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MarketScreener Homepage  >  Equities  >  Nasdaq  >  Severn Bancorp, Inc.    SVBI

SEVERN BANCORP, INC.

(SVBI)
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SEVERN BANCORP : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

05/11/2020 | 09:56am EST
When used in this report, the terms "the Company," "we," "us," and "our" refer
to Severn Bancorp and, unless the context requires otherwise, its consolidated
subsidiaries. The following discussion should be read and reviewed in
conjunction with Management's Discussion and Analysis of Financial Condition and
Results of Operations set forth in Severn Bancorp's Annual Report on Form 10­K
as of and for the year ended December 31, 2019.

The Company


The Company is a savings and loan holding company chartered as a corporation in
the state of Maryland in 1990. It conducts business primarily through three
subsidiaries, Severn Savings Bank, FSB (the "Bank"), Mid-Maryland Title
Company, Inc. (the "Title Company"), and SBI Mortgage Company ("SBI"). The Title
Company is a real estate settlement company that handles commercial and
residential real estate settlements in Maryland. SBI holds mortgages that do not
meet the underwriting criteria of the Bank, and is the parent company of
Crownsville Development Corporation ("Crownsville"), which is doing business as
Annapolis Equity Group and acquires real estate for syndication and investment
purposes. The Bank's principal subsidiary, Louis Hyatt, Inc. ("Hyatt
Commercial"), conducts business as Hyatt Commercial, a commercial real estate
brokerage and property management company. We maintain seven branches in Anne
Arundel County, Maryland at March 31, 2020. The branches offer a full range of
deposit products and we originate mortgages in the Bank's primary market of Anne
Arundel County, Maryland and, to a lesser extent, in other parts of Maryland,
Delaware, and Virginia. As of March 31, 2020, we had 174 full-time equivalent
employees.

Significant Developments - COVID-19


On March 11, 2020, the World Health Organization declared the outbreak of a
novel coronavirus ("COVID-19") as a global pandemic, which continues to spread
throughout the United States of America ("U.S.") and around the world. The
declaration of a global pandemic indicates that almost all public commerce and
related business activities must be, to varying degrees, curtailed with the goal
of decreasing the rate of new infections. The COVID-19 pandemic in the U.S. is
expected to have a complex and significant adverse impact on the economy, the
banking industry, and the Company in future fiscal periods, all subject to a
high degree of uncertainty.

Effects on Our Market Areas

Our commercial and consumer banking products and services are offered primarily
in Maryland, where individual and governmental responses to the COVID-19
pandemic have led to a broad curtailment of economic activity beginning in March
2020. In Maryland, the Governor issued a series of orders, including ordering
schools to close for an indefinite period of time and an order that, subject to
limited exceptions, all individuals stay at home and non­essential businesses
cease all activities for an indeterminate amount of time. The Bank has remained
open during these orders because banks have been identified as essential
services. The Bank has been serving its customers through its drive-ups, ATMs,
and in all of its branch offices by appointment only.

To date, many of the public health and economic effects of COVID-19 have been concentrated in large cities, such as New York City, but we anticipate that similar effects will occur on a more delayed basis in smaller cities and communities, where our banking operations are primarily focused.

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Locally, as well as nationally, we have experienced an increase in unemployment levels as a result of the curtailment of business activities, the levels of which are expected to continue to increase for the foreseeable future.

Policy and Regulatory Developments

Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic, including the following:

· The Federal Reserve Board ("FRB") decreased the range for the federal funds

target rate by 0.5% on March 3, 2020, and by another 1.0% on March 16, 2020,

reaching the current range of 0.0% - 0.25%.

· On March 27, 2020, President Trump signed the Coronavirus Aid, Relief and

Economic Security Act ("CARES Act"), which established a $2.0 trillion economic

stimulus package, including cash payments to individuals, supplemental

unemployment insurance benefits and a $349.0 billion loan program administered

through the U.S. Small Business Administration ("SBA"), referred to as the

paycheck protection program ("PPP"). Under the PPP, small businesses, sole

proprietorships, independent contractors and self-employed individuals may

apply for loans from existing SBA lenders and other approved regulated lenders

that enroll in the program, subject to numerous limitations and eligibility

criteria. PPP loans have an interest rate of 1.0%, a two-year loan term to

maturity, and principal and interest payments deferred for six months from the

date of disbursement. The Bank is participating as a lender in the PPP. In

addition, the CARES Act provides financial institutions the option to

temporarily suspend certain requirements under accounting principles generally

accepted in the U.S. ("GAAP") related to troubled debt restructure loans ("TDR"

or "TDRs") for a limited period of time to account for the effects of COVID-19.

· On April 7, 2020, federal banking regulators issued a revised Interagency

Statement on Loan Modifications and Reporting for Financial Institutions,

which, among other things, encouraged financial institutions to work prudently

with borrowers who are or may be unable to meet their contractual payment

obligations because of the effects of COVID-19, and stated that institutions

generally do not need to categorize COVID-19-related modifications as TDRs and

that the agencies will not direct supervised institutions to automatically

categorize all COVID-19 related loan modifications as TDRs.

· On April 9, 2020, the FRB announced additional measures aimed at supporting

small and mid-sized businesses, as well as state and local governments impacted

by COVID-19. The FRB announced the Main Street Business Lending Program, which

establishes two new loan facilities intended to facilitate lending to small and

mid-sized businesses: (1) the Main Street New Loan Facility ("MSNLF") and (2)

the Main Street Expanded Loan Facility ("MSELF"). MSNLF loans are unsecured

term loans originated on or after April 8, 2020, while MSELF loans are provided

as upsized tranches of existing loans originated before April 8, 2020. The

combined size of the program will be up to $600.0 billion. The program is

designed for businesses with up to 10,000 employees or $2.5 billion in 2019

revenues. To obtain a loan, borrowers must confirm that they are seeking

financial support because of COVID-19 and that they will not use proceeds from

the loan to pay off debt. The FRB also stated that it would provide additional

funding to banks offering PPP loans to help struggling small businesses. The

PPPLF was created by the FRB on April 9, 2020 to facilitate lending by

participating financial institutions to small businesses under the PPP of the

CARES Act. Under the facility, the FRB lends to participating financial

institutions on a non-recourse basis, taking PPP loans as collateral. Lenders

participating in the PPP will be able to exclude loans financed by the facility

from their leverage ratio. In addition, the FRB created a Municipal Liquidity

Facility to support state and local governments with up to $500.0 billion in

lending, with the Treasury Department backing $35.0 billion for the facility

using funds appropriated by the CARES Act. The facility will make short-term

financing available to cities with a population of more than one million or

counties with a population of greater than two million. The FRB expanded both

the size and scope of its Primary and Secondary Market Corporate Credit

Facilities to support up to $750.0 billion in credit to corporate debt issuers.

This will allow companies that were investment grade before the onset of

COVID-19 but then subsequently downgraded after March 22, 2020 to gain access

    to the facility. Finally, the FRB announced that its Term Asset-Backed
    Securities Loan Facility will be scaled up


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in scope to include the triple A-rated tranche of commercial mortgage-backed
securities and newly issued collateralized loan obligations. The size of the
facility is $100.0 billion.


Effects on Our Business

We currently expect that the COVID-19 pandemic and the specific developments
referred to above could have a significant impact on our business. The outbreak
of COVID-19 could adversely impact a broad range of industries in which the
Company's customers operate and impair their ability to fulfill their financial
obligations to the Company. In particular, we anticipate that a significant
portion of the Bank's borrowers in the hotel, restaurant, and retail industries
will continue to endure significant economic distress, which has caused, and may
continue to cause, them to draw on their existing lines of credit and adversely
affect their ability to repay existing indebtedness, and is expected to
adversely impact the value of collateral. These developments, together with
economic conditions generally, are also expected to impact our commercial real
estate portfolio, particularly with respect to real estate with exposure to
these industries, and the value of certain collateral securing our loans. As a
result, we anticipate that our financial condition, capital levels, and results
of operations could be adversely affected.

Our Response

We have taken numerous steps in response to the COVID-19 pandemic, including the following:

· actively working with loan customers to evaluate prudent loan modification

terms;

· continuing to promote our digital banking options through our website.

Customers are encouraged to utilize online and mobile banking tools, and our

customer service and retail departments are fully staffed and available to

assist customers remotely;

· acting as a participating lender in the PPP. We believe it is our

responsibility as a community bank to assist the SBA in the distribution of

funds authorized under the CARES Act to our customers and communities, which we

are carrying out in a prudent and responsible manner. As of April 30, the

Company had originated $38.9 million in PPP loans, and is working diligently

with the SBA to qualify customers to receive such loans; and

· closing all branches to customer activity indefinitely, except for drive-up and

appointment only services. We continue to pay all employees according to their

normal work schedule, even if their work has been reduced. No employees have

been furloughed. Employees whose job responsibilities can be effectively

carried out remotely are working from home. Employees whose critical duties

require their continued presence on-site are observing social distancing and

    cleaning protocols.


Overview

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

We have experienced a decline in profitability for the three months ended
March 31, 2020, primarily due to a decrease in net interest income, an increased
provision for loan losses, and increased noninterest expenses, slightly offset
by increased noninterest income. Net interest income decreased primarily due to
a declining interest rate environment, resulting from rate reductions by the FRB
in response to the COVID-19 pandemic (see additional information on COVID-19
above and in Item 1A - Risk Factors of Part II of this Quarterly Report on Form
10-Q). We recognized increased revenue from mortgage-banking activities and
increased deposit service charges as a result of fees from medical-use cannabis
deposit

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accounts. We recorded a $750,000 provision for loan losses. Noninterest expenses
increased for the three months ended March 31, 2020 due to increased
professional fees and investments in staff, property, and systems to enhance
production and efficiency.

The Company expects to experience similar market conditions during the remainder
of 2020, provided interest rates do not increase or decrease rapidly. If
interest rates change rapidly, demand for loans may fluctuate and our interest
rate spread could change significantly. We continue to manage loan and deposit
pricing against the potential risks of rising costs of our deposits and
borrowings. Interest rates are outside of our control, so we must attempt to
balance the pricing and duration of the loan portfolio against the risks of
rising or declining costs of our deposits and borrowings. The continued success
and attraction of Anne Arundel County, Maryland, and vicinity, will also be
important to our ability to originate and grow loans and deposits, as will our
continued focus on maintaining a low overhead. If volatility in the market and
the economy continues to occur, our business, financial condition, results of
operations, access to funds, and the price of our stock could be materially and
adversely impacted. Despite our declining profitability in the first quarter of
2020, we believe the Company is well prepared for the economic and social
consequences of the COVID-19 global pandemic.

Critical Accounting Policies


Our accounting and financial reporting policies conform to GAAP and prevailing
practices within the banking industry. Accordingly, preparation of the financial
statements requires management to exercise significant judgment or discretion or
make significant assumptions and estimates based on the information available
that have, or could have, a material impact on the carrying value of certain
assets or on income. These estimates and assumptions affect the reported amounts
of assets and liabilities at the date of the financial statements and the
reported amounts of income and expenses during the periods presented. The
accounting policies we view as critical are those relating to the allowance for
loan losses ("Allowance"), the valuation of real estate acquired through
foreclosure, and the valuation of deferred tax assets and liabilities.
Significant accounting policies are discussed in detail in "Notes to
Consolidated Financial Statements - Note 1 - Summary of Significant Account
Policies" in our Annual Report on Form 10-K as of and for the year ended
December 31, 2019. There have been no material changes to the significant
accounting policies as described in the Annual Report other than those mentioned
in Note 1 to the financial statements in this Quarterly Report on Form 10-Q.
Disclosures regarding the effects of new accounting pronouncements are included
in Note 1 to our Consolidated Financial Statements included in this Quarterly
Report on Form 10-Q.

Results of Operations

Net Income

Net income decreased by $2.0 million, or 78.3%, to $565,000 for the three months
ended March 31, 2020 compared to $2.6 million for the three months ended
March 31, 2019. Basic and diluted income per share were $0.04 for the three
months ended March 31, 2020, compared to basic and diluted income per share of
$0.20 for the three months ended March 31, 2019. The decrease in net income
reflected decreased net interest income, an increased provision for loan losses,
and increased noninterest expense, partially offset by increased noninterest
income.

Net Interest Income

Net interest income decreased by $1.3 million, or 16.5%, to $6.8 million for the
three months ended March 31, 2020, compared to $8.1 million for the same period
of 2019. Our net interest margin decreased from 3.65% for the three months ended
March 31, 2019 to 3.38% for the three months ended March 31, 2020. Our net
interest spread decreased from 3.35% for the three months ended March 31, 2019
to 2.95% for the three months ended March 31, 2020.

Net interest income was significantly impacted by a declining interest rate
environment directly related to the COVID-19 pandemic. The abrupt decline in
interest rates during the first quarter of 2020 not only reduced interest income
on floating-rate commercial loans and other liquid assets, but it also reduced
competitive pressures and depositor expectations concerning deposit interest
rates. Because of the need to maintain higher levels of liquidity and delays in
business investment activity due to COVID-19 disruptions, some further
compression of our net interest margin is likely in the next

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two quarters, but a reasonably robust recovery in business conditions could enable us to deploy our additional asset generation resources and thus reallocate some of our excess liquidity.

Interest Income


Interest income decreased by $1.6 million, or 15.4%, to $8.9 million for the
three months ended March 31, 2020, compared to $10.5 million for the three
months ended March 31, 2019, due to both a low interest rate environment created
by the COVID-19 pandemic and a decreased level of average interest-earning
assets in the first quarter of 2020. Average interest-earning assets decreased
from $898.4 million for the three months ended March 31, 2019 to $803.2 million
for the three months ended March 31, 2020, due primarily to a decline in average
other interest-earning assets of $55.9 million. Such decrease resulted primarily
from decreased average interest-earning deposits in banks, which was the result
of decreased deposits from our medical-use cannabis customers. The average yield
on other interest-earning assets decreased to 1.25% for the three months ended
March 31, 2020 from 2.66% for the three months ended March 31, 2019, primarily
due to a change in the mix of other interest-earning asset types and the
decreased rate environment. We held less Federal Home Loan Bank of Atlanta
("FHLB") stock and certificates of deposit held for investment during the three
months ended March 31, 2020 than during the three months ended March 31, 2019.
Additionally, average loans outstanding decreased $34.3 million from $678.4
million for the three months ended March 31, 2019 to $644.1 million for the
three months ended March 31, 2020. The average yield on interest-earning assets
decreased 30 basis points to 4.46% for the three months ended March 31, 2020
from 4.76% for the three months ended March 31, 2019. The average yield on loans
held for investment decreased from 5.47% for the three months ended March 31,
2019 to 5.15% for the three months ended March 31, 2020 as a result of the
decreased interest rate environment in the first quarter of 2020 compared to the
first quarter of 2019.

Interest Expense

Total interest expense was $2.2 million for the three months ended
March 31, 2020 and $2.5 million for the three months ended March 31, 2019. We
experienced a decrease in deposit interest expense, primarily due to a decrease
in the average balance of interest-bearing deposits from $622.4 million for the
three months ended March 31, 2019 to $519.4 million for the three months ended
March 31, 2020. The average balance of checking and savings accounts decreased
significantly from $411.3 million for the three months ended March 31, 2019 to
$323.7 million for the three months ended March 31, 2020, primarily due to
decreases in our medical-use cannabis related accounts, occurring mostly in the
latter part of 2019. The average balance of certificates of deposit decreased
from $211.1 million for the three months ended March 31, 2019 to $195.7 million
for the same period of 2020 due to runoff from maturing certificates of deposit.
Average borrowings decreased $27.1 million during the three months ended
March 31, 2020 compared to the same period of 2019, due to payoffs of FHLB
advances.

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

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




                                                              Three Months Ended March 31,
                                                     2020                                      2019
                                     Average                       Yield/      Average                        Yield/
                                     Balance     Interest (2)     Rate (4)    Balance       Interest (2)     Rate (4)
ASSETS                                                           (dollars in thousands)
Loans (1)                           $ 644,087$       8,240        5.15 %  $ 678,357$        9,151        5.47 %
Loans held for sale ("LHFS")           13,528               98        2.91 %      6,573                16        0.99 %
Available-for-sale ("AFS")
securities                             14,247               81        2.29 %     12,057                52        1.75 %
Held-to-maturity ("HTM")
securities                             24,267              138        2.29 %     37,622               207        2.23 %
Other interest-earning assets
(3)                                   104,614              325        1.25 %    160,538             1,053        2.66 %
Restricted stock investments, at
cost                                    2,431               34        5.63 %      3,301                64        7.86 %
Total interest-earning assets         803,174            8,916        4.46 %    898,448            10,543        4.76 %
Allowance                             (7,156)                                   (8,068)
Cash and other
noninterest-earning assets             45,497                                    41,857
Total assets                        $ 841,515            8,916                $ 932,237            10,543

LIABILITIES AND STOCKHOLDERS'
EQUITY
Interest-bearing deposits:
Checking and savings                $ 323,709              661        0.82 %  $ 411,344               817        0.81 %
Certificates of deposit               195,722            1,136        2.33 %    211,099             1,052        2.02 %
Total interest-bearing deposits       519,431            1,797        1.39 %    622,443             1,869        1.22 %
Borrowings                             55,619              364        2.63 %     82,730               589        2.89 %
Total interest-bearing
liabilities                           575,050            2,161        1.51 %    705,173             2,458        1.41 %
Noninterest-bearing deposit
accounts                              150,628                                   122,859
Other noninterest-bearing
liabilities                             8,085                                     3,118
Stockholders' equity                  107,752                                   101,087
Total liabilities and
stockholders' equity                $ 841,515            2,161                $ 932,237             2,458
Net interest income/net interest
spread                                           $       6,755        2.95 %               $        8,085        3.35 %
Net interest margin                                                   3.38 %                                     3.65 %

--------------------------------------------------------------------------------

(1)Nonaccrual loans are included in average loans.

(2)There are no tax equivalency adjustments.

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

(4)Annualized.




The "Rate/Volume Analysis" below indicates the changes in our net interest
income as a result of changes in volume and rates. We maintain an asset and
liability management policy designed to provide a proper balance between
rate-sensitive assets and rate-sensitive liabilities to attempt to optimize
interest margins while providing adequate liquidity for our anticipated needs.
Changes in interest income and interest expense that result from variances in
both volume and rates have been allocated to rate and volume changes in
proportion to the absolute dollar amounts of the change in each.



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                                                               Three Months

Ended March 31, 2020 vs. 2019

Due to Variances in

                                                                 Rate               Volume           Total
Interest earned on:                                                      (dollars in thousands)
Loans                                                       $         (493)      $      (418)$    (911)
LHFS                                                                     53                29              82
AFS securities                                                           18                11              29
HTM Securities                                                           37             (106)            (69)
Other interest-earning assets                                         (439)             (289)           (728)
Restricted stock investments, at cost                                  (16)              (14)            (30)
Total interest income                                                 (840)             (787)         (1,627)

Interest paid on:
Interest-bearing deposits:
Checking and savings                                                    109             (265)           (156)
Certificates of deposit                                                 479             (395)              84
Total interest-bearing deposits                                         588             (660)            (72)
Borrowings                                                             (48)             (177)           (225)
Total interest expense                                                  540             (837)           (297)
Net interest income                                         $       (1,380)
     $         50      $  (1,330)




Provision for Loan Losses

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

We recorded $750,000 in provision for loan losses for the three months ended
March 31, 2020 primarily due to the potential economic factors related to the
COVID-19 pandemic. We did not record any provision for loan losses during the
three months ended March 31, 2019.

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

Noninterest Income


Total noninterest income increased by $765,000 or 33.8%, to $3.0 million for the
three months ended March 31, 2020, compared to $2.3 million for the three months
ended March 31, 2019, with the majority of the increase from mortgage-banking
revenue and deposit service charges. Mortgage-banking revenue increased
$914,000, or 126.9%, due to the increased volume of loans originated from $19.4
million during the three months ended March 31, 2019 to $43.2 million during the
three months ended March 31, 2020. Deposit service charges increased $52,000 due
primarily to on-boarding and monthly fees associated with medical-use cannabis
customer accounts. The Title Company generated $238,000 in revenue during the
three months ended March 31, 2020 compared to $217,000 for the three months
ended March 31, 2019 due to an increase in loan closings and related title work.





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Noninterest Expense

Total noninterest expense increased $1.5 million, or 22.3%, to $8.3 million for
the three months ended March 31, 2020, compared to $6.8 million for the three
months ended March 31, 2019, primarily due to increases in compensation and
related expenses, occupancy expenses, legal fees, professional fees, data
processing fees, and licensing and software expenses. Additionally, we
experienced increases in general office and communications expenses.
Compensation and related expenses increased by $936,000, or 20.7%, to $5.5
million for the three months ended March 31, 2020, compared to $4.5 million for
the three months ended March 31, 2019. This increase was primarily due to annual
salary increases, additional hirings for our new branch, and increased
commission expense that corresponds with our increased mortgage-banking volumes.
Occupancy expenses increased $103,000, or 24.8%, primarily due to the addition
of the Crofton branch. The additional branch also contributed to the increased
office and telecommunications expenses recognized ($31,000 and $27,000,
respectively). Professional fees increased $163,000 due to increased audit and
consulting costs. Legal fees increased $117,000 also related to the increased
audit and consulting fees. Data processing fees and licensing and software
expense increased $118,000 and $36,000, respectively, due to additional
efficiency and security enhancements to our core and related systems, as well as
the implementation in late 2019 of a new customer relationship management
("CRM") system. We recognized a $76,000 loss on disposal of premises and
equipment when we terminated a lease agreement.

Income Tax Provision


We recorded a $213,000 tax provision on net income before income taxes of
$778,000 for the three months ended March 31, 2020 for an effective tax rate of
27.4%, compared to an income tax provision of $986,000 on net income before
income taxes of $3.6 million for the three months ended March 31, 2019, for an
effective tax rate of 27.4%.

Financial Condition

Total assets increased $30.4 million to $857.4 million at March 31, 2020,
compared to $826.9 million at December 31, 2019. This increase was primarily due
to a $27.4 million, or 31.1%, increase in cash and cash equivalents, to $115.6
million at March 31, 2020 from $88.2 million at December 31, 2019 due primarily
to loan payoffs and increased deposits. We experienced a decrease in loans of
$9.7 million, or 1.5%, to $636.0 million at March 31, 2020 from $645.7 million
at December 31, 2019. Total deposits increased $29.2 million, or 4.4%, to $690.2
million at March 31, 2020 compared to $661.0 million at December 31, 2019.
Stockholders' equity increased $249,000 to $105.7 million at March 31, 2020
compared to $105.5 million at December 31, 2019, due to quarterly net income and
increased accumulated comprehensive income, partially offset by dividends paid
to stockholders.

Securities

We utilize the securities portfolio as part of our overall asset/liability
management practices to enhance interest revenue while providing necessary
liquidity for the funding of loan growth or deposit withdrawals. We continually
monitor the credit risk associated with investments and diversify the risk in
the securities portfolios. We held $18.8 million and $12.9 million in securities
classified as AFS as of March 31, 2020 and December 31, 2019, respectively. We
held $22.7 million and $26.0 million, respectively, in securities classified as
HTM as of March 31, 2020 and December 31, 2019, respectively.

Changes in current market conditions, such as interest rates and the economic
uncertainties in the mortgage, housing, and banking industries impact the
securities market. Quarterly, we review each security in our portfolio to
determine the nature of any decline in value and evaluate if any impairment
should be classified as other-than-temporary impairment ("OTTI"). For the three
months ended March 31, 2020, we determined that no OTTI charges were required.

All of the AFS and HTM securities that are temporarily impaired as of
March 31, 2020 are so due to declines in fair values resulting from changes in
interest rates or decreased credit/liquidity spreads compared to the time they
were purchased. We have the intent to hold these securities to maturity
(including those designated as AFS) and it is more likely than not that we will
not be required to sell the securities before recovery of value. As such,
management considers the impairments to be temporary.

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Our securities portfolio composition is as follows:


                                                                   AFS                                       HTM
                                                  March 31, 2020      December 31, 2019     March 31, 2020      December 31, 2019
                                                                               (dollars in thousands)
U.S. Treasury securities                          $             -    $                 -    $           996    $               994
U.S. government agency notes                                5,031                  5,019              2,985                  4,986
Corporate obligations                                       2,000                      -                  -                      -
Mortgage-backed securities                                 11,811                  7,887             18,756                 19,980
                                                  $        18,842    $            12,906    $        22,737    $            25,960




LHFS

We originate residential mortgage loans for sale on the secondary market. Such
LHFS, which are carried at fair value, amounted to $22.0 million at
March 31, 2020 and $10.9 million at December 31, 2019, the majority of which are
subject to purchase commitments from investors. The increase in LHFS was
primarily due to increased originations and to the timing of loans pending sale
on the secondary market.

Loans

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

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


                                         March 31, 2020          December 31, 2019
                                                   Percent                   Percent
                                       Amount      of Total      Amount      of Total
                                                  (dollars in thousands)
 Residential Mortgage                $  260,981        40.9 %  $  269,654        41.6 %
 Commercial                              43,490         6.8 %      43,127         6.7 %
 Commercial real estate                 220,654        34.5 %     229,257        35.3 %

Land acquisition, development,

 and construction ("ADC")                99,861        15.6 %      92,822        14.3 %
 Home equity/2nds                        12,199         1.9 %      12,031         1.9 %
 Consumer                                 1,474         0.3 %       1,541         0.2 %
                                     $  638,659       100.0 %  $  648,432       100.0 %




Loans (net of unearned loan fees) decreased by $9.7 million, or 1.5%, to $636.0
million at March 31, 2020, compared to $645.7 million at December 31, 2019. This
decrease was due to decreased demand and originations, as well as increased
payoffs of residential real estate and commercial real estate. We did experience
an increase in commercial loan and ADC loan demand during the three months ended
March 31, 2020.

Credit Risk Management and the Allowance


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

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

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management recognizes that loan losses will occur and the amount of these losses
will fluctuate depending on the risk characteristics of our loan portfolio, as
well as general and regional economic conditions.

Management has an established methodology to determine the adequacy of the
Allowance that assesses the risks and losses inherent in the loan portfolio. Our
Allowance methodology employs management's assessment as to the level of future
losses on existing loans based on our internal review of the loan portfolio,
including an analysis of the borrowers' current financial position, and the
consideration of current and anticipated economic conditions and their potential
effects on specific borrowers and/or lines of business. In determining our
ability to collect certain loans, we also consider the fair value of any
underlying collateral. In addition, we evaluate credit risk concentrations,
including trends in large dollar exposures to related borrowers, industry and
geographic concentrations, and economic and environmental factors. Our risk
management practices are designed to ensure timely identification of changes in
loan risk profiles; however, undetected losses may inherently exist within the
loan portfolio. The assessment aspects involved in analyzing the quality of
individual loans and assessing collateral values can also contribute to
undetected, but probable, losses. In the first quarter of 2020, we adjusted our
economic risk factors to incorporate the current economic implications and
rising unemployment rate from the COVID-19 pandemic. For more detailed
information about our Allowance methodology and risk rating system, see Note 3
to the Consolidated Financial Statements.

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


                                               Three Months Ended March 31,
                                                 2020                2019
                                                   (dollars in thousands)
     Allowance, beginning of year           $        7,138     $       

8,044

     Charge-offs:
     Residential mortgage                                -                  -
     Commercial                                          -                  -
     Commercial real estate                              -                  -
     ADC                                                 -                  -
     Home equity/2nds                                    -                  -
     Consumer                                         (15)                  -
     Total charge-offs                                (15)                  -
     Recoveries:
     Residential mortgage                                3                  5
     Commercial                                          5                  -
     Commercial real estate                             32                 34
     ADC                                                 -                  -
     Home equity/2nds                                    2                  2
     Consumer                                            3                  -
     Total recoveries                                   45                 41
     Net recoveries                                     30                 41
     Provision for loan losses                         750                  -
     Allowance, end of period               $        7,918     $       

8,085

Loans:

     Period-end balance                     $      635,950     $      

674,220

     Average balance during period                 644,087            

678,357

Allowance as a percentage of

       period-end loan balance                        1.25 %            

1.20 %

Percent of average loans (annualized):

     Provision for loan losses                        0.47 %               
- %
     Net recoveries                                   0.02 %             0.02 %




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


                                           March 31, 2020                    December 31, 2019
                                                          Percent                            Percent
                                                          of Loans                           of Loans
                                              Percent     to Total               Percent     to Total
                                   Amount     of Total     Loans      Amount     of Total     Loans
                                                         (dollars in thousands)
Residential mortgage               $ 2,484        31.4 %      40.9 %  $ 2,264        31.7 %      41.6 %
Commercial                           1,565        19.8 %       6.8 %    1,421        19.9 %       6.7 %
Commercial real estate               1,040        13.1 %      34.5 %      984        13.8 %      35.3 %
ADC                                  2,615        33.0 %      15.6 %    2,286        32.0 %      14.3 %
Home equity/2nds                       151         1.9 %       1.9 %      134         1.9 %       1.9 %
Consumer                                 -           - %       0.3 %        -           - %       0.2 %
Unallocated                             63         0.8 %         - %       49         0.7 %         - %
Total                              $ 7,918       100.0 %     100.0 %  $ 7,138       100.0 %     100.0 %



Based upon management's evaluation, provisions are made to maintain the Allowance as a best estimate of inherent losses within the portfolio. The Allowance totaled $7.9 million at March 31, 2020 and $7.1 million at December 31, 2019. Any changes in the Allowance from period to period reflect management's ongoing application of its methodologies to establish the Allowance, which, for the three months ended March 31, 2020, resulted in increased allocated Allowances for the majority of the loan segments.




As result of our Allowance analysis, we recorded a provision for loan losses of
$750,000 during the three months ended March 31, 2020. We did not record any
provision for loan losses for the three months ended March 31, 2019. We recorded
net recoveries of $30,000 and $41,000, respectively, during the three months
ended March 31, 2020 and 2019.  During both the three months ended
March 31, 2020 and 2019, annualized net recoveries as a percentage of average
loans outstanding amounted to 0.02%. The Allowance as a percentage of
outstanding loans was 1.25% as of March 31, 2020 compared to 1.11% as
of December 31, 2019.

Although management uses available information to establish the appropriate
level of the Allowance, future additions or reductions to the Allowance may be
necessary based on estimates that are susceptible to change as a result of
changes in economic conditions, and other factors. As a result, our Allowance
may not be sufficient to cover actual loan losses, and future provisions for
loan losses could materially adversely affect our operating results. In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review our Allowance and related methodology. Such
agencies may require us to recognize adjustments to the Allowance based on their
judgments about information available to them at the time of their examination.
Management believes the Allowance is adequate as of March 31, 2020 and is
sufficient to address the credit losses inherent in the current loan portfolio.
Management will continue to evaluate the adequacy of the Allowance as more
economic data becomes available and as changes within our portfolio are known.
The effects of the COVID-19 pandemic may require us to fund additional increases
in the Allowance in future periods.

Nonperforming Assets ("NPAs")


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

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NPAs, expressed as a percentage of total assets,
totaled 1.04% at March 31, 2020 and 0.80% at December 31, 2019. The ratio of the
Allowance to nonperforming loans was 109.3% at March 31, 2020 and
168.3% at December 31, 2019.

The distribution of our NPAs is illustrated in the following table. We did not have any loans greater than 90 days past due and still accruing at March 31, 2020 or December 31, 2019.



                                             March 31, 2020      December 31, 2019
Nonaccrual Loans:                                   (dollars in thousands)
Residential mortgage                        $          6,696    $             3,766
Commercial real estate                                   234                    237
ADC                                                      173                     89
Home equity/2nds                                         143                    150
                                                       7,246                  4,242
Real Estate Acquired Through Foreclosure:
Residential mortgage                                     674                  1,377
Commercial real estate                                   452                    452
ADC                                                      558                    558
                                                       1,684                  2,387
Total Nonperforming Assets                  $          8,930    $             6,629




Nonaccrual loans totaled $7.2 million, or 1.14% of total loans, at
March 31, 2020 and $4.2 million, or 0.66% of total loans at December 31, 2019.
Significant activity in nonaccrual loans during the three months ended March 31,
2020 included the addition of five loans in the amount of $3.7 million to
nonaccrual loans.

Real estate acquired through foreclosure decreased $703,000 to $1.7 million at
March 31, 2020 compared to $2.4 million at December 31, 2019 primarily due to
the sale of one residential property existing at December 31, 2019.

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


                                                                   Three Months Ended March 31,
                                                                    2020                  2019
                                                                      (dollars in thousands)
Balance at beginning of period                                 $         2,387       $         1,537
Real estate acquired in satisfaction of loans                                -                   171

Write-downs and losses on real estate acquired through foreclosure

                                                               (80)                 (107)
Proceeds from sales of real estate acquired through
foreclosure                                                              (623)                     -
Balance at end of period                                       $         1,684       $         1,601




TDRs

In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a TDR. See Significant Developments - COVID-19 above for information regarding the CARES Act and its effect on modifications.


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


                                      March 31, 2020      December 31, 2019
        Residential mortgage:                (dollars in thousands)
        Nonaccrual                   $             85    $                85
        <90 days past due/current               7,615                  7,675
        Commercial real estate:
        Nonaccrual                                  -                      -
        <90 days past due/current                 974                    984
        ADC:
        Nonaccrual                                  -                      -
        <90 days past due/current                 129                    130
        Consumer:
        Nonaccrual                                  -                      -
        <90 days past due/current                  68                     69
        Totals:
        Nonaccrual                                 85                     85
        <90 days past due/current               8,786                  8,858
                                     $          8,871    $             8,943



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

Deposits


Deposits totaled $690.2 million at March 31, 2020 and $661.0 million
at December 31, 2019. The $29.2 million increase was primarily the result of
short-term medical-use cannabis related funds (funds that have not actually been
used in the medical-use cannabis industry yet) that account holders have placed
at the Bank temporarily while looking for desired investments in the industry.
Management is aware of the short-term nature of such medical-use cannabis
related deposits and offset those funds by maintaining short-term liquidity to
meet any deposit outflows.

The deposit breakdown is as follows:



                                         March 31, 2020          December 31, 2019
                                                   Percent                  Percent
                                       Balance     of Total     Balance     of Total
                                                  (dollars in thousands)
   NOW                                $  75,204        10.9 %  $  83,612        12.6 %
   Money market                         151,490        21.9 %    162,621        24.6 %
   Savings                               60,488         8.8 %     61,514         9.3 %
   Certificates of deposit              237,940        34.5 %    230,401        34.9 %
   Total interest-bearing deposits      525,122        76.1 %    538,148        81.4 %
   Noninterest-bearing deposits         165,090        23.9 %    122,901        18.6 %
   Total deposits                     $ 690,212       100.0 %  $ 661,049       100.0 %




Borrowings

Our borrowings consist of advances from the FHLB.


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

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At March 31, 2020, our total credit line with the FHLB was  $247.1 million. The
Bank, from time to time, utilizes the line of credit when interest rates are
more favorable than obtaining deposits from the public. Our outstanding FHLB
advance balance at both March 31, 2020 and December 31, 2019 was $35.0 million.

The following table sets forth information concerning the interest rates and maturity dates of the advances from the FHLB as of March 31, 2020:


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



Subordinated Debentures


As of both March 31, 2020 and December 31, 2019, the Company had outstanding
$20.6 million in principal amount of Junior Subordinated Debt Securities, due in
2035 (the "2035 Debentures"). The 2035 Debentures were issued pursuant to an
Indenture dated as of December 17, 2004 (the "2035 Indenture") between the
Company and Wells Fargo Bank, National Association as Trustee. The 2035
Debentures pay interest quarterly at a floating rate of interest of 3­month
LIBOR plus 200 basis points, and mature on January 7, 2035. Payments of
principal, interest, premium and other amounts under the 2035 Debentures are
subordinated and junior in right of payment to the prior payment in full of all
senior indebtedness of the Company, as defined in the 2035 Indenture. The 2035
Debentures became redeemable, in whole or in part, by the Company on January 7,
2010.

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

Under the terms of the 2035 Debentures, we are permitted to defer the payment of interest on the 2035 Debentures for up to 20 consecutive quarterly periods, provided that no event of default has occurred and is continuing. As of March 31, 2020, we were current on all interest due on the 2035 Debentures.

Capital Resources


Total stockholders' equity increased $249,000 to $105.7 million at March 31,
2020 compared to $105.5 million as of December 31, 2019. The increase was the
result of 2020 net income to date and an increase in accumulated other
comprehensive income, partially offset by dividends paid to stockholders during
the three months ended March 31, 2020.

Capital Adequacy


The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory and possible additional discretionary, actions by the
regulators that, if undertaken, could have a direct material effect on the
Bank's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classifications are also
subject to qualitative judgments by the regulators about components,
risk-weightings, and other factors. As of March 31, 2020 and December 31, 2019,
the Bank exceeded all capital adequacy requirements to which it is subject and
meets the qualifications

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to be considered "well capitalized." As of January 1, 2020, the Bank elected to
follow the Community Bank Leverage Ratio. See details of our capital ratios in
Note 4 of the Consolidated Financial Statements.

Liquidity


Liquidity describes our ability to meet financial obligations, including lending
commitments and contingencies, which arise during the normal course of business.
Liquidity is primarily needed to meet the borrowing and deposit withdrawal
requirements of our customers, to fund the operations of our mortgage-banking
business, as well as to meet current and planned expenditures. These cash
requirements are met on a daily basis through the inflow of deposit funds, the
maintenance of short-term overnight investments, maturities and calls in our
securities portfolio, and available lines of credit with the FHLB, which
requires pledged collateral. Fluctuations in deposit and short-term borrowing
balances may be influenced by the interest rates paid, general consumer
confidence, and the overall economic environment. There can be no assurances
that deposit withdrawals and loan fundings will not exceed all available sources
of liquidity on a short-term basis. Such a situation would have an adverse
effect on our ability to originate new loans and maintain reasonable loan and
deposit interest rates, which would negatively impact earnings.

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

In addition to our ability to generate deposits, we have external sources of
funds, which may be drawn upon when desired. The primary source of external
liquidity is an available line of credit with the FHLB. The Bank's total credit
availability under the FHLB's credit availability program was $247.1 million at
March 31, 2020, of which $35.0 million was outstanding.

The borrowing requirements of customers include commitments to extend credit and
the unused portion of lines of credit (collectively "commitments"), which
totaled $110.3 million at March 31, 2020. Historically, many of the commitments
expire without being fully drawn; therefore, the total commitment amounts do not
necessarily represent future cash requirements. We expect to fund these
commitments from the sources of liquidity described above.

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

In addition to the foregoing, the payment of dividends is a use of cash, but is
not expected to have a material effect on liquidity. As of March 31, 2020, we
had no material commitments for capital expenditures.

Our ability to acquire deposits or borrow could be impaired by factors that are
not specific to us, such as a severe disruption of the financial markets or
negative views and expectations about the prospects for the financial services
industry as a whole. Additionally, the origination volume of PPP loans could be
a drain on our liquidity. At March 31, 2020, management considered the Company's
liquidity level to be sufficient for the purposes of meeting our cash flow
requirements. We are not aware of any undisclosed known trends, demands,
commitments, or uncertainties that are reasonably likely to result in material
changes in our liquidity.

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

Off-Balance Sheet Arrangements and Derivatives


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

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  Table of Contents

Credit Commitments

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

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

See detailed information on credit commitments above under "Liquidity."

Derivatives

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


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

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



                                                     March 31, 2020              December 31, 2019
                                                Notional      Estimated      Notional        Estimated
                                                 Amount      Fair Value       Amount        Fair Value
                                                                (dollars in thousands)
Asset - IRLCs                                   $       -    $         -    $     7,645$       179
Asset - mandatory forward contracts                21,160            584         10,591              23
Asset - best effort forward contracts              35,773            817          7,645              23
Liability - IRLCs                                  35,773             61              -               -




Inflation

The consolidated financial statements and related consolidated financial data
presented herein have been prepared in accordance with GAAP and practices within
the banking industry which require the measurement of financial condition and
operating results in terms of historical dollars without considering the changes
in the relative purchasing power of money over time due to inflation. As a
financial institution, virtually all of our assets and liabilities are monetary
in nature and interest rates have a more significant impact on our performance
than the effects of general levels of inflation. A prolonged period of inflation
could cause interest rates, wages, and other costs to increase and could
adversely affect our results of operations unless mitigated by a corresponding
increase in our revenues. However, we believe that the impact of inflation on
our operations was not material for the three months ended March 31, 2020 and
2019.

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