Report of
Independent Registered


Public Accounting
Firm




To the
Board of Directors and Stockholders


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, 2004 and 2003, and the related
consolidated statements of income, stockholders’ equity and cash flows for each
of the three years in the period ended December 31, 2004. These
consolidated financial statements are the responsibility of the Company’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 the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the 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 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, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with accounting principles generally
accepted in the United States of America.
















Baltimore,
Maryland


March 11,
2005











*320
East Market Street         P.O. Box
625        Harrisburg, PA 
17108-0625*


*Tel. 
717-236-1100         Fax
717-236-2200        
www.beardmiller.com*








F-1








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION


(dollars in
thousands, except per share data)





December
      31,2004
    
    
    2003ASSETSCash and due
      from banks
    
    $
    7,950
    
    $
    4,055Interest
      bearing deposits in other banks
    
    
    3,259
    
    
    457Federal funds
      sold
    
    
    6,829
    
    
    3,914Cash and cash
      equivalents
    
    
    18,038
    
    
    8,426Investment
      securities held to maturity
    
    
    9,955
    
    
    12,721Loans held
      for sale
    
    
    6,654
    
    
    3,175Loans
      receivable, net of allowance for loan losses of$5,935 and
      $4,832, respectively
    
    
    650,313
    
    
    502,851Premises and
      equipment, net
    
    
    7,004
    
    
    5,327Federal Home
      Loan Bank stock at cost
    
    
    5,083
    
    
    3,250Accrued
      interest receivable and other assets
    
    
    6,569
    
    
    4,721Total
      assets
    
    $
    703,616
    
    $
    540,471LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilitiesDeposits
    
    $
    527,413
    
    $
    419,726Short-term
      borrowings
    
    
    -
    
    
    6,000Long-term
      borrowings
    
    
    89,000
    
    
    59,000Subordinated
      debentures
    
    
    20,619
    
    
    -Accrued
      interest payable and other liabilities
    
    
    2,430
    
    
    2,775Total
      liabilities
    
    
    639,462
    
    
    487,501Minority
      interest - preferred securities of subsidiary
    
    
    4,000
    
    
    4,000Stockholders’
      EquityCommon stock,
      $0.01 par value, 20,000,000 shares authorized;8,318,184 and
      4,159,092 issued and outstanding, respectively
    
    
    83
    
    
    42Additional
      paid-in capital
    
    
    11,516
    
    
    11,516Retained
      earnings
    
    
    48,555
    
    
    37,412Total
      stockholders' equity
    
    
    60,154
    
    
    48,970Total
      liabilities and stockholders' equity
    
    $
    703,616
    
    $
    540,471





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







F-2


SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


CONSOLIDATED
STATEMENTS OF INCOME


(dollars in
thousands, except per share data)


Years Ended
      December 31,Interest
      Income
    
    
    2004
    
    
    2003
    
    
    2002Loans
    
    $
    43,881
    
    $
    36,403
    
    $
    32,723Securities,
      taxable
    
    
    419
    
    
    453
    
    
    416Other
    
    
    319
    
    
    231
    
    
    263Total
      interest income
    
    
    44,619
    
    
    37,087
    
    
    33,402Interest
      ExpenseDeposits
    
    
    11,292
    
    
    10,961
    
    
    12,300Short-term
      borrowings
    
    
    259
    
    
    9
    
    
    155Long-term
      borrowings
    
    
    3,080
    
    
    1,371
    
    
    1,344Total
      interest expense
    
    
    14,631
    
    
    12,341
    
    
    13,799Net interest
      income
    
    
    29,988
    
    
    24,746
    
    
    19,603Provision for
      loan losses
    
    
    1,200
    
    
    900
    
    
    670Net interest
      income after provision for loan losses
    
    
    28,788
    
    
    23,846
    
    
    18,933Other
      IncomeMortgage
      banking activities
    
    
    1,435
    
    
    2,491
    
    
    1,988Real estate
      commissions
    
    
    1,234
    
    
    1,160
    
    
    1,237Real estate
      management fees
    
    
    404
    
    
    369
    
    
    383Gain on sale
      of foreclosed real estate
    
    
    -
    
    
    169
    
    
    -Other
      income
    
    
    539
    
    
    485
    
    
    525Total other
      income
    
    
    3,612
    
    
    4,674
    
    
    4,133Non-Interest
      ExpensesCompensation
      and related expenses
    
    
    8,167
    
    
    6,976
    
    
    6,065Occupancy
    
    
    610
    
    
    534
    
    
    488Other
    
    
    2,434
    
    
    2,106
    
    
    1,894Total
      non-interest expenses
    
    
    11,211
    
    
    9,616
    
    
    8,447Income before
      income tax provision
    
    
    21,189
    
    
    18,904
    
    
    14,619Income tax
      provision
    
    
    8,258
    
    
    7,575
    
    
    5,671Net
      income
    
    $
    12,931
    
    $
    11,329
    
    $
    8,948Basic
      earnings per share
    
    $
    1.56
    
    $
    1.34
    
    $
    1.06Diluted
      earnings per share
    
    $
    1.56
    
    $
    1.33
    
    $
    1.06





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, 2004, 2003, and 2002


(dollars in
thousands, except per share data)





Common
      Stock
    
    
    Additional
      Paid-In Capital
    
    
    Retained
      Earnings
    
    
    Total
      Stockholders’ EquityBalance -
      December 31, 2001
    $
    13
    
    $
    10,817
    
    $
    20,000
    
    $
    30,830Comprehensive
      IncomeNet
      income
    
    -
    
    
    -
    
    
    8,948
    
    
    8,948Three-for-one
      stock split in theform of a
      200% dividend
    
    27
    
    
    -
    
    
    (27
    )
    
    -Exercise of
      85,500 options
    
    1
    
    
    479
    
    
    -
    
    
    480Tax benefit
      of exercised options
    
    -
    
    
    130
    
    
    -
    
    
    130Other
    
    -
    
    
    -
    
    
    (221
    )
    
    (221
    )Dividends on
      common stock($.12 per
      share)
    
    -
    
    
    -
    
    
    (986
    )
    
    (986
    )Balance -
      December 31, 2002
    
    41
    
    
    11,426
    
    
    27,714
    
    
    39,181Comprehensive
      IncomeNet
      income
    
    -
    
    
    -
    
    
    11,329
    
    
    11,329Exercise of
      16,500 options
    
    1
    
    
    90
    
    
    -
    
    
    91Other
    
    -
    
    
    -
    
    
    (221
    )
    
    (221
    )Dividends on
      common stock($.17 per
      share)
    
    -
    
    
    -
    
    
    (1,410
    )
    
    (1,410
    )Balance -
      December 31, 2003
    
    42
    
    
    11,516
    
    
    37,412
    
    
    48,970Comprehensive
      IncomeNet
      income
    
    -
    
    
    -
    
    
    12,931
    
    
    12,931Two-for-one
      stock split in theform of a
      100% dividend
    
    41
    
    
    -
    
    
    (41
    )
    
    -Dividends on
      common stock($.21 per
      share)
    
    -
    
    
    -
    
    
    (1,747
    )
    
    (1,747
    )Balance -
      December 31, 2004
    $
    83
    
    $
    11,516
    
    $
    48,555
    
    $
    60,154





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











F-4








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(dollars in
thousands)


Years Ended
      December 31,2004
    
    
    2003
    
    
    2002Cash Flows
      from Operating ActivitiesNet
      income
    
    $
    12,931
    
    $
    11,329
    
    $
    8,948Adjustments
      to reconcile net income to netcash provided
      by (used in) operating activities:Amortization
      of deferred loan fees
    
    
    (3,390
    )
    
    (2,417
    )
    
    (2,123
    )Net
      amortization (accretion) of premiums anddiscounts
    
    
    33
    
    
    78
    
    
    (4
    )Provision for
      loan losses
    
    
    1,200
    
    
    900
    
    
    670Provision for
      depreciation
    
    
    329
    
    
    291
    
    
    260Gain on sale
      of foreclosed real estate
    
    
    -
    
    
    (169
    )
    
    -Gain on sale
      of loans
    
    
    (791
    )
    
    (1,563
    )
    
    (1,264
    )Proceeds from
      loans sold to others
    
    
    71,664
    
    
    135,435
    
    
    101,798Loans
      originated for sale
    
    
    (74,370
    )
    
    (119,660
    )
    
    (110,565
    )Principal
      collected on loans originated for sale
    
    
    18
    
    
    94
    
    
    48Tax effect of
      exercised options
    
    
    -
    
    
    -
    
    
    130Increase in
      accrued interest receivableand other
      assets
    
    
    (1,848
    )
    
    (313
    )
    
    (862
    )Decrease in
      accrued interest payable andother
      liabilities
    
    
    (346
    )
    
    (464
    )
    
    (64
    )Net cash
      provided by (used in) operating activities
    
    
    5,430
    
    
    ****23,541
    
    
    (3,028
    )Cash Flows
      from Investing ActivitiesPurchase of
      investment securities
    
    
    -
    
    
    (14,485
    )
    
    (9,760
    )Proceeds from
      maturing investment securities
    
    
    1,000
    
    
    8,000
    
    
    7,000Principal
      collected on mortgage backed securities
    
    
    1,733
    
    
    3,318
    
    
    308Net increase
      in loans
    
    
    (145,271
    )
    
    (99,716
    )
    
    (64,544
    )Loans
      purchased
    
    
    -
    
    
    (246
    )
    
    (197
    )Proceeds from
      sale of foreclosed real estate
    
    
    -
    
    
    393
    
    
    88Investment in
      premises and equipment
    
    
    (2,006
    )
    
    (880
    )
    
    (355
    )(Purchase)
      Redemption of FHLB stock
    
    
    (1,833
    )
    
    (1,350
    )
    
    600Net cash used
      in investing activities
    
    
    (146,377
    )
    
    (104,966
    )
    
    (66,860
    )




















F-5








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(dollars in
thousands)


For the Years
      Ended December 31,2004
    
    
    2003
    
    
    2002Cash Flows
      from Financing ActivitiesNet increase
      in deposits
    
    $
    107,687
    
    $
    41,510
    
    $
    91,016Net increase
      (decrease) in short term borrowings
    
    
    (6,000
    )
    
    6,000
    
    
    (17,000
    )Additional
      borrowed funds, long term
    
    
    35,000
    
    
    35,000
    
    
    17,000Repayment of
      borrowed funds, long term
    
    
    (5,000
    )
    
    (10,000
    )
    
    (8,000
    )Cash
      dividends paid
    
    
    (1,747
    )
    
    (1,410
    )
    
    (986
    )Proceeds from
      exercise of options
    
    
    -
    
    
    91
    
    
    480Proceeds from
      issuance of subordinated debentures
    
    
    20,619
    
    
    -
    
    
    -Net cash
      provided by financing activities
    
    
    150,559
    
    
    71,191
    
    
    82,510Increase
      (Decrease) in cash and cash equivalents
    
    
    9,612
    
    
    (10,234
    )
    
    12,622Cash and cash
      equivalents at beginning of year
    
    
    8,426
    
    
    18,660
    
    
    6,038Cash and cash
      equivalents at end of year
    
    $
    18,038
    
    $
    8,426
    
    $
    18,660Supplemental
      disclosure of cash flows information:Cash paid
      during year for:Interest
    
    $
    14,587
    
    $
    12,433
    
    $
    13,805Income
      taxes
    
    $
    8,559
    
    $
    7,577
    
    $
    5,556





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


























F-6








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS







**Note 1 -** **Summary
of Significant Accounting Policies**





**A.**  **Principles
of Consolidation -** The consolidated
financial statements include the accounts of Severn Bancorp, Inc. ("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, which qualified as a real estate investment trust ("REIT")
under the Internal Revenue Code of 1986, as amended, liquidated effective
January 31, 2005.





**B.****Business**
-The
Bank's primary business activity is the acceptance of depositsfrom the general
public and the use of the proceeds for investments and loan originations. The
Bank is subject to competition from other financial institutions. In addition,
the Bank is subject to the regulations of certain federal agencies and undergoes
periodic examinations by those regulatory authorities.





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.
































F-7








SEVERN BANCORP,
INC.  AND
SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**





**D.
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. Declines in the fair value of held to maturity
securities below their cost that are deemed to be other than temporary are
reflected in earnings as realized losses. In estimating other than temporary
impairment losses, management considers (1) the length of time and the extent to
which the fair value has been less than cost, (2) the financial condition and
near term prospects of the issuer, and (3) the intent and ability of the Bank to
retain its investment in the issuer for a period of time sufficient to allow for
any anticipated recovery in fair value.





**E. 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. Mortgage loans held for sale are generally sold with the mortgage
servicing rights released by the Bank. Gains and losses on sales of mortgage
loans are recognized based on the difference between the selling price and the
carrying value of the related mortgage loans sold.





**F. Loans**- Loans that
management has the intent and ability to hold for the foreseeable future or
until maturity or pay-off generally are reported at their outstanding unpaid
principal balances adjusted for charge-offs, the allowance for loan losses, and
any deferred fees or costs on originated loans. Interest income is accrued on
the unpaid principal balance. Loan origination fees, net of certain direct
origination costs, are deferred and recognized as an adjustment of the related
loan yield using the interest method.





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





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














F-8








SEVERN BANCORP,
INC.  AND
SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**





**G.****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 allowance 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. ****


****


The allowance
consists of specific, general and unallocated components. The specific component
relates to loans that are classified as either doubtful, substandard or special
mention. For such loans that are also classified as impaired, an allowance is
established when the discounted cash flows (or collateral value or observable
market price) or the impaired loan is lower than the carrying value of that
loan. The general component covers non-classified loans and is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained to cover uncertainties that could affect management’s
estimate of probable losses. The unallocated component of the allowance reflects
the margin of imprecision inherent in the underlying assumptions used in the
methodologies for estimating specific and general losses in the
portfolio.














F-9








SEVERN BANCORP,
INC.  AND
SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS





**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**





A loan is
considered impaired when, based on current information and events, it is
probable that the Bank will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment, include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower’s prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan-by-loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loan’s
effective interest rate, the loan’s obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.





Large groups of
smaller balance homogeneous loans are collectively evaluated for impairment.
Accordingly, the Bank does not separately identify individual consumer and
residential loans for impairment disclosures, unless such loans are the subject
of a restructuring agreement.





**H.  
Foreclosed
Real Estate -**Real estate
acquired through or in the process of foreclosure is recorded at 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





**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**





**I.   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. Mortgage servicing rights
totaled $6,000 and $13,000 at December 31, 2004 and 2003, respectively, and are
included in Other Assets.





**J.****Transfers
of Financial Assets -**Transfers of
financial assets, including loan and loan participation sales, are accounted for
as sales, when control over the assets has been surrendered. Control over
transferred assets is deemed to be surrendered when (1) the assets have been
isolated from 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.





**K.**  **Premises
and Equipment -** Premises and
equipment are carried at cost less accumulated depreciation. Depreciation and
amortization of premises and equipment is accumulated by the use of the
straight-line method over the estimated useful lives of the assets. Additions
and improvements are capitalized, and charges for repairs and maintenance are
expensed when incurred. The related cost and accumulated depreciation are
eliminated from the accounts when an asset is sold or retired and the resultant
gain or loss is credited or charged to income.





**L. Income Taxes
-**Deferred income
taxes are recognized for temporary differences between the financial reporting
basis and income tax basis of assets and liabilities based on enacted tax rates
expected to be in effect when such amounts are realized or settled. Deferred tax
assets are recognized only to the extent that it is more likely than not that
such 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.

**M. 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, and federal funds
sold.
























F-11








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**





**N.**  **Earnings
Per Share -** Basic earnings per
share of common stock for the years ended December 31, 2004, 2003 and 2002 is
computed by dividing net income available to common stockholders by 8,318,184,
8,293,132 and 8,184,376, respectively, the weighted average number of shares of
common stock outstanding for each year. Diluted earnings per share reflects
additional common shares that would have been outstanding if dilutive potential
common shares had been issued. Potential common shares that may be issued by the
Corporation relate solely to outstanding stock options, and are determined using
the treasury stock method. Diluted earnings per share of common stock for the
years ended December 31, 2004, 2003 and 2002, is computed by dividing net income
available to common stockholders for each year by 8,318,184, 8,314,604 and
8,206,446, respectively, the weighted average number of diluted shares of common
stock. The above amounts have been retroactively adjusted to give effect to a
2-for-1 stock split in the form of a 100% stock dividend declared in November
2004.





**O.**  **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.





**P.**  **Advertising
Cost -** Advertising cost is
expensed as incurred and totaled $240,000, $131,000 and $131,000 for the years
ended December 31, 2004, 2003, and 2002, respectively.





**Q.  Reclassifications
-**Certain prior year
amounts have been reclassified to conform to the current year's method of
presentation. These reclassifications had no effect on net
income.





**R.****Recent
Accounting Pronouncements -**In March 2004, the
SEC released Staff Accounting Bulletin (SAB) No. 105, “Application of Accounting
Principles to Loan Commitments.” SAB 105 provides guidance about the
measurements of loan commitments recognized at fair value under FASB Statement
No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SAB 105
also requires companies to disclose their accounting policy for those loan
commitments including methods and assumptions used to estimate fair value and
associated hedging strategies. SAB 105 is effective for all loan commitments
accounted for as derivatives that are entered into after March 31, 2004. The
adoption of SAB 105 did not have a material effect on the Corporation’s
consolidated financial statements.





















F-12







SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 1 -** **Summary
of Significant Accounting Policies** **-
Continued**








In December 2003,
the Accounting Standards Executive Committee issued Statement of Position 03-3
(SOP 03-3), “Accounting for Certain Loans or Debt Securities Acquired in a
Transfer.” SOP 03-3 addresses accounting for differences between contractual
cash flows and cash flows expected to be collected from an investor’s initial
investment in loans or debt securities acquired in a transfer, including
business combinations, if those differences are attributable, at least in part,
to credit quality. SOP 03-3 is effective for loans or debt securities acquired
in fiscal years beginning after December 15, 2004. The Corporation adopted the
provisions of SOP 03-3 effective January 1, 2005, and the initial implementation
did not have any effect on the Corporation’s consolidated financial statements.
Such guidance, however, will have an effect on the accounting for future
business combinations after the effective date.



































F-13








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 2 -** **Investment
Securities** ****





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







Amortized
      Cost
    
    Gross
      Unrealized Gains
    
    Gross
      Unrealized Losses
    
    Fair
      Value(dollars in
      thousands)December
      31, 2004:Federal Home
      Loan Bank(“FHLB”)
      Notes
    $
    5,000
    
    $
    -
    
    $
    78
    
    $
    4,922Mortgage
      backed securities
    
    4,955
    
    
    7
    
    
    70
    
    
    4,892$
    9,955
    
    $
    7
    
    $
    148
    
    $
    9,814December
      31, 2003:Federal Home
      Loan Bank(“FHLB”)
      Notes
    $
    6,000
    
    $
    -
    
    $
    78
    
    $
    5,922Mortgage
      backed securities
    
    6,721
    
    
    18
    
    
    45
    
    
    6,694$
    12,721
    
    $
    18
    
    $
    123
    
    $
    12,616











FHLB Notes in the
amount of $2,000,000 and mortgage backed securities in the amount of $1,816,000
are pledged as collateral for the Bank’s standby letters of credit issued on
behalf of various borrowers and developers in favor of Anne Arundel
County.





The scheduled
maturities of investment securities held to maturity are as follows at December
31, 2004:





Amortized
      Cost
    
    
    Fair
      Value(dollars in
      thousands)Due after one
      year through five years
    
    $
    5,815
    
    $
    5,700More than
      five to ten years
    
    
    1,000
    
    
    1,000Greater than
      10 years
    
    
    3,140
    
    
    3,114$
    9,955
    
    $
    9,814










F-14








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 2 -** **Investment
Securities** **-
Continued**





The following table
shows fair value and unrealized losses, aggregated by investment category and
length of time that the individual securities have been in a continuous
unrealized loss position as of December 31, 2004. Included in the table are two
Federal Home Loan Bank notes and four mortgage backed securities. Management
believes that the unrealized losses are the result of interest rate levels
differing from those existing at the time of purchase of the securities and, as
to mortgage backed securities, actual and estimated prepayment speeds. These
unrealized losses are considered temporary as they reflect fair values on
December 31, 2004 and are subject to change daily as interest rates
fluctuate.








Less than 12
      months
    12 Months or
      More
    TotalFair
      Value
    
    
    UnrealizedLosses
    
    
    Fair
      Value
    
    
    UnrealizedLosses
    
    
    Fair
      Value
    
    
    UnrealizedLosses(dollars in
      thousands)Federal Home
      Loan Bank Notes
    
    $
    1,975
    
    $
    25
    
    $
    1,947
    
    $
    53
    
    $
    3,922
    
    $
    78Mortgage
      Backed Securities
    
    
    4,830
    
    
    70
    
    
    -
    
    
    -
    
    
    4,830
    
    
    70Total
      temporarily impaired securities
    
    $
    6,805
    
    $
    95
    
    $
    1,947
    
    $
    53
    
    $
    8,752
    
    $
    148





























F-15








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 3 -** **Loans
Receivable**





Loans receivable
consist of the following:





December
      31,2004
    
    
    2003(dollars in
      thousands)Residential
      mortgage
    
    $
    215,767
    
    $
    187,498Construction,
      land acquisition anddevelopment
    
    
    343,101
    
    
    240,757Land
    
    
    33,419
    
    
    25,820Lines of
      credit
    
    
    29,096
    
    
    19,581Commercial
      real estate
    
    
    127,768
    
    
    106,823Commercial
      non-real estate
    
    
    3,859
    
    
    3,813Home
      equity
    
    
    28,101
    
    
    18,391Consumer
    
    
    2,489
    
    
    2,364783,600
    
    
    605,047LessLoans in
      process
    
    
    (123,195
    )
    
    (94,020
    )Allowance for
      loan losses
    
    
    (5,935
    )
    
    (4,832
    )Deferred loan
      origination fees
    
    
    (4,157
    )
    
    (3,344
    )$
    650,313
    
    $
    502,851





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 of a property and requires private
mortgage insurance on residential mortgages with loan-to-value ratios in excess
of 80%.











F-16








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 3 -** **Loans
Receivable** **-
Continued**





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





The following is a
summary of the allowance for loan losses for the three years ended December
31:





2004
    
    
    2003
    
    
    2002(dollars in
      thousands)Balance at
      beginning of year
    
    $
    4,832
    
    $
    3,991
    
    $
    3,353Provision for
      loan losses
    
    
    1,200
    
    
    900
    
    
    670Charge-offs
    
    
    (97
    )
    
    (59
    )
    
    (32
    )Balance at
      end of year
    
    $
    5,935
    
    $
    4,832
    
    $
    3,991





The following table
summarizes impaired loans as defined by SFAS No.114 for the years ended December
31:





2004
    
    
    2003
    
    
    2002(dollars in
      thousands)Recorded
      investment
    
    $
    -
    
    $
    -
    
    $
    253Average
      balances
    
    $
    -
    
    $
    -
    
    $
    372Interest
      income that would have beenrecorded
    
    $
    -
    
    $
    -
    
    $
    30Interest
      income recognized
    
    $
    -
    
    $
    -
    
    $
    22Interest
      income not recognized
    
    $
    -
    
    $
    -
    
    $
    8













F-17








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS





**Note 3 -** **Loans
Receivable** **-
Continued**





Nonaccrual loans
amounted to approximately $939,000 and $469,000 at December 31, 2004 and 2003,
respectively. The Bank had no loans greater than ninety days past due and still
accruing at December 31, 2004 and 2003.





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:





2004
    
    
    2003
    
    
    2002(dollars in
      thousands)Interest
      income that would havebeen
      recorded
    
    $
    70
    
    $
    28
    
    $
    126Interest
      income recognized
    
    
    37
    
    
    17
    
    
    59Interest
      income not recognized
    
    $
    33
    
    $
    11
    
    $
    67





Mortgage loans
serviced for others not included in the accompanying consolidated statements of
financial condition totaled $23,363,000 and $24,016,000 at December 31, 2004 and
2003, 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.





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.














F-18








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 3 -** **Loans
Receivable** **-
Continued**








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
      31,2004
    
    
    2003(dollars in
      thousands)Standby
      letters of credit
    
    $
    7,866
    
    $
    7,982Home equity
      lines of credit
    
    
    16,497
    
    
    12,142Unadvanced
      construction commitments
    
    
    123,195
    
    
    94,020Loan
      commitments
    
    
    18,188
    
    
    24,520Lines of
      credit
    
    
    24,831
    
    
    20,436Loans sold
      and serviced with limitedrepurchase
      provisions
    
    $
    25,709
    
    $
    32,877





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, 2004 and 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, 2004
include $11,537,000 at fixed rates ranging from 4.5% to 8.0% and $6,651,000 at
rates ranging from prime plus 1% 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




**Note 3 -** **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, 2004 and 2003
as a liability for credit loss.





**Note 4 -** **Premises
and Equipment**





Premises and
equipment are summarized by major classification as follows:





December
      31,
    
    Estimated2004
    
    
    2003
    
    
    Useful
      Lives(dollars in
      thousands)Land
    
    $
    1,924
    
    $
    1,924
    
    
    -Building
    
    
    2,290
    
    
    1,931
    
    
    39
      YearsLeasehold
      improvements
    
    
    592
    
    
    574
    
    
    15-27.5
      YearsFurniture,
      fixtures and equipment
    
    
    2,052
    
    
    1,759
    
    
    3-10
      YearsConstruction
      in progress
    
    
    2,023
    
    
    711
    
    
    -Total at
      cost
    
    
    8,881
    
    
    6,899Accumulated
      depreciation
    
    
    (1,877
    )
    
    (1,572
    )$
    7,004
    
    $
    5,327





Depreciation
expense for the years ended December 31, 2004, 2003 and 2002 was $329,000,
$291,000, and $260,000, respectively.





HS West, LLC is
constructing a building in Annapolis, Maryland to serve as the Corporation’s
administrative headquarters. A branch office will be included. To date, HS West,
LLC has incurred approximately $3,122,000 of costs, which are included in land
and construction in progress above. The total cost is expected to be
approximately $20,700,000 before interior fit-out, with completion expected in
February 2006. Interest capitalized during the year ended December 31, 2004 and
2003 was $53,000 and $39,000, respectively. There was no interest capitalized
during 2002.





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, (in thousands)2005
    
    $
    992006
    
    
    852007
    
    
    602008
    
    
    602009
    
    
    60Thereafter
    
    
    35










F-20








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 4 -** **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 $108,000, $78,000, and $65,000 for the years ended December 31, 2004, 2003
and 2002, respectively.





**Note 5 -** **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 6 -** **Deposits**





Deposits in the
Bank as of December 31, 2004 and 2003 consisted of the following:








2004
    2003Category
    
    
    Amount
    
    
    Percent
    
    
    Amount
    
    
    Percent(dollars in
      thousands)NOW
      accounts
    
    $
    4,872
    
    
    0.92
    %
    $
    8,610
    
    
    2.06
    %Money market
      accounts
    
    
    131,014
    
    
    24.85
    %
    
    152,413
    
    
    36.31
    %Passbooks
    
    
    18,198
    
    
    3.45
    %
    
    19,191
    
    
    4.57
    %Certificates
      of deposit
    
    
    356,447
    
    
    67.58
    %
    
    226,902
    
    
    54.06
    %Non-interest
      bearing accounts
    
    
    16,882
    
    
    3.20
    %
    
    12,610
    
    
    3.00
    %Total
      deposits
    
    $
    527,413
    
    
    100.00
    %
    $
    419,726
    
    
    100.00
    %













F-21








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 6 -** **Deposits** **-
Continued**





At December 31,
2004 scheduled maturities of certificates of deposit are as
follows:




Amount(dollars in
      thousands)One year or
      less
    
    $
    231,089More than 1
      year to 2 years
    
    
    79,172More than 2
      years to 3 years
    
    
    26,707More than 3
      years to 4 years
    
    
    12,062More than 4
      years to 5 years
    
    
    7,376More than 5
      years
    
    
    41$
    356,447





The aggregate
amount of jumbo certificates of deposit with a minimum denomination of $100,000
was $131,870,000 and $57,879,000 at December 31, 2004 and 2003,
respectively.





Interest expense on
deposits is summarized as follows:





For Years
      Ended December 31,2004
    
    
    2003
    
    
    2002(dollars in
      thousands)NOW
      accounts
    
    $
    59
    
    $
    65
    
    $
    75Money market
      accounts
    
    
    2,350
    
    
    2,596
    
    
    2,854Passbooks
    
    
    283
    
    
    336
    
    
    556Certificates
      of deposit
    
    
    8,600
    
    
    7,964
    
    
    8,815$
    11,292
    
    $
    10,961
    
    $
    12,300














F-22








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 7 -** **Federal
Home Loan Bank Advances**





The Bank's credit
availability under the FHLB of Atlanta’s credit availability program was
$210,422,000 and $134,688,000 at December 31, 2004 and 2003, respectively.
Advances outstanding were $89,000,000 and $65,000,000 at December 31, 2004 and
2003, respectively. The maturities of these advances at December 31, 2004 are as
follows (dollars in thousands):





Description
    
    
    Rate
    
    
    Amount
    
    
    MaturityFHLB
      advances
    
    
    4.52
    %
    
    2,000
    
    
    2005FHLB
      advances
    
    
    2.99% to
      3.24
    %
    
    10,000
    
    
    2006FHLB
      advances
    
    
    2.89% to
      4.01
    %
    
    15,000
    
    
    2007FHLB
      advances
    
    
    3.33
    %
    
    5,000
    
    
    2008FHLB
      advances
    
    
    3.09
    %
    
    5,000
    
    
    2009FHLB
      advances
    
    
    2.57% to
      4.48
    %
    
    52,000
    
    
    Thereafter$
    89,000





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 8 -** **Subordinated
Debentures**





Bancorp has a
non-consolidated subsidiary trust, Severn Capital Trust I, 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 (the
capital securities) to third-party investors and investing the proceeds from the
sale of such capital securities solely in subordinated debt securities of
Bancorp (the debentures). The 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 debentures held by the trust. The capital securities are
subject to mandatory redemption, in whole or in part, upon repayment of the
debentures. Bancorp has entered into an agreement which, taken collectively,
fully and unconditionally guarantees the capital securities subject to the terms
of the guarantee. The debentures held by Severn Capital Trust I are first
redeemable, in whole or in part, by the Bancorp on January 7, 2010.





The subordinated
debentures from Bancorp to the trust consist of a $20,619,000 note, which is at
a floating rate of interest of LIBOR plus 200 basis points, and matures in
2035.





$17,000,000 of the
proceeds from Bancorp’s issuance of the debentures was contributed to the Bank,
and qualifies as Tier 1 capital for the Bank under Federal Reserve Board
guidelines.











F-23








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 9 -** **Employee
Benefit Plans**





The Bank had a
Supplemental Executive Retirement Plan covering selected officers, and elected
to terminate the plan in January 2005. The plan was funded by Bank owned life
insurance policies, of which the Bank was the beneficiary. The amount of cost
recognized for the years ended December 31, 2004, 2003 and 2002 was $12,000 per
year.





The Bank has a
401(k) Retirement Savings Plan. Employees may contribute a percentage of their
salary up to a maximum of $13,000 for 2004. 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 $104,000,
$79,000 and $93,000 for the years ended December 31, 2004, 2003 and 2002,
respectively.





The Bank has an
Employee Stock Ownership Plan ("ESOP") for the exclusive benefit of
participating employees. The Bank recognized ESOP expense of $140,000 for each
of the years ended December 31, 2004, 2003 and 2002.





**Note 10-** **Minority
Interest**





Minority interest
represented the equity attributable to that portion of a consolidated subsidiary
(Severn Preferred Capital Corporation) that was owned by parties independent of
the Corporation.





Severn Preferred
Capital Corporation issued 200,002 shares of preferred stock at $20.00 per
share, which were acquired by independent parties. The Bank purchased all of the
outstanding common stock. Severn Preferred Capital Corporation liquidated
effective January 31, 2005.





**Note 11-** **Stockholders’
Equity**





In November, 2004,
the Corporation’s Board of Directors declared a 2-for-1 stock split in the form
of a 100% stock dividend, which was effective for shares outstanding as of
December 15, 2004 and was distributed December 30, 2004. All per share data in
the accompanying financial statements and all share and per share data in the
footnotes (except for the stock option disclosures below) have been adjusted to
give retroactive effect to this transaction.











F-24








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 11-** **Stockholders
Equity** **-
Continued**





The Bank’s Stock
Option Plan (“Plan”) provided for the granting of options to acquire common
stock to directors and key employees. Option prices were 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, of which all have been exercised as
of December 31, 2003.





The following table
summarizes the status of and changes in the Bank’s stock option
plan.





Shares
    
    
    Weighted
      Average Exercise PriceOutstanding
      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
    
    
    -
    
    $
    -





As
of December 31, 2004, there were 144,000 options available to be granted under
the Plan.








**Note 12-** **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, 2004
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-25








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 12-** **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, 2004, that the Bank meets all capital
adequacy requirements to which it is subject.





As of December 31,
2004, the most recent notification from the regulators categorized the Bank as
well capitalized under the regulatory framework for prompt corrective action. To
be categorized as well capitalized the Bank must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
table. There are no conditions or events since that notification that management
believes have changed the Bank’s category. The Bank’s actual capital amounts and
ratios are also presented in the table.





The following table
presents the Bank's capital position based on the financial
statements.





Actual
    
    For Capital
      Adequacy
      Purposes
    
    To Be
      Well
      Capitalized
      Under
      Prompt
      Corrective
      Action
      ProvisionsAmount
    
    %
    
    Amount
    
    %
    
    Amount
    
    %(dollars in
      thousands)December 31,
      2004Tangible
      (1)
    $73,572
    
    10.5%
    
    $10,521
    
    1.50%
    
    N/A
    
    N/ATier I
      capital (2)
    73,572
    
    13.4%
    
    N/A
    
    N/A
    
    $33,023
    
    6.00%Core
      (1)
    73,572
    
    10.5%
    
    28,056
    
    4.00%
    
    35,070
    
    5.00%Risk-weighted
      (2)
    79,419
    
    14.4%
    
    44,031
    
    8.00%
    
    55,039
    
    10.00%December 31,
      2003Tangible
      (1)
    $49,569
    
    9.2%
    
    $8,095
    
    1.50%
    
    N/A
    
    N/ATier I
      capital (2)
    49,569
    
    12.0%
    
    N/A
    
    N/A
    
    $24,692
    
    6.00%Core
      (1)
    49,569
    
    9.2%
    
    21,588
    
    4.00%
    
    26,984
    
    5.00%Risk-weighted
      (2)
    54,314
    
    13.2%
    
    32,923
    
    8.00%
    
    41,154
    
    10.00%










(1) To adjusted
total assets.


(2) To
risk-weighted assets.













F-26








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 12-** **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
stockholders’ equity below its regulatory capital requirement, or the
accumulated bad debt deduction.





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.



























F-27








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 13-** **Income
Taxes**





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





For Years
      Ended December 31,2004
    
    
    2003
    
    
    2002(dollars in
      thousands)CurrentFederal
    
    $
    6,420
    
    $
    6,436
    
    $
    4,869State
    
    
    1,430
    
    
    1,325
    
    
    1,0797,850
    
    
    7,761
    
    
    5,948DeferredFederal
    
    
    343
    
    
    (152
    )
    
    (227
    )State
    
    
    65
    
    
    (34
    )
    
    (50
    )408
    
    
    (186
    )
    
    (277
    )Total income
      tax provision
    
    $
    8,258
    
    $
    7,575
    
    $
    5,671






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:





2004
    2003
    2002Amount
    
    
    Percent of
      Pretax
      Income
    
    
    Amount
    
    
    Percent of
      Pretax Income
    
    
    Amount
    
    
    Percent
      of
      Pretax
      Income(dollars in
      thousands)Statutory
      Federalincome tax rate
    
    $
    7,416
    
    
    35.0
    %
    $
    6,616
    
    
    35.0
    %
    $
    4,971
    
    
    34.0
    %State tax net
      ofFederal income tax benefit
    
    
    972
    
    
    4.6
    %
    
    840
    
    
    4.4
    %
    
    689
    
    
    4.7
    %Other
      adjustments
    
    
    (130
    )
    
    (0.6
    %)
    
    119
    
    
    0.6
    %
    
    11
    
    
    0.1
    %$
    8,258
    
    
    39.0
    %
    $
    7,575
    
    
    40.0
    %
    $
    5,671
    
    
    38.8
    %














F-28








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 13-** **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, 2004 and 2003 are presented
below:





2004
    
    
    2003(dollars in
      thousands)Deferred Tax
      Assets:Allowances
      for losses
    
    $
    2,341
    
    $
    1,864Reserve for
      uncollected interest
    
    
    11
    
    
    4Total
      deferred tax assets
    
    
    2,352
    
    
    1,868Deferred Tax
      Liabilities:Federal Home
      Loan Bank stock dividends
    
    
    (82
    )
    
    (80
    )Other
    
    
    (66
    )
    
    (5
    )Accelerated
      depreciation
    
    
    (519
    )
    
    (506
    )Total
      deferred tax liabilities
    
    
    (667
    )
    
    (591
    )Net deferred
      tax assets
    
    $
    1,685
    
    $
    1,277





**Note 14-** **Related
Party Transactions**





During the years
ended December 31, 2004, 2003 and 2002, the Bank engaged in the transactions
described below with parties that may be deemed affiliated.





Two subsidiaries
rent property from a director of the Bank. Rent paid on these properties was
$59,000, $49,000 and $39,000 for 2004, 2003 and 2002, 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 $129,000, $167,000 and
$162,000 for the years ended December 31, 2004, 2003 and 2002, respectively.





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.















F-29








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 15-** **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 instruments. 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. 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.





















F-30








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 15-** **Disclosure
About Fair Value of Financial Instruments** **-
Continued**




The estimated fair
values of the Bank's financial instruments are as follows:





December 31,
      2004
    December 31,
      2003Carrying
      Amount
    
    
    Fair
      Value
    
    
    Carrying
      Amount
    
    
    Fair
      Value(dollars in
      thousands)Financial
      AssetsCash,
      interest bearing depositsin other
      banks and Federalfunds sold
    
    $
    18,038
    
    $
    18,038
    
    $
    8,426
    
    $
    8,426Investment
      securities
    
    
    9,955
    
    
    9,814
    
    
    12,721
    
    
    12,616FHLB
      stock
    
    
    5,083
    
    
    5,083
    
    
    3,250
    
    
    3,250Loans held
      for sale
    
    
    6,654
    
    
    6,654
    
    
    3,175
    
    
    3,175Loans
      receivable, net
    
    
    650,313
    
    
    552,389
    
    
    502,851
    
    
    457,887Accrued
      interest receivable
    
    
    3,339
    
    
    3,339
    
    
    2,702
    
    
    2,702Financial
      LiabilitiesDeposits
    
    $
    527,413
    
    $
    527,678
    
    $
    419,726
    
    $
    421,557FHLB
      advances
    
    
    89,000
    
    
    85,810
    
    
    65,000
    
    
    63,595Accrued
      interest payable
    
    
    166
    
    
    166
    
    
    70
    
    
    70Off Balance
      Sheet Commitments
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -


















F-31








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 16-** **Condensed
Financial Information (Parent Company Only)**





Information as to
the financial position of Severn Bancorp, Inc. as of December 31, 2004 and 2003
and results of operations and cash flows for each of the years ended December
31, 2004, 2003 and 2002 is summarized below.





December
      31,2004
    
    
    2003(dollars in
      thousands)Statements of
      Financial ConditionCash
    
    $
    3,485
    
    $
    464Equity in net
      assets of subsidiaries:Bank
    
    
    73,543
    
    
    45,569Non-Bank
    
    
    3,512
    
    
    3,266Other
      assets
    
    
    732
    
    
    51Total
      assets
    
    $
    81,272
    
    $
    49,350Subordinated
      debentures
    
    $
    20,619
    
    $
    -Other
      liabilities
    
    
    499
    
    
    380Total
      liabilities
    
    
    21,118
    
    
    380Stockholders’
      equity
    
    
    60,154
    
    
    48,970Total
      liabilities and stockholders’ equity
    
    $
    81,272
    
    $
    49,350








For the Year
      Ended December 31,2004
    
    
    2003
    
    
    2002(dollars in
      thousands)Statements of
      IncomeDividends
      received from subsidiaries
    
    $
    1,747
    
    $
    1,410
    
    $
    987General and
      administrative expenses
    
    
    159
    
    
    95
    
    
    138Income before
      income taxes and equity inundistributed
      net income of subsidiaries
    
    
    1,588
    
    
    1,315
    
    
    849Income tax
      benefit
    
    
    44
    
    
    19
    
    
    56Equity in
      undistributed net income of subsidiaries
    
    
    11,299
    
    
    9,995
    
    
    8,043Net
      income
    
    $
    12,931
    
    $
    11,329
    
    $
    8,948













F-32








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 16-** **Condensed
Financial Information (Parent Company Only)** **-
Continued**





For the Years
      Ended December 31,2004
    
    
    2003
    
    
    2002(dollars in
      thousands)Statements of
      Cash FlowsCash Flows
      from Operating Activities:Net
      income
    
    $
    12,931
    
    $
    11,329
    
    $
    8,948Adjustments
      to reconcile net income to netcash provided
      by operating activities:Equity in
      undistributed earnings of subsidiaries
    
    
    (11,299
    )
    
    (9,995
    )
    
    (8,043
    )Increase in
      other assets
    
    
    (602
    )
    
    (38
    )
    
    (2
    )Increase in
      other liabilities
    
    
    119
    
    
    124
    
    
    58Tax benefit
      of exercised options
    
    
    -
    
    
    -
    
    
    130Cash provided
      by operating activities
    
    
    1,149
    
    
    1,420
    
    
    1,091Cash Flows
      from Investing Activities:Investment in
      subsidiaries
    
    
    (17,000
    )
    
    -
    
    
    (588
    )Cash Flows
      from Financing Activities:Dividends
      paid on capital stock
    
    
    (1,747
    )
    
    (1,410
    )
    
    (986
    )Proceeds from
      issuance of subordinated debentures
    
    
    20,619
    
    
    -
    
    
    -Proceeds from
      exercise of options
    
    
    -
    
    
    91
    
    
    480Cash provided
      by (used in) financing activities
    
    
    18,872
    
    
    (1,319
    )
    
    (506
    )Increase
      (Decrease) in cash and cash equivalents
    
    
    3,021
    
    
    101
    
    
    (3
    )Cash and cash
      equivalents at beginning of year
    
    
    464
    
    
    363
    
    
    366Cash and cash
      equivalents at end of year
    
    $
    3,485
    
    $
    464
    
    $
    363













F-33








SEVERN BANCORP,
INC. AND SUBSIDIARIES


Annapolis,
Maryland


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS




**Note 17-** **Quarterly
Financial Data (Unaudited)**





Summarized
unaudited quarterly financial data for the year ended December 31, 2004 is as
follows:





First
      Quarter
    
    
    Second
      Quarter
    
    
    Third
      Quarter
    
    
    Fourth
      Quarter(dollars in
      thousands, except per share data)Interest
      income
    
    $
    10,032
    
    $
    10,702
    
    $
    11,411
    
    $
    12,474Interest
      expense
    
    
    3,167
    
    
    3,402
    
    
    3,804
    
    
    4,258Net interest
      income
    
    
    6,865
    
    
    7,300
    
    
    7,607
    
    
    8,216Provision for
      loan losses
    
    
    250
    
    
    300
    
    
    350
    
    
    300Net interest
      income after provision for loan losses
    
    
    6,615
    
    
    7,000
    
    
    7,257
    
    
    7,916Other
      income
    
    
    754
    
    
    1,115
    
    
    928
    
    
    815Other
      expense
    
    
    2,492
    
    
    2,798
    
    
    2,846
    
    
    3,075Income before
      income tax provision
    
    
    4,877
    
    
    5,317
    
    
    5,339
    
    
    5,656Income tax
      provision
    
    
    1,848
    
    
    2,091
    
    
    2,059
    
    
    2,260Net
      income
    
    $
    3,029
    
    $
    3,226
    
    $
    3,280
    
    
    3,396Per share
      data:Earnings -
      basic
    
    $
    .36
    
    $
    .39
    
    $
    .40
    
    $
    .41Earnings -
      diluted
    
    $
    .36
    
    $
    .39
    
    $
    .40
    
    $
    .41





Summarized
unaudited quarterly financial data for the year ended December 31, 2003 is as
follows:





First
      Quarter
    
    
    Second
      Quarter
    
    
    Third
      Quarter
    
    
    Fourth
      Quarter(dollars in
      thousands, except per share data)Interest
      income
    
    $
    8,863
    
    $
    9,172
    
    $
    9,460
    
    $
    9,592Interest
      expense
    
    
    3,137
    
    
    3,106
    
    
    3,065
    
    
    3,033Net interest
      income
    
    
    5,726
    
    
    6,066
    
    
    6,395
    
    
    6,559Provision for
      loan losses
    
    
    225
    
    
    225
    
    
    225
    
    
    225Net interest
      income after provision for loan losses
    
    
    5,501
    
    
    5,841
    
    
    6,170
    
    
    6,334Other
      income
    
    
    1,165
    
    
    1,318
    
    
    1,321
    
    
    870Other
      expense
    
    
    2,121
    
    
    2,603
    
    
    2,469
    
    
    2,423Income before
      income tax provision
    
    
    4,545
    
    
    4,556
    
    
    5,022
    
    
    4,781Income tax
      provision
    
    
    1,838
    
    
    1,759
    
    
    1,935
    
    
    2,043Net
      income
    
    $
    2,707
    
    $
    2,797
    
    $
    3,087
    
    $
    2,738Per share
      dataEarnings -
      basic
    
    $
    .32
    
    $
    .33
    
    $
    .36
    
    $
    .33Earnings -
      diluted
    
    $
    .32
    
    $
    .33
    
    $
    .36
    
    $
    .32











F-34