made by the Board as part of the Derivatives Implementation Group process. This Statement is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003 and should be applied prospectively. The provisions of the Statement that relate to implementation issues addressed by the Derivatives Implementation Group that have been effective should continue to be applied in accordance with their respective dates. Adoption of this standard did not have an impact on the Corporations financial condition or results of operations.
 
 In May 2003, the Financial Accounting Standards Board issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement requires that an issuer classify a financial instrument that is within its scope as a liability. Many of these instruments were previously classified as equity. This Statement was effective for financial instruments entered into or modified after May 31, 2003 and otherwise was effective beginning July 1, 2003. The adoption of this standard did not have an impact on the Corporations financial condition or results of operations.
 
 F-36
 
  
 SEVERN BANCORP, INC. AND SUBSIDIARIES
 Annapolis, Maryland
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER 31, 2003 AND 2002
 
 Note 20- Quarterly Financial Data (Unaudited)
 
 
 Summarized unaudited quarterly financial data for the year ended December 31, 2003 is as follows:
 
 Operating Summary:
****
****
**First**
**Quarter**
****
****
**Second Quarter**
****
****
**Third**
**Quarter**
****
****
**Fourth**
**Quarter**
********
****
****
****
****
****
****
****
****
****
****
****
****
****Interest Income
****
**$**
**8,863,214**
****
**$**
**9,172,403**
****
**$**
**9,459,964**
****
**$**
**9,591,425**
****Interest Expense
****
****
**3,137,156**
****
****
**3,105,706**
****
****
**3,064,482**
****
****
**3,033,733**
********
****
****
****
****
****
****
****
****
****Net Interest Income
****
****
**5,726,058**
****
****
**6,066,697**
****
****
**6,395,482**
****
****
**6,557,692**
****Provision for Loan Losses
****
****
**225,000**
****
****
**225,000**
****
****
**225,000**
****
****
**225,000**
********
****
****
****
****
****
****
****
****
****Net Interest Income afterprovision for loan losses
****
****
**5,501,058**
****
****
**5,841,697**
****
****
**6,170,482**
****
****
**6,332,692**
****Other Income
****
****
**1,165,065**
****
****
**1,317,817**
****
****
**1,319,317**
****
****
**871,439**
****Other Expense
****
****
**2,120,847**
****
****
**2,602,612**
****
****
**2,468,117**
****
****
**2,423,996**
********
****
****
****
****
****
****
****
****
****Income beforeincome tax provision
****
****
**4,545,276**
****
****
**4,556,902**
****
****
**5,021,682**
****
****
**4,780,135**
****Income Taxes
****
****
**1,838,664**
****
****
**1,759,484**
****
****
**1,935,136**
****
****
**2,041,573**
********
****
****
****
****
****
****
****
****
****Net Income
****
**$**
**2,706,612**
****
**$**
**2,797,418**
****
**$**
**3,086,546**
****
**$**
**2,738,562**
********
****
****
****
****
****
****
****
****
****Per share data:
****
****
****
****
****
****
****
****
****
****
****
****
****Earnings  basic
****
**$**
**.64**
****
**$**
**.66**
****
**$**
**.73**
****
**$**
**.65**
****Earnings  diluted
****
**$**
**.64**
****
**$**
**.66**
****
**$**
**.73**
****
**$**
**.65**
****
 
 Summarized unaudited quarterly financial data for the year ended December 31, 2002 is as follows:
 
 Operating Summary:


First
Quarter


Second Quarter


Third Quarter


Fourth QuarterInterest Income

$
7,799,000

$
8,167,122

$
8,510,349

$
8,925,528Interest Expense


3,585,497


3,349,683


3,468,175


3,395,922Net Interest Income


4,213,503


4,817,439


5,042,174


5,529,606Provision for Loan Losses


105,000


135,000


205,000


225,000Net Interest Income afterprovision for loan losses


4,108,503


4,682,439


4,837,174


5,304,606Other Income


867,306


894,455


749,465


1,621,459Other Expense


1,882,313


1,994,795


1,948,119


2,621,406Income before income tax provision


3,093,496


3,582,099


3,638,520


4,304,659Income Taxes


1,197,497


1,404,558


1,404,963


1,663,536Net Income

$
1,895,999

$
2,177,541

$
2,233,557

$
2,641,123Per share dataEarnings  basic

$
.45

$
.52

$
.53

$
.63Earnings  diluted

$
.45

$
.51

$
.53

$
.63
 
 F-37