**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

| **ý**                                              |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                    |
| **For  the quarterly period ended June 30, 2003**       |
|                                                    |
| **OR**                                                  |
|                                                    |
| **o**                                                   |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                    |
| **Commission  file number 0-12638**                     |
|                                                    |
| **F&M  BANCORP**                                    |
| (Exact name of registrant as specified in  its charter) |

 

| **Maryland**                                                    |   | **52-1316473**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**110 Thomas Johnson Drive**

**Frederick, Maryland 21702**

(Address of principal executive offices) (Zip Code)

 

**(888) 694-4170**

(Registrant’s telephone number, including area code)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

**NONE**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**Common Stock ($5 par value)**

(Title of class)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

Common Stock of10,785,723 shares outstanding as of July 18, 2003.

 

 

----

 

Form 10-Q

TABLE OF CONTENTS

 
| **PART I**    | **Financial Information**                                                                               |
|---------------|---------------------------------------------------------------------------------------------------------|
| Item 1.       | Financial Statements                                                                                    |
|          | Consolidated  Statements of Income (Unaudited)                                                          |
|          | Consolidated Balance Sheets  (Unaudited)                                                                |
|          | Consolidated  Statements of Changes in Shareholders’ Equity and Comprehensive Income  (Unaudited)  |
|          | Consolidated  Statements of Cash Flows (Unaudited)                                                      |
|          | Notes to Financial  Statements (Unaudited)                                                              |
|          |                                                                                                    |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  (MD&A) |
|          | Summary Financial Data                                                                                  |
|          | Overview                                                                                                |
|          | Earnings Performance                                                                                    |
|          | Net  Interest Income                                                                                    |
|          | Provision for Credit Losses                                                                             |
|          | Noninterest  Income                                                                                     |
|          | Noninterest  Expense                                                                                    |
|          | Balance Sheet Analysis                                                                                  |
|          | Securities Available for  Sale                                                                          |
|          | Loan Portfolio                                                                                          |
|          | Nonaccrual Loans and  Other Assets                                                                      |
|          | Nonaccrual  Loans and Other Real Estate Owned                                                           |
|          | Allowance for Credit Losses                                                                             |
|          | Deposits                                                                                                |
|          | Capital  Adequacy/Ratios                                                                                |
|          | Contractual  Obligations and Other Commitments                                                          |
|          | Asset/Liability  and Market Risk Management                                                             |
|          | Capital Management                                                                                      |
|          |                                                                                                    |
| Item  3.      | Quantitative  and Qualitative Disclosure about Market Risk                                              |
|          |                                                                                                    |
| Item 4.       | Controls and Procedures                                                                                 |
|          | Factors that May  Affect Future Results                                                                 |
| **PART II**   | **Other Information**                                                                                   |
| Item 4.       | Submission of Matters to a Vote of Security Holders                                                     |
| Item  6.      | Exhibits  and Reports on Form 8-K                                                                       |
|          |                                                                                                    |
| **Signature** |                                                                                                    |

 

The information furnished in these interim statements reflects alladjustments that are, in the opinion of management, necessary for a fairstatement of the results for such periods. Such adjustments are of a normalrecurring nature, unless otherwise disclosed in this Form 10-Q.  The results of operations in the interimstatements are not necessarily indicative of the results that may be expectedfor the full year. The interim financial information should be read inconjunction with F&M Bancorp’s 2003 Annual Report on Form 10-K.

 

2

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**PART I – FINANCIAL INFORMATION**

F&M BANCORP ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME(Unaudited)

 
|                                                  |   | **Quarter ended  June 30,** |       | **Six months ended  June 30,** |       |
|-------------------------------------------------------|--------|-----------------------------|------------|--------------------------------|------------|
| **(in thousands, except shares)**                     |   | **2003**                    |       | **2002**                       |       | **2003** |   | **2002** |   |
| **INTEREST  INCOME**                                  |   |                        |       |                           |       |   |   |   |   |
| Loans                                                 |   | **$**                       | **20,080** |                           | $          | 20,447 | ** ** | **$** | **40,571** |   | $ | 41,439 |   |
| Loans held for sale                                   |   | **368**                     |       | 203                            | ** ** | **664** |   | 495 |   |
| Securities available for sale                         |   | **5,994**                   |       | 7,011                          | ** ** | **12,350** |   | 13,554 |   |
| Other interest income                                 |   | **101**                     |       | 158                            | ** ** | **194** |   | 294 |   |
| Total interest income                                 |   | **26,543**                  |       | 27,819                         | ** ** | **53,779** |   | 55,782 |   |
| **INTEREST  EXPENSE**                                 |   |                        |       |                           |       |   |   |   |   |
| Deposits                                              |   | **6,301**                   |       | 8,071                          | ** ** | **12,751** |   | 16,920 |   |
| Short-term borrowings                                 |   | **333**                     |       | 329                            | ** ** | **700** |   | 641 |   |
| Long-term borrowings                                  |   | **931**                     |       | 828                            | ** ** | **1,876** |   | 1,607 |   |
| Total interest expense                                |   | **7,565**                   |       | 9,228                          | ** ** | **15,327** |   | 19,168 |   |
| **NET INTEREST INCOME**                               |   | **18,978**                  |       | 18,591                         | ** ** | **38,452** |   | 36,614 |   |
| Provision for credit losses                           |   | **700**                     |       | 150                            | ** ** | **1,225** |   | 975 |   |
| Net interest income after provision for credit losses |   | **18,278**                  |       | 18,441                         | ** ** | **37,227** |   | 35,639 |   |
| **NONINTEREST  INCOME**                               |   |                        |       |                           |       |   |   |   |   |
| Service charges on deposit accounts                   |   | **2,285**                   |       | 2,282                          | ** ** | **4,398** |   | 4,478 |   |
| Insurance income                                      |   | **3,201**                   |       | 2,540                          | ** ** | **6,141** |   | 5,190 |   |
| Mortgage banking fees                                 |   | **1,247**                   |       | 814                            | ** ** | **1,925** |   | 1,651 |   |
| Trust and investment fees                             |   | **760**                     |       | 910                            | ** ** | **1,476** |   | 1,831 |   |
| Gains on sales of securities                          |   | **50**                      |       | —                         | ** ** | **516** |   | — |   |
| Gains on sales of property                            |   | **189**                     |       | 36                             | ** ** | **225** |   | 122 |   |
| Other operating income                                |   | **1,514**                   |       | 1,357                          | ** ** | **2,896** |   | 2,672 |   |
| Total noninterest income                              |   | **9,246**                   |       | 7,939                          | ** ** | **17,577** |   | 15,944 |   |
| **NONINTEREST  EXPENSE**                              |   |                        |       |                           |       |   |   |   |   |
| Salaries                                              |   | **7,731**                   |       | 7,549                          | ** ** | **15,063** |   | 14,663 |   |
| Incentive compensation                                |   | **968**                     |       | 573                            | ** ** | **1,814** |   | 1,202 |   |
| Employee benefits                                     |   | **1,721**                   |       | 1,459                          | ** ** | **3,158** |   | 3,373 |   |
| Occupancy and equipment expense                       |   | **2,537**                   |       | 2,625                          | ** ** | **4,768** |   | 5,099 |   |
| Core deposit intangible                               |   | **237**                     |       | 224                            | ** ** | **483** |   | 439 |   |
| Other operating expense                               |   | **3,579**                   |       | 4,765                          | ** ** | **8,184** |   | 9,188 |   |
| Total noninterest expenses                            |   | **16,773**                  |       | 17,195                         | ** ** | **33,470** |   | 33,964 |   |
| **INCOME BEFORE  INCOME TAX EXPENSE**                 |   | **10,751**                  |       | 9,185                          | ** ** | **21,334** |   | 17,619 |   |
| Income tax expense                                    |   | **3,230**                   |       | 3,069                          | ** ** | **6,614** |   | 5,726 |   |
| **NET INCOME**                                        |   | **$**                       | **7,521**  |                           | $          | 6,116 | ** ** | **$** | **14,720** |   | $ | 11,893 |   |
| **EARNINGS PER  COMMON SHARE**                        |   |                        |       |                           |       |   |   |   |   |
| Earnings per common share                             |   | **$**                       | **0.70**   |                           | $          | 0.57 | ** ** | **$** | **1.37** |   | $ | 1.10 |   |
| Diluted earnings per common share                     |   | **$**                       | **0.68**   |                           | $          | 0.56 | ** ** | **$** | **1.35** |   | $ | 1.09 |   |
| **DIVIDENDS  PAID PER COMMON SHARE**                  |   | **$**                       | **0.29**   |                           | $          | 0.28 | ** ** | **$** | **0.58** |   | $ | 0.56 |   |
| Average common shares outstanding                     |   | **10,772,543**              |       | 10,814,183                     | ** ** | **10,755,483** |   | 10,833,329 |   |
| Diluted average common shares outstanding             |   | **11,017,292**              |       | 10,877,815                     | ** ** | **10,942,118** |   | 10,895,311 |   |

 

3

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**F&M BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS******(Unaudited)

 
| **(in thousands, except shares)**                                                                                                           |   | **June 30,  2003** |          | **December 31,  2002** |   | **June 30,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|---------------|------------------------|--------|--------------------|--------|
| **ASSETS**                                                                                                                                  |   |               |          |                   |   |               |   |
| Cash and due from banks                                                                                                                     |   | **$**              | **81,916**    | ** **             | $      | 81,444             |   | $ | 58,732 |   |
| Federal funds sold                                                                                                                          |   | **143**            | ** **    | 232                    |   | 8,327              |   |
| Total cash and cash equivalents                                                                                                             |   | **82,059**         | ** **    | 81,676                 |   | 67,059             |   |
|                                                                                                                                        |   |               | ** **    |                   |   |               |   |
| Loans held for sale                                                                                                                         |   | **24,110**         | ** **    | 28,722                 |   | 10,655             |   |
| Securities available for sale                                                                                                               |   | **651,710**        | ** **    | 618,452                |   | 606,826            |   |
| Nonmarketable equity securities                                                                                                             |   | **7,274**          | ** **    | 6,780                  |   | 6,866              |   |
|                                                                                                                                        |   |               | ** **    |                   |   |               |   |
| Loans                                                                                                                                       |   | **1,331,509**      | ** **    | 1,305,348              |   | 1,171,946          |   |
| Less: Allowance for credit losses                                                                                                           |   | **(12,980**        | **)**         | (13,668                | )      | (13,999            | )      |
| Net loans                                                                                                                                   |   | **1,318,529**      | ** **    | 1,291,680              |   | 1,157,947          |   |
|                                                                                                                                        |   |               | ** **    |                   |   |               |   |
| Bank premises and equipment, net                                                                                                            |   | **36,109**         | ** **    | 36,024                 |   | 34,751             |   |
| Other real estate owned, net                                                                                                                |   | **422**            | ** **    | 414                    |   | 354                |   |
| Interest receivable                                                                                                                         |   | **8,572**          | ** **    | 9,513                  |   | 8,982              |   |
| Core deposit intangible                                                                                                                     |   | **1,403**          | ** **    | 1,886                  |   | 2,378              |   |
| Mortgage servicing rights                                                                                                                   |   | **274**            | ** **    | 580                    |   | 898                |   |
| Cash value of life insurance                                                                                                                |   | **12,408**         | ** **    | 12,109                 |   | 11,256             |   |
| Other assets                                                                                                                                |   | **5,936**          | ** **    | 7,150                  |   | 8,132              |   |
| Total assets                                                                                                                                |   | **$**              | **2,148,806** | ** **             | $      | 2,094,986          |   | $ | 1,916,104 |   |
|                                                                                                                                        |   |               | ** **    |                   |   |               |   |
| **LIABILITIES  & SHAREHOLDERS’ EQUITY**                                                                                            |   |               | ** **    |                   |   |               |   |
| Liabilities:                                                                                                                                |   |               | ** **    |                   |   |               |   |
| Deposits:                                                                                                                                   |   |               | ** **    |                   |   |               |   |
| Noninterest-bearing                                                                                                                         |   | **$**              | **307,694**   | ** **             | $      | 264,965            |   | $ | 260,082 |   |
| Interest-bearing                                                                                                                            |   | **1,386,763**      | ** **    | 1,330,174              |   | 1,289,159          |   |
| Total deposits                                                                                                                              |   | **1,694,457**      | ** **    | 1,595,139              |   | 1,549,241          |   |
|                                                                                                                                        |   |               | ** **    |                   |   |               |   |
| Short-term borrowings                                                                                                                       |   | **166,012**        | ** **    | 219,060                |   | 96,437             |   |
| Long-term borrowings                                                                                                                        |   | **77,692**         | ** **    | 78,023                 |   | 78,342             |   |
| Accrued taxes and other liabilities                                                                                                         |   | **15,421**         | ** **    | 18,508                 |   | 14,622             |   |
| Total liabilities                                                                                                                           |   | **1,953,582**      | ** **    | 1,910,730              |   | 1,738,642          |   |
| Shareholders’ equity:                                                                                                                  |   |               | ** **    |                   |   |               |   |
| Common stock, $5 par value; authorized 50,000,000 shares; issued  10,784,383 shares, 10,862,257 shares, and 10,884,140 shares, respectively |   | **53,922**         | ** **    | 53,646                 |   | 53,882             |   |
| Surplus                                                                                                                                     |   | **71,720**         | ** **    | 70,598                 |   | 72,121             |   |
| Retained earnings                                                                                                                           |   | **58,352**         | ** **    | 50,179                 |   | 43,657             |   |
| Accumulated other comprehensive income                                                                                                      |   | **11,230**         | ** **    | 9,833                  |   | 7,802              |   |
| Total shareholders’ equity                                                                                                             |   | **195,224**        | ** **    | 184,256                |   | 177,462            |   |
| Total liabilities and shareholders’ equity                                                                                             |   | **$**              | **2,148,806** | ** **             | $      | 2,094,986          |   | $ | 1,916,104 |   |

 

4

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**F&M BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS****’**

**EQUITY AND COMPREHENSIVE INCOME**(Unaudited)

 
| **(in thousands, except per share data)**                                                                                        |   | **Number  of shares** |       | **Common  stock** |       | **Surplus** |       | **Retained  earnings** |       | **Accumulated  other  comprehensive  (loss) income** |       | **Total**   |       |
|----------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|-------------------|------------|-------------|------------|------------------------|------------|------------------------------------------------------|------------|-------------|------------|
|                                                                                                                             |   |                  |       |              |       |        |       |                   |       |                                                 |       |        |       |
| Balance at December 31, 2001                                                                                                     |   | 10,862,257            |       | $                 | 54,311     |        | $          | 75,147                 |       | $                                                    | 34,782     |        | $          | 3,185 |   | $ | 167,425 |   |
| Comprehensive income:                                                                                                            |   |                  |       |              |       |        |       |                   |       |                                                 |       |        |       |
| Net income                                                                                                                       |   | —                |       | —            |       | —      |       | 11,893                 |       | —                                               |       | 11,893      |       |
| Other comprehensive income net of tax:                                                                                           |   |                  |       |              |       |        |       |                   |       |                                                 |       |        |       |
| Net unrealized gains on securities                                                                                               |   | —                |       | —            |       | —      |       | —                 |       | 4,617                                                |       | 4,617       |       |
| Total comprehensive income                                                                                                       |   |                  |       |              |       |        |       |                   |       |                                                 |       | 16,510      |       |
| Dividend reinvestment plan                                                                                                       |   | —                |       | —            |       | —      |       | (24                    | )          | —                                               |       | (24         | )          |
| Cash dividends declared ($.56 per share)                                                                                         |   | —                |       | —            |       | —      |       | (2,985                 | )          | —                                               |       | (2,985      | )          |
| Stock consideration for options exercised                                                                                        |   | (596                  | )          | (3                | )          | (674        | )          | (9                     | )          | —                                               |       | (686        | )          |
| Stock options exercised                                                                                                          |   | 30,484                |       | 152               |       | 469         |       | —                 |       | —                                               |       | 621         |       |
| Stock repurchase and retirement                                                                                                  |   | (115,830              | )          | (578              | )          | (2,821      | )          | —                 |       | —                                               |       | (3,399      | )          |
| Net change                                                                                                                       |   | (85,942               | )          | (429              | )          | (3,026      | )          | 8,875                  |       | 4,617                                                |       | 10,037      |       |
| Balance at June 30, 2002                                                                                                         |   | 10,776,315            |       | $                 | 53,882     |        | $          | 72,121                 |       | $                                                    | 43,657     |        | $          | 7,802 |   | $ | 177,462 |   |
|                                                                                                                             |   |                  |       |              |       |        |       |                   |       |                                                 |       |        |       |
| **Balance at  December 31, 2002**                                                                                                |   | **10,729,304**        | ** ** | **53,646**        | ** ** | **70,598**  | ** ** | **50,179**             | ** ** | **9,833**                                            | ** ** | **184,256** | ** ** |
| **Comprehensive  income:**                                                                                                       |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                 | ** ** |        | ** ** |
| **Net income**                                                                                                                   |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **14,720**             | ** ** | **—**                                           | ** ** | **14,720**  | ** ** |
| **Other  comprehensive income net of tax:**                                                                                      |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                 | ** ** |        | ** ** |
| **Net  unrealized gains on securities available for sale, net of reclassification of  $317 of net gains included in net income** |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **—**             | ** ** | **1,397**                                            | ** ** | **1,397**   | ** ** |
| **Total  comprehensive income**                                                                                                  |   |                  | ** ** |              | ** ** |        | ** ** |                   | ** ** |                                                 | ** ** | **16,117**  | ** ** |
| **Dividend  reinvestment plan**                                                                                                  |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **—**             | ** ** | **—**                                           | ** ** | **—**  | ** ** |
| **Cash  dividends declared ($.58 per share)**                                                                                    |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **(6,236**             | **)**      | **—**                                           | ** ** | **(6,236**  | **)**      |
| **Stock  consideration for options exercised**                                                                                   |   | **(9,572**            | **)**      | **(47**           | **)**      | **(62**     | **)**      | **(311**               | **)**      | **—**                                           | ** ** | **(420**    | **)**      |
| **Stock options  exercised**                                                                                                     |   | **64,651**            | ** ** | **323**           | ** ** | **1,184**   | ** ** | **—**             | ** ** | **—**                                           | ** ** | **1,507**   | ** ** |
| **Stock  repurchase and retirement**                                                                                             |   | **—**            | ** ** | **—**        | ** ** | **—**  | ** ** | **—**             | ** ** | **—**                                           | ** ** | **—**  | ** ** |
| **Net change**                                                                                                                   |   | **55,079**            | ** ** | **276**           | ** ** | **1,122**   | ** ** | **8,173**              | ** ** | **1,397**                                            | ** ** | **10,968**  | ** ** |
| **Balance at  June 30, 2003**                                                                                                    |   | **10,784,383**        | ** ** | **$**             | **53,922** | ** **  | **$**      | **71,720**             | ** ** | **$**                                                | **58,352** | ** **  | **$**      | **11,230** | ** ** | **$** | **195,224** | ** ** |

 

5

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**F&M BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOW******(Unaudited)

 
|                                                                                                        |   | **Six months ended  June 30,** |       |
|-------------------------------------------------------------------------------------------------------------|--------|--------------------------------|------------|
| **(in thousands)**                                                                                          |   | **2003**                       |       | **2002** |   |
| **Cash Flows  from Operating Activities**                                                                   |   |                           | ** ** |   |   |
| Net Income                                                                                                  |   | **$**                          | **14,720** | ** ** | $ | 11,893 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities                           |   |                           | ** ** |   |   |
| Provision for credit losses                                                                                 |   | **1,225**                      | ** ** | 975 |   |
| Depreciation and amortization                                                                               |   | **1,480**                      | ** ** | 1,939 |   |
| Amortization of intangibles                                                                                 |   | **789**                        | ** ** | 591 |   |
| Net premium amortization on investment securities                                                           |   | **1,254**                      | ** ** | 1,349 |   |
| Decrease in interest receivable                                                                             |   | **941**                        | ** ** | 435 |   |
| Decrease in interest payable                                                                                |   | **(18**                        | **)**      | (407 | ) |
| Gain on sales of property                                                                                   |   | **(225**                       | **)**      | (122 | ) |
| Gain on sales of securities                                                                                 |   | **(516**                       | **)**      | — |   |
| Decrease in loans held for sale                                                                             |   | **4,612**                      | ** ** | 18,124 |   |
| (Increase) decrease in other assets                                                                         |   | **(247**                       | **)**      | 372 |   |
| Decrease in other liabilities                                                                               |   | **(3,068**                     | **)**      | (1,923 | ) |
| Gain on sales of loans                                                                                      |   | **(1,925**                     | **)**      | (1,721 | ) |
| Net cash provided by operating activities                                                                   |   | **19,022**                     | ** ** | 31,505 |   |
| **Cash Flows  from Investing Activities**                                                                   |   |                           | ** ** |   |   |
| Purchases of investment securities available for sale                                                       |   | **(253,846**                   | **)**      | (159,741 | ) |
| Proceeds from sales/maturities of securities available for sale                                             |   | **221,915**                    | ** ** | 105,340 |   |
| Net Increase in loans                                                                                       |   | **(26,327**                    | **)**      | (8,998 | ) |
| Purchases of premises and equipment                                                                         |   | **(1,745**                     | **)**      | (1,126 | ) |
| Proceeds from sales of property                                                                             |   | **575**                        | ** ** | 481 |   |
| Net cash used in investing activities                                                                       |   | **(59,428**                    | **)**      | (64,044 | ) |
| **Cash Flows  from Financing Activities**                                                                   |   |                           | ** ** |   |   |
| Net increase in noninterest-bearing deposits, interest-bearing  checking, savings and money market accounts |   | **92,705**                     | ** ** | 74,231 |   |
| Net increase (decrease) in certificates of deposit                                                          |   | **6,614**                      | ** ** | (41,058 | ) |
| Net decrease in short-term borrowings                                                                       |   | **(53,050**                    | **)**      | (21,108 | ) |
| Gross debt issued in long-term borrowings                                                                   |   | **—**                     | ** ** | 15,000 |   |
| Gross debt maturitiess in long-term borrowings                                                              |   | **(331**                       | **)**      | (102 | ) |
| Cash dividends paid                                                                                         |   | **(6,236**                     | **)**      | (2,984 | ) |
| Dividend reinvestment plan                                                                                  |   | **—**                     | ** ** | (24 | ) |
| Proceeds from issuance of common stock                                                                      |   | **1,087**                      | ** ** | (65 | ) |
| Common stock purchased and retired                                                                          |   | **—**                     | ** ** | (3,400 | ) |
| Net cash provided by financing activities                                                                   |   | **40,789**                     | ** ** | 20,490 |   |
| Net increase (decrease) in cash and cash equivalents                                                        |   | **383**                        | ** ** | (12,049 | ) |
| Cash and cash equivalents at beginning of year                                                              |   | **81,676**                     | ** ** | 79,108 |   |
| Cash and cash equivalents at end of period                                                                  |   | **$**                          | **82,059** | ** ** | $ | 67,059 |   |
| **Supplemental  Disclosures of Cash Flow Information**                                                      |   |                           | ** ** |   |   |
| Cash payments for interest                                                                                  |   | **$**                          | **15,346** | ** ** | $ | 19,574 |   |
| Cash payments for income tax                                                                                |   | **$**                          | **7,581**  | ** ** | $ | 5,711 |   |
| **Non-Cash  Investing and Financing Activities**                                                            |   |                           | ** ** |   |   |
| Fair value adjustment for securities available for sale, net of income  taxes                               |   | **$**                          | **1,397**  | ** ** | $ | 4,617 |   |

 

6

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**F&M BANCORP AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL****STATEMENTS**(Unaudited)

 

1. Summary of Significant Accounting Policies

 

F&M Bancorp and Subsidiaries (consolidated) (the Bancorp) is adiversified financial services company providing banking, insurance,investments, mortgage banking and consumer finance through banking branches,the internet and other distribution channels to consumers and businesseslocated primarily within the State of Maryland.  F&M Bancorp (the Parent) is a bank holding company.

 

The accounting and reporting policies and practices of the Bancorpconform with accounting principles generally accepted in the United States ofAmerica (“GAAP”) and prevailing practice within the financial servicesindustry. The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect reportedamounts of assets and liabilities at the date of the financial statements andincome and expenses during the reporting period. Actual results could differfrom those estimates. Certain amounts in the financial statements for prioryears have been reclassified to conform with the current financial statementpresentation.

 

Descriptions of the significant accounting policies of F&M Bancorpand Subsidiaries (the Bancorp) are included in Note 1 (Summary of SignificantAccounting Policies) to the audited consolidated financial statements includedin the Bancorp’s 2002 Annual Report on Form 10-K. There have been nosignificant changes to these policies.

 

The table below reflects the fair value-based accounting of stockoptions under the provisions of FASB Statement No. 148, *Accounting for Stock-BasedCompensation.*

 
|                                                                                                                                        |   | **Quarter ended June 30,** |      | **Six months ended June 30,** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|-----------|-------------------------------|------------|
| **(in thousand, except per share  amounts)**                                                                                                |   | **2003**                   |      | **2002**                      |       | **2003** |   | **2002** |   |
| Net income, as reported                                                                                                                     |   | **$**                      | **7,521** |                          | $          | 6,116 | ** ** | **$** | **14,720** |   | $ | 11,893 |   |
| Add: Stock-based employee compensation expense included in reported net  income, net of related tax effect                                  |   | **—**                 |      | —                        | ** ** | **—** |   | — |   |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effect |   | **(151**                   | **)**     | (47                           | )          | **(291** | **)** | (81 | ) |
| Pro forma net income                                                                                                                        |   | **$**                      | **7,370** |                          | $          | 6,069 | ** ** | **$** | **14,429** |   | $ | 11,812 |   |
|                                                                                                                                        |   |                       |      |                          |       |   |   |   |   |
| Earnings per common share                                                                                                                   |   |                       |      |                          |       |   |   |   |   |
| As reported                                                                                                                                 |   | **0.70**                   |      | 0.57                          | ** ** | **1.37** |   | 1.10 |   |
| Pro forma                                                                                                                                   |   | **0.68**                   |      | 0.56                          | ** ** | **1.34** |   | 1.09 |   |
| Diluted earnings per common share                                                                                                           |   |                       |      |                          |       |   |   |   |   |
| As reported                                                                                                                                 |   | **0.68**                   |      | 0.56                          | ** ** | **1.35** |   | 1.09 |   |
| Pro forma                                                                                                                                   |   | **0.67**                   |      | 0.56                          | ** ** | **1.32** |   | 1.08 |   |

 

2. Business Combinations

 

On July 8, 2003, the Board of Governors of the Federal Reserve Systemapproved the application by Mercantile Bankshares Corporation to merge withF&M Bancorp. The Federal Reserve Board also approved the application byF&M Bancorp’s bank subsidiary, Farmers & Mechanics Bank, to merge withFredericktown Bank and Trust, a Mercantile Bankshares subsidiary. The mergerbetween Mercantile Bankshares and F&M Bancorp is subject

 

7

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to approval by state regulators and the shareholders of F&M Bancorp.The shareholders meeting to approve the F&M Bancorp transaction will occuron August 6, 2003. Provided that state bank regulators and shareholders approvethe transaction, it is expected that the merger closing for the holding companywill occur on August 12, 2003.

 

3. Earnings Per Share

 

The table below shows dual presentation of earnings per common shareand diluted earnings per common share and a reconciliation of the numerator anddenominator of both earnings per common share calculations.

 
|                                     |   | **Quarter ended June 30,** |      | **Six months ended June 30,** |       |
|------------------------------------------|--------|----------------------------|-----------|-------------------------------|------------|
| **(in thousands except per share data)** |   | **2003**                   |      | **2002**                      |       | **2003** |   | **2002** |   |
|                                     |   |                       |      |                          |       |   |   |   |   |
| Net income                               |   | **$**                      | **7,521** |                          | $          | 6,116 | ** ** | **$** | **14,720** |   | $ | 11,893 |   |
| Basic EPS                                |   |                       |      |                          |       |   |   |   |   |
| Average Shares                           |   | **10,772,543**             |      | 10,814,183                    | ** ** | **10,755,483** |   | 10,833,329 |   |
| EPS                                      |   | **$**                      | **0.70**  |                          | $          | 0.57 | ** ** | **$** | **1.37** |   | $ | 1.10 |   |
| Dilutive shares                          |   |                       |      |                          |       |   |   |   |   |
| Stock options                            |   | **244,749**                |      | 63,632                        | ** ** | **186,635** |   | 61,982 |   |
| EPS                                      |   | **$**                      | **0.02**  |                          | $          | 0.01 | ** ** | **$** | **0.02** |   | $ | 0.01 |   |
| Diluted EPS                              |   |                       |      |                          |       |   |   |   |   |
| Average Shares including options         |   | **11,017,292**             |      | 10,877,815                    | ** ** | **10,942,118** |   | 10,895,311 |   |
| EPS                                      |   | **$**                      | **0.68**  |                          | $          | 0.56 | ** ** | **$** | **1.35** |   | $ | 1.09 |   |

 

4. Operating Segments

 

Operating segments as defined by SFAS No. 131 *Disclosures about Segments of anEnterprise and Related Information* are components of an enterprise withseparate financial information.  Thecomponent engages in business activities, from which it derives revenues andincurs expenses and whose operating result’s management relies on for decisionmaking and performance assessment. The Bancorp, as defined by this standard,does not have any segment whose revenues, reported profit and loss, or assetsare 10% or more of the combined revenues of all reporting segments.

 

5. Intangible Assets

 

The gross carrying amount of intangible assets and the associated accumulatedamortization at June 30 is presented in the following table.

 
|                         |   | **June 30, 2003**          |       |
|------------------------------|--------|----------------------------|------------|
| **(in thousands)**           |   | **Gross  Carrying amount** |       | **Accumulated  amortization** |   | **Valuation  allowance** |   | **Net intangible  assets** |   |
|                         |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Amortized intangible assets: |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Core deposit intangible      |   | **$**                      | **8,565**  | ** ** | **$** | **7,162** | ** ** | **$** | **—** | ** ** | **$** | **1,403** | ** ** |
| Mortgage servicing rights    |   | **1,757**                  | ** ** | **1,120** | ** ** | **363** | ** ** | **274** | ** ** |
| Total                        |   | **$**                      | **10,322** | ** ** | **$** | **8,282** | ** ** | **$** | **363** | ** ** | **$** | **1,677** | ** ** |

 

8

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|                         |   | **June 30, 2002**          | ** ** |
|------------------------------|--------|----------------------------|------------|
| **(in thousands)**           |   | **Gross  carrying amount** | ** ** | **Accumulated  amortization** | ** ** | **Valuation  allowance** | ** ** | **Net intangible  assets** | ** ** |
|                         |   |                       |       |   |   |   |   |   |   |
| Amortized intangible assets: |   |                       |       |   |   |   |   |   |   |
| Core deposit intangible      |   | $                          | 8,565      |   | $ | 6,187 |   | $ | — |   | $ | 2,378 |   |
| Mortgage servicing rights    |   | 1,757                      |       | 859 |   | — |   | 898 |   |
| Total                        |   | $                          | 10,322     |   | $ | 7,046 |   | $ | — |   | $ | 3,276 |   |

 

The projections of amortization expense shown below for mortgageservicing rights are based on asset balances and the interest rate environmentas of June 30, 2003. Future amortization expense may be significantly differentdepending upon changes in the mortgage servicing portfolio, mortgage interestrates and market conditions.

 

The following table shows the current period and estimated futureamortization expense for amortized intangible assets. Core deposit intangiblesare amortized on useful lives of up to 15 years. The Bancorp reviews otherintangible assets for impairment quarterly (except mortgage servicing rights,which are reviewed monthly), or whenever events or changes in circumstances indicatethat their carrying amounts may not be recoverable. For those intangible assetssubject to amortization, impairment is indicated if the sum of undiscountedestimated future net cash flow is less than the carrying amount of the asset.Impairment is recognized by accelerating the write off of the asset to theextent that the carrying value exceeds the estimated fair value.

 
| **(in thousands)**                             |   | **Core  deposit  intangibles** |   | **Mortgage  servicing  rights** |   | **Total** |   |
|------------------------------------------------|--------|--------------------------------|--------|---------------------------------|--------|-----------|--------|
|                                           |   |                           |   |                            |   |      |   |
| Six months ended June 30, 2003 (actual)        |   | $                              | 419    |                            | $      | 130       |   | $ | 549 |   |
|                                           |   |                           |   |                            |   |      |   |
| Six months ended December 31, 2003 (estimated) |   | 470                            |   | 130                             |   | 600       |   |
|                                           |   |                           |   |                            |   |      |   |
| Estimate for year ended December 31,           |   |                           |   |                            |   |      |   |
| 2004                                           |   | 790                            |   | 144                             |   | 934       |   |
| 2005                                           |   | 143                            |   | —                          |   | 143       |   |
| 2006                                           |   | —                         |   | —                          |   | —    |   |
| 2007                                           |   | —                         |   | —                          |   | —    |   |
| 2008                                           |   | —                         |   | —                          |   | —    |   |
|                                                |        |                                |        |                                 |        |           |        |  |  |  |

 

6. Commitments

 

Various commitments to extend credit (lines of credit) are made in thenormal course of the banking business. Total unused lines of creditapproximated $297.2 million, $154.1 million and $255.3 million at June 30,2003, December 31, 2002 and June 30, 2002, respectively. In addition, lettersof credit are issued for the benefit of customers. Outstanding letters ofcredit were $29.1 million at June 30, 2003, $23.8 million at December 31,

 

9

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2002 and $23.9 million at June 30, 2002 in accordance with FASBInterpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*.A liability of $90 thousand for performance under standby letters of credit wasrecorded as of June 30, 2003. All standby letters of credit are supported bycollateral or recourse provisions that are expected to cover the majority ofthese obligations. The fees received for issuing letters of credit are deferredand amortized over the life of the commitment.

 

7. Derivative Instruments and Hedging Activities

 

FASB Statement No. 133 (SFAS No. 133), *Accounting for Derivative Instrumentsand Hedging Activities,*and FASB Statement No. 138 (SFAS No. 138), *Accountingfor Certain Derivative Instruments and Certain Hedging Activities – anamendment to FASB Statement No. 133,*collectively (SFAS No. 133)establishes accounting and reporting standards for derivative instruments andfor hedging activities. The Bancorp enters into interest rate locks withmortgage loan customers and forward commitments to sell loans to mortgageinvestors. These are considered derivative instruments under SFAS No. 133.

 

All derivative instruments are recognized on the balance sheet at fairvalue. On the date the Bancorp enters into a derivative contract, the Bancorpdesignates the derivative instrument as (1) a hedge of the fair value of arecognized asset or liability or of a unrecognized firm commitment (“fair valuehedge”), or (2) a hedge of a forecasted transaction or of the variability ofcash flows to be received or paid related to a recognized asset or liability(“cash flow hedge”).**For a fair value hedge, changes in thefair value of the derivative instrument and changes in the fair value of thehedged asset or liability or of an unrecognized firm commitment attributable tothe hedged risk are recorded in current period net income in the same financialstatement category of the hedged item. For a cash flow hedge, changes in thefair value of the derivative instrument to the extent that it is effective arerecorded in other comprehensive income within stockholders’ equity andsubsequently reclassified to net income in the same period(s) that the hedgedtransaction impacts net income in the same financial statement category as thehedged item.

 

The fair value of derivative instruments was $437 thousand in loansheld for sale, $337 thousand in other assets, and $774 thousand in accruedexpenses and other liabilities at June 30, 2003.

 

8.  RecentAccounting Standards

 

In April 2003, the FASB issued SFAS No. 149 (SFAS No.149), Amendment of Statement No.133 on *Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies accountingfor derivative instruments, including certain derivative instruments embeddedin other contracts, and for hedging activities under SFAS No. 133.  In particular, SFAS No. 149 clarifies underwhat circumstances a contract with an initial net investment meets thecharacteristic of a derivative and when a derivative contains a financingcomponent that warrants special reporting in the statement of cash flows. ThisStatement is generally effective for contracts entered into or modified afterJune 30, 2003 and is not expected to have a material impact on the Bancorp’sfinancial statements.

 

In May 2003, the FASB issued SFAS No. 150 (SFAS No. 150), *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*.  SFAS No. 150establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  This Statement is not expected to have amaterial impact on the Bancorp’s financial statements.

 

On January 17, 2003, FASB issued FASB Interpretation No. 46Consolidation of Variable Interest Entities – an interpretation of ARB No. 51(FIN 46).  FIN 46 is applicableimmediately to all entities with variable interests in variable interestentities created after January 31, 2003. For the Bancorp, FIN 46 is applicable beginning June 15, 2003 to anyvariable interest entity acquired before February 1, 2003.  The Bancorp is currently in the process ofevaluating the impact of FIN 46.

 

10

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**ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS****OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

**SUMMARY FINANCIAL DATA**

 
|                                                                               |   | **Quarter ended** |       | **% Change  June 30, 2003  from** |   |
|------------------------------------------------------------------------------------|--------|-------------------|------------|-----------------------------------|--------|
| **(in thousands, except per share  amounts)**                                      |   | **Jun 30,  2003** |       | **Mar 31,  2003**                 |   | **Jun 30,  2002** |   | **Mar 31,  2003** |   | **Jun 30,  2002** |   |
| **For the  Period**                                                                |   |              |       |                              |   |   |   |   |   |   |   |
| Net income                                                                         |   | **7,521**         |       | 7,199                             |   | 6,116 |   | 4 | % | 23 | % |
| Diluted earnings per common share                                                  |   | **0.68**          |       | 0.66                              |   | 0.56 |   | 3 |   | 21 |   |
| Profitability ratios (annualized)                                                  |   |              |       |                              |   |   |   |   |   |   |   |
| Net income to average total assets (ROA)                                           |   | **1.44**          | **%**      | 1.42                              | %      | 1.30 | % | 2 |   | 11 |   |
| Net income applicable to common stock to average common stockholders  equity (ROE) |   | **15.59**         | **%**      | 15.59                             | %      | 14.14 | % | — |   | 10 |   |
| Efficiency ratio (1)                                                               |   | **58.15**         | **%**      | 58.64                             | %      | 63.19 | % | (1 | ) | (8 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Dividends paid per common share                                                    |   | **0.29**          | ** ** | 0.29                              |   | 0.28 |   | — |   | 4 |   |
| Average common shares outstanding                                                  |   | **10,772,543**    | ** ** | 10,738,234                        |   | 10,814,183 |   | — |   | — |   |
| Diluted average common shares outstanding                                          |   | **11,017,292**    | ** ** | 10,843,032                        |   | 10,877,815 |   | 2 |   | 1 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Total revenue                                                                      |   | **28,224**        | ** ** | 27,804                            |   | 26,530 |   | 2 |   | 6 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Average loans                                                                      |   | **1,316,390**     | ** ** | 1,306,446                         |   | 1,166,373 |   | 1 |   | 13 |   |
| Average assets                                                                     |   | **2,093,050**     | ** ** | 2,056,449                         |   | 1,882,011 |   | 2 |   | 11 |   |
| Average deposits                                                                   |   | **1,647,090**     | ** ** | 1,595,580                         |   | 1,528,191 |   | 3 |   | 8 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Net interest margin                                                                |   | **3.95**          | **%**      | 4.19                              | %      | 4.36 | % | (6 | ) | (9 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| **At Period End**                                                                  |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Securities available for sale                                                      |   | **651,710**       | ** ** | 627,633                           |   | 606,826 |   | 4 |   | 7 |   |
| Loans                                                                              |   | **1,331,509**     | ** ** | 1,317,789                         |   | 1,171,946 |   | 1 |   | 14 |   |
| Allowance for credit losses                                                        |   | **(12,980**       | **)**      | (13,673                           | )      | (13,999 | ) | (5 | ) | (7 | ) |
| Assets                                                                             |   | **2,148,806**     | ** ** | 2,098,469                         |   | 1,916,104 |   | 2 |   | 12 |   |
| Deposits                                                                           |   | **1,694,457**     | ** ** | 1,649,633                         |   | 1,549,241 |   | 3 |   | 9 |   |
| Shareholders’ equity                                                          |   | **195,224**       | ** ** | 189,717                           |   | 177,462 |   | 3 |   | 10 |   |
| Tier 1 capital (2)                                                                 |   | **182,564**       | ** ** | 177,491                           |   | 167,161 |   | 3 |   | 9 |   |
| Total capital (2)                                                                  |   | **196,507**       | ** ** | 191,952                           |   | 181,160 |   | 2 |   | 8 |   |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Capital ratios                                                                     |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Shareholders’ equity to assets                                                |   | **9.09**          | **%**      | 9.04                              | %      | 9.26 | % | — |   | (2 | ) |
| Risk-based capital (2)                                                             |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Tier 1 capital                                                                     |   | **12.19**         | **%**      | 11.85                             | %      | 12.20 | % | 3 |   | — |   |
| Total capital                                                                      |   | **13.12**         | **%**      | 12.82                             | %      | 13.24 | % | 2 |   | (1 | ) |
| Leverage (2)                                                                       |   | **8.73**          | **%**      | 8.64                              | %      | 8.81 | % | 1 |   | (1 | ) |
|                                                                               |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Book value per common share                                                        |   | **18.12**         | ** ** | 17.67                             |   | 16.47 |   | 3 |   | 10 |   |
| Staff (active, full-time equivalent)                                               |   | **718**           | ** ** | 728                               |   | 715 |   | (1 | ) | — |   |
| Common Stock Price                                                                 |   |              | ** ** |                              |   |   |   |   |   |   |   |
| High                                                                               |   | **50.85**         | ** ** | 44.94                             |   | 35.66 |   | 13 |   | 43 |   |
| Low                                                                                |   | **43.87**         | ** ** | 28.45                             |   | 26.21 |   | 54 |   | 67 |   |
| Period end                                                                         |   | **49.23**         | ** ** | 44.01                             |   | 35.28 |   | 12 |   | 40 |   |
| Credit Quality                                                                     |   |              | ** ** |                              |   |   |   |   |   |   |   |
| Nonperforming assets/total assets                                                  |   | **0.10**          | **%**      | 0.12                              | %      | 0.13 | % | (17 | ) | (23 | ) |
| Net chargeoffs/total loans                                                         |   | **0.40**          |       | 0.16                              |   | 0.08 |   | 153 |   | 400 |   |
| Allowance for credit losses/total loans                                            |   | **0.97**          |       | 1.05                              |   | 1.20 |   | (8 | ) | (19 | ) |

 

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(1)          The efficiency ratio isdefined as noninterest expense divided by the total revenue (net interestincome and noninterest income).

(2)          See the CapitalAdequacy/Ratios section for additional information.

 

11

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*Statementsmade in this document, other than statements of historical information, areforward-looking statements that are made pursuant to the safe harbor provisionsof Section 21E of the Securities Exchange Act of 1934. These forward-lookingstatements may sometimes be identified by words such as “expect”, “may”,“looking forward”, “we plan”, “we believe”, “are planned”, “could be” and“currently anticipate”. Although we believe these statements, as well as otheroral and written forward-looking statements made by us from time to time, to betrue and reasonable, we can give no assurance that these plans, intentions orexpectations will be achieved. Actual results, performance or achievementscould differ materially from those contemplated, expressed or implied by theforward-looking statements. Important factors that could cause actual resultsto differ materially from our forward-looking statements are set forth in ourother filings with the SEC, and in this document under the heading “RiskFactors”, beginning in the section captioned “Management’s Discussion andAnalysis of Financial Condition and Results of Operations”. We caution that therisks and factors discussed below and in such filings are not exclusive. We donot undertake to update any forward-looking statement that may be made fromtime to time by or on behalf of the Bancorp.*

 

OVERVIEW

 

F&M Bancorp is the registered bank holding company for Farmers& Mechanics Bank (the “Bank”), headquartered in Frederick, Maryland. TheBancorp is a $2.1 billion diversified financial services company providingbanking, insurance, wealth management, and mortgage banking through banking branches,the internet and other distribution channels to consumers and commercialbusinesses. The Bank operates 48 community offices in Frederick, Howard,Baltimore, Montgomery, Washington, Carroll and Alleghany Counties in Maryland,together with two insurance agencies.

 

Certain amounts in the financial review for prior quarters have beenreclassified to conform with the current financial statement presentation.

 

Net income for the second quarter of 2003 reached a record $7.5million, an increase of 23% compared with earnings of $6.1 million for thesecond quarter of 2002. Earnings per diluted share for the second quarter of2003 reached a record $0.68 per share, a 21% increase over the prior year’s$0.56 per share results. Return on average assets (ROA) was 1.44% and return onaverage equity (ROE) was 15.59% for the second quarter of 2003, compared with1.30% and 14.14%, respectively, for the same period of 2002.

 

Net income for the first six months of 2003 reached $14.7 million, or$1.35 per diluted share, compared with $11.9 million, or $1.09 per dilutedshare, for the first six months of 2002. ROA was 1.43% in the first six monthsof 2003, compared with 1.28% for the first six months of 2002. ROE was 15.59%in the first six months of 2003, compared with 13.93% for the same period of2002.

 

Net interest income on a taxable-equivalent basis was $19.6 million forthe second quarter of 2003 and $39.7 million for the first six months of 2003compared with $19.3 million and $38.2 million for the same periods of 2002. TheBancorp’s net interest margin was 3.95% for the second quarter and 4.07% forthe first six months of 2003, compared with 4.36% and 4.35% for the sameperiods of 2002.

 

Noninterest income totaled $9.2 million and $17.6 million for thesecond quarter and the first six months of 2003, respectively, compared with$7.9 million and $15.9 million for the same periods of 2002.

 

Noninterest expense totaled $16.8 million and $33.5 million for thesecond quarter and the first six months of 2003, respectively, compared with$17.2 million and $34.0 million for the same periods of 2002.

 

12

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The provision for credit losses was $700 thousand and $1.2 million inthe second quarter and the first six months of 2003, respectively, comparedwith $150 thousand and $975 thousand in the same periods in 2002. During thesecond quarter of 2003, net charge-offs were $1.4 million, or .42% of averageloans outstanding (annualized), compared with $283 thousand, or .08%, in the secondquarter of 2002. The provision for credit losses during the quarter representedapproximately 50 percent of net charge-offs. The allowance for credit losseswas $13.0 million, or .97% of total loans, at June 30, 2003, compared with$13.7 million, or 1.08%, at December 31, 2002 and $14.0 million, or 1.19% atJune 30, 2002.

 

At June 30, 2003, total nonperforming assets were $2.2 million, or .10%of total assets, compared with $2.5 million, or .12%, at December 31, 2002 and$2.5 million, or .13%, at June 30, 2002. In this foreclosed assets amounted to $422 thousand at June 30, 2003,$414 thousand at December 31, 2002 and $354 thousand at June 30, 2002.

 

At June 30, 2003, the ratio of shareholders’ equity to total assets was9.09%, compared with 9.26% at June 30, 2002. The Bancorp’s total risk-basedcapital (RBC) ratio at June 30, 2003 was 13.12% and its Tier 1 RBC ratio was12.19%, exceeding the minimum regulatory guidelines of 8% and 4%, respectivelyfor bank holding companies. The Bancorp’s ratios at June 30, 2002 were 13.24%and 12.20%, respectively. The Bancorp’s leverage ratio was 8.73% at June 30,2003 and 8.81% at June 30, 2002, exceeding the minimum regulatory guideline of3% for bank holding companies.

 

CRITICAL ACCOUNTING POLICIES

 

*Reservefor Credit Losses*

 

The Bancorp has an established process to determine the adequacy of theallowance for credit losses which assesses the risk inherent in its portfolio.This process provides an allowance consisting of two components, allocated andunallocated. To arrive at the allocated component of the allowance, the Bancorpcombines estimates of the allowance needed for loans analyzed individually(including impaired loans subject to Statement of Financial AccountingStandards No. 114 (SFAS No. 114), *Accounting by Creditors for Impairment of a Loan*)and loans analyzed on a pool basis.

 

The determination of the allocated allowance for portfolios of largercommercial and commercial real estate loans involves a review of individualhigher-risk transactions, focusing on the accuracy of loan grading, assessmentsof specific loss indicators, and in some cases, strategies for resolvingproblem credits. These considerations are supplemented by the application ofloss factors delineated by individual loan grade to the existing distributionof risk exposures, which provides an assessment of inherent losses across theentire wholesale lending portfolio segment which respond to shifts in portfoliorisk indicators. The loss factors used for this analysis have been derived fromtracking historical loss experience by asset loan grade over a 5-year period.The loan loss allocations arrived at through this factor methodology areadjusted by management’s judgement concerning the effect of recent economicevents on portfolio performance.

 

In the case of most homogeneous portfolios, such as consumer loans,residential mortgage loans, and some segments of small business lending, thedetermination of the allocated allowance is performed in the aggregate, orpooled, level. For such portfolios, the risk assessment process captures thenet charge-offs experienced over the past year. The historic loss factors arethen considered for either positive or negative adjustment by management toreflect the current risk inherent in the portfolios as of the date presented.These adjustments in the loss factors are tied to management’s evaluation of anumber of factors including: 1) changes in the trend of the volume and severityof past due, classified and non-accrual assets; 2) changes in the nature andvolume of the portfolio; 3) changes in lending policies, underwritingstandards, or collection practices; and 4) changes in the experience, ability,depth of lending management and staff.

 

13

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While coverage of one year’s losses is often adequate (particularly forhomogeneous pools of loans), the time period covered by the allowance may varyby portfolio, based on the Bancorp’s best estimate of the inherent losses inthe entire portfolio as of the evaluation date. To mitigate the imprecisioninherent in most estimates of expected credit losses, the allocated componentof the allowance is supplemented by an unallocated component. The unallocatedcomponent includes management’s judgmental determination of the amountsnecessary for concentrations, economic uncertainties and other subjectivefactors; correspondingly, the relationship of the unallocated component to thetotal allowance for credit losses may fluctuate from period to period.  Although management has allocated a portionof the allowance to specific loan categories, the adequacy of the allowancemust be considered in its entirety.

 

The Bancorp’s determination of the level of the allowance and,correspondingly, the provision for credit losses rests upon various judgementsand assumptions, including general economic conditions, loan portfoliocomposition, prior loan loss experience and the Bancorp’s ongoing examinationprocess and that of its regulators. The Bancorp has an internal risk analysisand review staff that continuously reviews loan quality and reports the resultsof its examinations to the President and Chief Executive Officer, the Board ofDirectors and its Audit Committee. Such reviews also assist executivemanagement in establishing the level of the allowance.

 

The Bancorp is examined annually by the Federal Reserve Board and theState of Maryland, including specific segments of the loan portfolio.

 

The Bancorp considers the allowance for credit losses of $13.0 millionadequate to cover probable losses inherent in loans, loan commitments andstandby and other letters of credit at June 30, 2003.

 

*Valuationof Mortgage Servicing Rights*

 

The Bancorp recognizes as assets the right to service mortgage loansfor others that were retained upon sales of loan originations. For purposes ofevaluating and measuring impairment of mortgage servicing rights, the Bancorpstratifies its portfolio on the basis of certain risk characteristics includingloan type and note rate. Based upon current fair values, mortgage servicingrights are periodically assessed for impairment. Any such indicated impairmentis recognized in income, during the period in which it occurs, in a mortgageservicing valuation account which is adjusted each subsequent period to reflectany increase or decrease in the indicated impairment. Mortgage servicing rightsare amortized over the period of estimated net servicing income and take intoaccount appropriate prepayment assumptions.

 

Key economic assumptions used in measuring any potential impairment ofthe servicing rights include the prepayment speed of the underlying mortgageloans, the weighted-average life of the loan and the discount rate. The primaryrisk of material changes to the value of the mortgage servicing rights residesin the potential volatility in the economic assumptions used, particularly theprepayment speed. The Bancorp monitors this risk and adjusts its valuationallowance as necessary to adequately reserve for any probable impairment in theportfolio. By adjusting the allowance, as necessary each quarter, the Bancorpmitigates its risk to material adverse changes in the value of the portfolio.See further discussion in Note 1 and Note 16 to Financial Statements of F&MBancorp’s 2002 Annual Report on Form 10-K.

 

*Valuationof Identifiable Intangible Assets*

 

Identifiable intangible assets primarily consist of core depositintangibles acquired in branch office acquisitions. Core deposit intangibleassets represent the excess of the fair value of liabilities assumed over thefair value of tangible assets acquired in branch office acquisitions. Theseintangible assets are amortized on an accelerated basis over an original lifeof 10 to 15 years. The Bancorp reviews its intangible assets periodically forother-than-temporary impairment. If such impairment is indicated, impairment isrecognized by accelerating the amortization of the asset to the extent that thecarrying value exceeds the estimated fair value.

 

14

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EARNINGS PERFORMANCE

 

NET INTERESTINCOME

 

Net interest income on a taxable-equivalent basis was $19.6 million insecond quarter 2003, up 1 percent from second quarter of last year. Netinterest income is affected by both changes in interest rates and thecomposition of interest-earning assets and interest-bearing liabilities. Netinterest income benefited from continued growth in earning asset levels, up 12%over the second quarter of 2002. Average investment securities increased 9% to$634 million compared to $580 million in the prior year, and increased 4% sincelast quarter. Average total loans increased 13% to $1.316 billion compared tothe prior year and 1% (3% annualized) from the first quarter of 2003. Theresidential real estate portfolio and commercial real estate portfolio reflectstrong growth, up 33% and 27%, respectively from last year. The growth in theseportfolios was slightly offset by a 14% reduction in the consumer loanportfolio, which reflects higher prepayments on the indirect automobileportfolio. Total average interest-bearing deposits increased 6% to $1.362billion in the second quarter 2003 from $1.281 billion a year ago. For the sameperiod, total average noninterest-bearing deposits increased by 15% to $285million from $247 million.

 

Offsetting this growth was the current low interest rate environment,which caused a decline in net interest margin from 4.36 percent a year ago to3.95 percent in second quarter 2003. Bancorp is asset sensitive, with assetsrepricing more quickly than liabilities in response to changes in interestrates. As a result, Bancorp’s net interest margin tends to compress and growthin net interest income tends to slow in a falling interest rate environment,which has been occurring since the first quarter of 2001. Average funding costsdeclined 66 basis points in second quarter 2003, while average net asset yieldsdeclined 96 basis points.

 

For the six months ended 2003 taxable-equivalent net interest incomewas $39.7 million, an increase of 4% over the same period of 2002.  The net interest margin for the first halfof 2003 decline 28 basis to 4.07 percent from 4.35 percent in the first half of2002.

 

Individual components of net interest income and the net interestmargin are presented in the rate/yield table on the following pages.

 

15

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**AVERAGEBALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENT BASIS) (1)**

 
|                                                                               |   | **Quarter ended Jun 30,** |          |
|------------------------------------------------------------------------------------|--------|---------------------------|---------------|
|                                                                               |   | **2003**                  |          | **2002** |   |
| **(in thousands)**                                                                 |   | **Average  balance**      |          | **Interest  income/  expense** |   | **Yields/  rates** |   | **Average  balance** |   | **Interest  income/  expense** |   | **Yields/  rates** |   |
| **ASSETS**                                                                         |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| **Interest  earning assets:**                                                      |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| Short-term funds                                                                   |   | **$**                     | **5,821**     | ** ** | **$** | **17** | ** ** | **1.17** | % | $ | 13,183 |   | $ | 57 |   | 1.73 | % |
| Loans held for sale                                                                |   | **25,666**                | ** **    | **368** | ** ** | **5.75** |   | 11,797 |   | 203 |   | 6.90 |   |
| Securities available for sale (2)(4);                                              |   |                      |          |   |   |   |   |   |   |   |   |   |   |
|                                                                               |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and federal agencies                                                 |   | **74,194**                | ** **    | **595** | ** ** | **3.22** |   | 52,694 |   | 577 |   | 4.39 |   |
| U.S. States and political subdivisions                                             |   | **100,259**               | ** **    | **1,595** | ** ** | **6.38** |   | 115,430 |   | 1,954 |   | 6.79 |   |
| Mortgage-backed securities                                                         |   | **409,320**               | ** **    | **3,949** | ** ** | **3.87** |   | 387,253 |   | 4,898 |   | 5.07 |   |
| Other securities                                                                   |   | **49,986**                | ** **    | **413** | ** ** | **3.31** |   | 25,114 |   | 265 |   | 4.23 |   |
| Total investment securities                                                        |   | **633,759**               | ** **    | **6,552** | ** ** | **4.15** |   | 580,491 |   | 7,694 |   | 5.32 |   |
| FHLB / Federal Reserve stock                                                       |   | **7,274**                 | ** **    | **84** | ** ** | **4.63** |   | 6,866 |   | 101 |   | 5.90 |   |
| Portfolio Loans (3)(4):                                                            |   |                      |          |   |   |   |   |   |   |   |   |   |   |
|                                                                               |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| Commercial                                                                         |   | **172,180**               | ** **    | **2,548** | ** ** | **5.94** |   | 159,370 |   | 2,648 |   | 6.67 |   |
| Residential real estate                                                            |   | **358,573**               | ** **    | **5,002** | ** ** | **5.60** |   | 269,459 |   | 4,522 |   | 6.73 |   |
| Commercial real estate                                                             |   | **422,474**               | ** **    | **6,754** | ** ** | **6.41** |   | 333,822 |   | 6,142 |   | 7.38 |   |
| Real estate construction                                                           |   | **107,774**               | ** **    | **1,439** | ** ** | **5.36** |   | 107,083 |   | 1,532 |   | 5.74 |   |
| Consumer installment                                                               |   | **255,389**               | ** **    | **4,399** | ** ** | **6.91** |   | 296,639 |   | 5,677 |   | 7.68 |   |
| Total loans                                                                        |   | **1,316,390**             | ** **    | **20,142** | ** ** | **6.14** |   | 1,166,373 |   | 20,521 |   | 7.06 |   |
| Total interest-earning assets                                                      |   | **1,988,910**             | ** **    | **27,163** | ** ** | **5.48** |   | 1,778,710 |   | 28,576 |   | 6.44 |   |
| Total noninterest-earning assets                                                   |   | **104,140**               |          |   |   |   |   | 103,301 |   |   |   |   |   |
| Total assets                                                                       |   | **$**                     | **2,093,050** |   |   |   |   |   | $ | 1,882,011 |   |   |   |   |   |
| **LIABILITIES**                                                                    |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| **Interest  bearing liabilities:**                                                 |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                          |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| Savings                                                                            |   | **$**                     | **239,515**   | ** ** | **$** | **472** | ** ** | **0.79** |   | $ | 211,440 |   | $ | 627 |   | 1.19 |   |
| Checking                                                                           |   | **213,546**               | ** **    | **156** | ** ** | **0.29** |   | 204,478 |   | 281 |   | 0.55 |   |
| Money market accounts                                                              |   | **287,557**               | ** **    | **731** | ** ** | **1.02** |   | 272,194 |   | 1,120 |   | 1.65 |   |
| Certificates of deposit                                                            |   | **621,559**               | ** **    | **4,941** | ** ** | **3.19** |   | 592,966 |   | 6,043 |   | 4.09 |   |
| Total interest bearing deposits                                                    |   | **1,362,177**             | ** **    | **6,300** | ** ** | **1.86** |   | 1,281,078 |   | 8,071 |   | 2.53 |   |
| Short-term borrowings                                                              |   | **159,126**               | ** **    | **333** | ** ** | **0.84** |   | 94,116 |   | 329 |   | 1.40 |   |
| Long-term borrowings                                                               |   | **77,883**                | ** **    | **931** | ** ** | **4.79** |   | 71,983 |   | 828 |   | 4.61 |   |
| Total interest bearing liabilities                                                 |   | **1,599,186**             | ** **    | **7,564** | ** ** | **1.90** | % | 1,447,177 |   | 9,228 |   | 2.56 | % |
| Non-interest bearing liabilities:                                                  |   |                      |          |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                    |   | **284,913**               |          |   |   |   |   | 247,113 |   |   |   |   |   |
| Other liabilities                                                                  |   | **15,508**                |          |   |   |   |   | 14,276 |   |   |   |   |   |
| Total non-interest bearing liabilities                                             |   | **300,421**               |          |   |   |   |   | 261,389 |   |   |   |   |   |
| Shareholders’ equity                                                          |   | **193,443**               |          |   |   |   |   | 173,445 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                    |   | **$**                     | **2,093,050** |   |   |   |   |   | $ | 1,882,011 |   |   |   |   |   |
| **Net interest  income and net interest margin on a taxable-equivalent basis (4)** |   |                      | ** **    | **$** | **19,599** |   | **3.95** | **%** |   |   | **$** | 19,348 |   | 4.36 | % |

 

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(1)          The average prime rateof the Bancorp was 4.24% and 4.75% for the quarters ended June 30, 2003 and2002, respectively. The average three-month London Interbank Offered Rate(LIBOR) was 1.23% and 1.92% for the quarters ended June 30, 2003 and 2002,respectively.

(2)          Yields are based on amortized cost balances computed on a settlement daybasis.

(3)          Loan fee income is included in the interest income calculation, andnonaccrual loans are included in the average loan base upon which the interestrate earned on loans is calculated.

(4)          Interest and yield on obligations of state and political subdivisions andtax-exempt loans are computed on a taxable equivalent basis using U.S.statutory tax rate of 35 percent.

 

16

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**AVERAGEBALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENT BASIS) (1)**

** **
|                                                                               |   | **Six months ended June 30,** |          |
|------------------------------------------------------------------------------------|--------|-------------------------------|---------------|
|                                                                               |   | **2003**                      |          | **2002** |   |
| **(in thousands)**                                                                 |   | **Average  balance**          |          | **Interest  income/  expense** |   | **Yields/  rates** |   | **Average  balance** |   | **Interest  income/  expense** |   | **Yields/  rates** |   |
| **ASSETS**                                                                         |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| **Interest  earning assets:**                                                      |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Short-term funds                                                                   |   | **$**                         | **4,492**     | ** ** | **$** | **26** | ** ** | **1.17** | **%** | $ | 12,824 |   | $ | 101 |   | 1.59 | % |
| Loans held for sale                                                                |   | **22,550**                    | ** **    | **664** | ** ** | **5.94** |   | 15,374 |   | 495 |   | 6.49 |   |
| Securities available for sale (2)(4);                                              |   |                          |          |   |   |   |   |   |   |   |   |   |   |
|                                                                               |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and federal agencies                                                 |   | **79,450**                    | ** **    | **1,362** | ** ** | **3.46** |   | 47,305 |   | 1,039 |   | 4.43 |   |
| U.S. States and political subdivisions                                             |   | **103,277**                   | ** **    | **3,306** | ** ** | **6.46** |   | 116,906 |   | 3,978 |   | 6.86 |   |
| Mortgage-backed securities                                                         |   | **393,606**                   | ** **    | **8,106** | ** ** | **4.15** |   | 387,231 |   | 9,694 |   | 5.05 |   |
| Other securities                                                                   |   | **46,555**                    | ** **    | **733** | ** ** | **3.18** |   | 15,570 |   | 235 |   | 3.04 |   |
| Total investment securities                                                        |   | **622,888**                   | ** **    | **13,507** | ** ** | **4.37** |   | 567,012 |   | 14,946 |   | 5.32 |   |
| FHLB / Federal Reserve stock                                                       |   | **7,048**                     | ** **    | **168** | ** ** | **4.81** |   | 6,899 |   | 194 |   | 5.67 |   |
| Portfolio Loans (3)(4):                                                            |   |                          |          |   |   |   |   |   |   |   |   |   |   |
|                                                                               |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Commercial                                                                         |   | **172,393**                   | ** **    | **5,050** | ** ** | **5.91** |   | 159,645 |   | 5,470 |   | 6.91 |   |
| Residential real estate                                                            |   | **357,502**                   | ** **    | **10,200** | ** ** | **5.75** |   | 267,017 |   | 9,302 |   | 7.03 |   |
| Commercial real estate                                                             |   | **414,517**                   | ** **    | **13,464** | ** ** | **6.55** |   | 334,587 |   | 12,352 |   | 7.44 |   |
| Real estate construction                                                           |   | **105,814**                   | ** **    | **2,843** | ** ** | **5.42** |   | 105,758 |   | 2,980 |   | 5.68 |   |
| Consumer installment                                                               |   | **261,220**                   | ** **    | **9,142** | ** ** | **7.06** |   | 298,691 |   | 11,480 |   | 7.75 |   |
| Total loans                                                                        |   | **1,311,446**                 | ** **    | **40,699** | ** ** | **6.26** |   | 1,165,698 |   | 41,584 |   | 7.19 |   |
| Total interest-earning assets                                                      |   | **1,968,424**                 | ** **    | **55,064** | ** ** | **5.64** |   | 1,767,807 |   | 57,321 |   | 6.54 |   |
| Total noninterest-earning assets                                                   |   | **106,427**                   |          |   |   |   |   | 103,793 |   |   |   |   |   |
| Total assets                                                                       |   | **$**                         | **2,074,851** |   |   |   |   |   | $ | 1,871,600 |   |   |   |   |   |
| **LIABILITIES**                                                                    |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| **Interest  bearing liabilities:**                                                 |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                          |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Savings                                                                            |   | **$**                         | **233,121**   | ** ** | **$** | **970** | ** ** | **0.84** |   | $ | 202,657 |   | $ | 1,208 |   | 1.20 |   |
| Checking                                                                           |   | **212,777**                   | ** **    | **318** | ** ** | **0.30** |   | 201,139 |   | 541 |   | 0.54 |   |
| Money market accounts                                                              |   | **282,895**                   | ** **    | **1,480** | ** ** | **1.05** |   | 269,295 |   | 2,232 |   | 1.67 |   |
| Certificates of deposit                                                            |   | **620,438**                   | ** **    | **9,983** | ** ** | **3.24** |   | 609,148 |   | 12,939 |   | 4.28 |   |
| Total interest bearing deposits                                                    |   | **1,349,231**                 | ** **    | **12,751** | ** ** | **1.91** |   | 1,282,239 |   | 16,920 |   | 2.66 |   |
| Short-term borrowings                                                              |   | **168,131**                   | ** **    | **700** | ** ** | **0.84** |   | 98,460 |   | 641 |   | 1.31 |   |
| Long-term borrowings                                                               |   | **77,918**                    | ** **    | **1,876** | ** ** | **4.86** |   | 67,730 |   | 1,607 |   | 4.78 |   |
| Total interest bearing liabilities                                                 |   | **1,595,280**                 | ** **    | **15,327** | ** ** | **1.94** |   | 1,448,429 |   | 19,168 |   | 2.67 |   |
| Non-interest bearing liabilities:                                                  |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                    |   | **272,247**                   |          |   |   |   |   | 236,029 |   |   |   |   |   |
| Other liabilities                                                                  |   | **16,951**                    |          |   |   |   |   | 14,939 |   |   |   |   |   |
| Total non-interest bearing liabilities                                             |   | **289,198**                   |          |   |   |   |   | 250,968 |   |   |   |   |   |
| Shareholders’ equity                                                          |   | **190,373**                   |          |   |   |   |   | 172,203 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                    |   | **$**                         | **2,074,851** |   |   |   |   |   | $ | 1,871,600 |   |   |   |   |   |
| **Net interest  income and net interest margin on a taxable-equivalent basis (4)** |   |                          | ** **    | **$** | **39,737** |   | **4.07** | **%** |   |   | **$** | 38,153 |   | 4.35 | % |

 

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(1)          The average prime rateof the Bancorp was 4.25% and 4.75% for the six months ended June 30, 2003 and2002, respectively. The average six-month London Interbank Offered Rate (LIBOR)was 1.28% and 1.91% for the six months ended June 30, 2003 and 2002,respectively.

(2)          Yields are based on amortized cost balances computed on a settlement daybasis.

(3)          Loan fee income is included in the interest income calculation, andnonaccrual loans are included in the average loan base upon which the interestrate earned on loans is calculated.

(4)          Interest and yield on obligations of state and political subdivisions andtax-exempt loans are computed on a taxable equivalent basis using U.S.statutory tax rate of 35 percent.

 

17

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PROVISION FOR CREDIT LOSSES

 

The provision for credit losses was $700 thousand and $1.2 million inthe second quarter and the first six months of 2003, respectively, comparedwith $150 thousand and $975 thousand in the same periods in 2002. Lossesincurred in the second quarter primarily resulted from the charge-off of asingle commercial credit and normal levels of consumer portfolio losses. Theloan portfolio is well diversified, split nearly equally between consumer andcommercial borrowers

 

NONINTEREST INCOME

 
| **(in thousands)**                     |   |      |      |   |     | **%  Change** |   | **Six months ended Jun. 30** |   | **%  Change** |       |
|----------------------------------------|--------|-----------|-----------|--------|----------|---------------|--------|------------------------------|--------|---------------|------------|
| **Quarter ended Jun. 30**              |
| **2003**                               |   | **2002**  | **2003**  |   | **2002** |
|                                   |   |      |      |   |     |          |   |                         |   |          |       |   |   |
| Service charges on deposit accounts    |   | **$**     | **2,285** |   | $        | 2,282         |   | —                       | %      | **$**         | **4,398**  |   | $ | 4,478 |   | (2 | )% |
| Trust and investment fees:             |   |      |      |   |     |          |   |                         |   |          |       |   |   |
| Asset management and custody fees      |   | **484**   |      | 607    |     | (20           | )      | **957**                      |   | 1,218         |       | (21 | ) |
| Mutual fund and annuity sales fees     |   | **276**   |      | 303    |     | (9            | )      | **519**                      |   | 613           |       | (15 | ) |
| Total trust and invesment fees         |   | **760**   |      | 910    |     | (16           | )      | **1,476**                    |   | 1,831         |       | (19 | ) |
| Other fees:                            |   |      |      |   |     |          |   |                         |   |          |       |   |   |
| Cash network fees                      |   | **899**   |      | 832    |     | 8             |   | **1,681**                    |   | 1,543         |       | 9 |   |
| Charges and fees on loans              |   | **71**    |      | 122    |     | (42           | )      | **166**                      |   | 191           |       | (13 | ) |
| Bank-owned life insurance              |   | **177**   |      | 128    |     | 38            |   | **352**                      |   | 251           |       | 40 |   |
| All other fees                         |   | **367**   |      | 275    |     | 34            |   | **697**                      |   | 687           |       | 2 |   |
| Total other fees                       |   | **1,514** |      | 1,357  |     | 12            |   | **2,896**                    |   | 2,672         |       | 8 |   |
| Mortgage banking fees:                 |   |      |      |   |     |          |   |                         |   |          |       |   |   |
| Origination and other closing fees     |   | **410**   |      | 274    |     | 50            |   | **734**                      |   | 494           |       | 49 |   |
| Net gains on mortgage loan sales       |   | **782**   |      | 488    |     | 60            |   | **1,337**                    |   | 1,055         |       | 27 |   |
| Servicing fees, net of amortization    |   | **55**    |      | 52     |     | 6             |   | **(146**                     | )      | 102           |       | (243 | ) |
| Total mortgage banking                 |   | **1,247** |      | 814    |     | 53            |   | **1,925**                    |   | 1,651         |       | 17 |   |
| Insurance                              |   | **3,201** |      | 2,540  |     | 26            |   | **6,141**                    |   | 5,190         |       | 18 |   |
| Net gains (losses) on securities sold  |   | **50**    |      | — |     | 100           |   | **516**                      |   | —        |       | 100 |   |
| Net gains (losses) on sale of property |   | **189**   |      | 36     |     | 425           |   | **225**                      |   | 122           |       | 84 |   |
| Total                                  |   | **$**     | **9,246** |   | $        | 7,939         |   | 16                           | %      | **$**         | **17,577** |   | $ | 15,944 |   | 10 | % |

 

Noninterest income was $9.2 million in the second quarter 2003, up 16percent from $7.9 million in the second quarter of last year. Fee income growthgenerated in the second quarter from strong insurance sales were offset bydeclines in trust and investment fees. Mortgage banking fees remained strongincreasing 53 percent to $1.2 million in the second quarter of 2003, up from$814 thousand in the second quarter of 2002. Noninterest income during thesecond quarter of 2003 also included $189 thousand in gains on sales ofproperties due primarily to the sale of bank owned real estate, and $50thousand in realized gains on the sale of investment securities.

 

For the first half of 2003 noninterest income was $17.6 million, up 10percent from $15.9 million for the same period last year. Mortgage banking feesof $1.9 million in the first six months of 2003 were impacted by a $176thousand charge recorded for the impairment of mortgage servicing rights.Noninterest income during the first quarter of 2003 also included $516 thousandin gains on sales of securities due to a repositioning of the investmentportfolio as part of the ongoing asset/liability management strategy of theBancorp.

 

18

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NONINTERESTEXPENSE

 
| **(in thousands)**                   |   | **Quarter ended Jun. 30** |       | **%  Change** |     | **Six months ended Jun. 30** |   | **%  Change** |   |
|--------------------------------------|--------|---------------------------|------------|---------------|----------|------------------------------|--------|---------------|--------|
| **2003**                             |   | **2002**                  | **2003**   |          | **2002** |
|                                 |   |                      |       |          |     |                         |   |          |   |   |   |   |   |
| Salaries                             |   | **$**                     | **7,731**  |          | $        | 7,549                        |   | 2             | %      | **$** | **15,063** |   | $ | 14,663 |   | 3 | % |
| Incentive compensation               |   | **968**                   |       | 573           |     | 69                           |   | **1,814**     |   | 1,202 |   | 51 |   |
| Employee benefits                    |   | **1,721**                 |       | 1,459         |     | 18                           |   | **3,158**     |   | 3,373 |   | (6 | ) |
| Occupancy and equipment              |   | **2,537**                 |       | 2,625         |     | (3                           | )      | **4,768**     |   | 5,099 |   | (6 | ) |
| Professional services                |   | **334**                   |       | 465           |     | (28                          | )      | **900**       |   | 954 |   | (6 | ) |
| Telecommunications                   |   | **317**                   |       | 331           |     | (4                           | )      | **642**       |   | 633 |   | 1 |   |
| Advertising and promotions           |   | **40**                    |       | 896           |     | (96                          | )      | **407**       |   | 1,399 |   | (71 | ) |
| Computer software and maintenance    |   | **406**                   |       | 364           |     | 12                           |   | **757**       |   | 706 |   | 7 |   |
| Stationary and office supplies       |   | **286**                   |       | 354           |     | (19                          | )      | **652**       |   | 739 |   | (12 | ) |
| Core deposit intangible amortization |   | **237**                   |       | 224           |     | 6                            |   | **483**       |   | 439 |   | 10 |   |
| Postage                              |   | **199**                   |       | 226           |     | (12                          | )      | **437**       |   | 486 |   | (10 | ) |
| Other real estate owned              |   | **—**                |       | 8             |     | (100                         | )      | **1**         |   | 18 |   | (94 | ) |
| All other                            |   | **1,997**                 |       | 2,121         |     | (6                           | )      | **4,388**     |   | 4,253 |   | 3 |   |
| Total                                |   | **$**                     | **16,773** |          | $        | 17,195                       |   | (2            | )%     | **$** | **33,470** |   | $ | 33,964 |   | (1 | )% |

 

Management views the efficiency ratio (the ratio of noninterest expenseto the sum of tax equivalent net interest income and noninterest income) as animportant measure of overall operating expense performance and cost management.Bancorp’s efficiency ratio decreased to 58.15% for the quarter compared to63.19% for the comparable period in 2002. For the six months ended June 30, 2003and 2002 respectively, the Bancorp’s efficiency ratio was 58.40% and 62.78%.

 

Salary expenses of $7.7 million for the second quarter 2003 were 2%higher then the prior year’s quarter and on a year-to-date basis salary expenseincreased to $15.1 million or 3% higher than year-to-date 2002 due to normalmerit increases. Incentive compensation increased by 69% and 51% from the prioryear’s quarter and prior year year-to-date respectively. These increases aredirectly tied to the Bancorp’s revenue and overall profitability performance asmeasured by our team-based compensation and sale programs. While employeebenefit costs for the second quarter of 2003 were 18% greater that thecomparable quarter of 2002, they were 6% lower for the six months ended June2003 compared to the same period in 2002. A major component of benefits expenseis medical insurance which was impacted by lower medical claims incurred duringthe six month period.

 

Occupancy expenses for the quarter of $2.5 million decreased $88thousand or 3% compared to the second quarter of 2002, and on a year-to-datebasis decreased $331 thousand or 6% from year-to-date 2002 due to branchconsolidation efforts initiated in the previous year.

 

Most other categories of expenses for 2003 were reduced from the prioryears quarter, and year-to-date in 2002. Significant reductions in professionalservices and advertising related expenditures were reduced in anticipation ofthe pending merger.

 

INCOME TAXES

 

Tax expense varies from one period to the next with changes in thelevel of income before taxes, changes in the amount of tax-exempt income, andthe relationship of these changes to each other. The effective income taxexpense rate differs from the amount computed at statutory rates primarily dueto tax-exempt interest from certain loans and investment securities.

 

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For the second quarter of 2003, provision for income taxes increased by5% to $3.2 million from the previous year quarter due to lower levels of taxdeferred assets in relation to total assets. For the six months ended June 30, 2003, the provision for income taxesincreased 15.5% to $6.6 million from the comparable 2002 period.  The first half of 2003 effective tax ratewas 31.15% compared to 32.5% in the first half of 2002, as most of thecomponents of the increased revenues are fully taxable.

 

BALANCE SHEETANALYSIS

 

SECURITIES AVAILABLE FOR SALE

 

The following table provides the cost and fair value for the majorcomponents of securities available for sale carried at fair value. There wereno securities classified as held to maturity or trading at the end of theperiods presented.

 
|                                                  |   | **June 30, 2003** |        | **December 31, 2002**      |   | **June 30, 2002** |   |
|-------------------------------------------------------|--------|-------------------|-------------|----------------------------|--------|-------------------|--------|
| **(in thousands)**                                    |   | **Cost**          |        | **Estimated  fair  value** |   | **Cost**          |   | **Estimated  fair  value** |   | **Cost** |   | **Estimated  fair  value** |   |
|                                                  |   |              |        |                       |   |              |   |   |   |   |   |   |   |
| Securities of U. S. Treasury and federal agencies     |   | **$**             | **69,466**  | ** **                 | **$**  | **72,253**        |   | $ | 77,809 |   | $ | 79,830 |   | $ | 65,419 |   | $ | 66,735 |   |
| Securities of U. S. states and political subdivisions |   | **92,985**        | ** **  | **99,170**                 |   | 104,792           |   | 108,487 |   | 112,372 |   | 115,527 |   |
| Mortgage-backed securities                            |   | **430,771**       | ** **  | **436,487**                |   | 384,530           |   | 391,988 |   | 382,183 |   | 388,276 |   |
| Other                                                 |   | **38,143**        | ** **  | **38,911**                 |   | 33,041            |   | 33,556 |   | 30,979 |   | 31,185 |   |
| Total debt securities                                 |   | **631,365**       | ** **  | **646,821**                |   | 600,172           |   | 613,861 |   | 590,953 |   | 601,723 |   |
| Marketable equity securities                          |   | **2,751**         | ** **  | **4,889**                  |   | 2,751             |   | 4,591 |   | 3,806 |   | 5,103 |   |
|                                                  |   |              |        |                       |   |              |   |   |   |   |   |   |   |
| Total                                                 |   | **$**             | **634,116** | ** **                 | **$**  | **651,710**       |   | $ | 602,923 |   | $ | 618,452 |   | $ | 594,759 |   | $ | 606,826 |   |

 

The following table provides the components of the estimated unrealizednet gains on securities available for sale for the end of each periodpresented. The estimated unrealized net gain or loss on securities availablefor sale is reported on an after-tax basis as a component of cumulative othercomprehensive income.

 
| **(in thousands)**                |   | **June 30,  2003** |       | **December 31,  2002** |   | **June 30,  2002** |   |
|-----------------------------------|--------|--------------------|------------|------------------------|--------|--------------------|--------|
|                              |   |               |       |                   |   |               |   |
| Estimated unrealized gross gains  |   | **$**              | **19,061** |                   | 16,433 |               | $      | 12,507 |   |
| Estimated unrealized gross losses |   | **1,467**          |       | 904                    |   | 440                |   |
| Estimated unrealized net gain     |   | **$**              | **17,594** |                   | 15,529 |               | $      | 12,067 |   |

 

The weighted average expected remaining maturity of the debt securitiesportion of the securities available for sale portfolio was 2.2 years at June30, 2003. For adjustable rate securities, the weighted average time to the nextrepricing date was used in place of weighted average maturity in making thiscalculation.  Expected remainingmaturities will differ from contractual maturities because obligations may beprepaid.

 

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LOAN PORTFOLIO

** **
|                                                                                           |   |              |          |              |   |              |   | **% Change  Jun. 30, 2003 from** |      |
|------------------------------------------------------------------------------------------------|--------|-------------------|---------------|-------------------|--------|-------------------|--------|----------------------------------|-----------|
| **(in thousands)**                                                                             |   | **Jun. 30  2003** |          | **Dec. 31  2002** |   | **Jun. 30  2002** |   | **Dec. 31  2002**                |      | **Jun. 30  2002** |   |
|                                                                                           |   |              |          |              |   |              |   |                             |      |   |   |
| Commercial (1)                                                                                 |   | **$**             | **175,628**   |              | $      | 174,975           |   | $                                | 158,958   |   | 0 | % | 10 | % |
| Residential real estate (2)                                                                    |   | **372,288**       |          | 348,289           |   | 281,049           |   | 7                                |      | 32 |   |
| Commercial mortgage                                                                            |   | **422,017**       |          | 403,870           |   | 332,460           |   | 4                                |      | 27 |   |
| Real estate construction                                                                       |   | **112,206**       |          | 105,047           |   | 106,102           |   | 7                                |      | 6 |   |
| Consumer installment                                                                           |   | **249,370**       |          | 273,167           |   | 293,377           |   | (9                               | )         | (15 | ) |
| Total loans (net of unearned income, including net deferred loan fees,  of $926, $785 and $351 |   | **$**             | **1,331,509** |              | $      | 1,305,348         |   | $                                | 1,171,946 |   | 2 | % | 14 | % |

 

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(1)          Includes agriculturalloans (loans to finance agricultural production) of $177 thousand, $308thousand and $318 thousand at June 30, 2003, December 31, 2002 and June 30,2002, respectively.

(2)          Includes agriculturalloans that are secured by real estate of $6,363 thousand, $6,516 thousand and$5,489 thousand at June 30, 2003, December 31, 2002 and June 30, 2002,respectively.

 

NONACCRUAL LOANS AND OTHER ASSETS

 

The table below presents comparative data for nonaccrual loans andother assets. Management’s classification of a loan as nonaccrual does notnecessarily indicate that the principal of the loan is uncollectible in wholeor in part. The Bancorp anticipates changes in the amount of nonaccrual loansthat result from increases in loans outstanding, changes in borrower’scircumstances or from resolutions of loans in the nonaccrual portfolio. Theperformance of any individual loan can be affected by external factors, such asthe interest rate environment or factors particular to a borrower such asactions taken by a borrower’s management.

 

NONACCRUAL LOANS AND OTHER REAL ESTATE OWNED

 
| **(in thousands)**                                    |   | **Jun. 30,  2003** |      | **Dec. 31,  2002** |   | **Jun. 30,  2002** |   |
|-------------------------------------------------------|--------|--------------------|-----------|--------------------|--------|--------------------|--------|
| Nonaccrual loans:                                     |   |               |      |               |   |               |   |
| Commercial                                            |   | **$**              | **1,092** |               | $      | 1,186              |   | $ | 1,190 |   |
| Residential real estate                               |   | **—**         |      | 126                |   | 147                |   |
| Commercial mortgage                                   |   | **434**            |      | 461                |   | 535                |   |
| Real estate construction                              |   | **71**             |      | 71                 |   | 71                 |   |
| Consumer installment                                  |   | **213**            |      | 233                |   | 189                |   |
|                                                  |   |               |      |               |   |               |   |
| Total nonaccrual loans                                |   | **$**              | **1,810** |               | $      | 2,077              |   | $ | 2,132 |   |
| As a percentage of total loans                        |   | **0.14**           | **%**     | 0.16               | %      | 0.18               | %      |
| Other real estate owned                               |   | **422**            |      | 414                |   | 354                |   |
|                                                  |   |               |      |               |   |               |   |
| Total nonaccrual loans and other real estate owned    |   | **$**              | **2,232** |               | $      | 2,491              |   | $ | 2,486 |   |
| As a percentage of total assets                       |   | **0.10**           | **%**     | 0.12               | %      | 0.13               | %      |
| Loans past due 90 days as to interest & principal |   | **$**              | **1,198** |               | $      | 1,191              |   | $ | 890 |   |

 

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Loans are placed on nonaccrual status when, in the opinion ofmanagement, reasonable doubt exists as to the full, timely collection ofinterest or principal, or a specific loan meets the criteria for nonaccrualstatus established by regulatory authorities. When a loan is placed onnonaccrual status, all interest previously accrued but not collected is reversedagainst current period interest income. No interest is taken into income onnonaccrual loans until such time the borrower demonstrates sustainedperformance over a period of time in accordance with contractual terms and isremoved from nonaccrual status.

 

Other real estate owned includes real estate acquired by foreclosure(in partial or complete satisfaction of debt), or otherwise surrendered by theborrower to Bancorp’s possession. Other real estate owned is recorded at thelower of cost or fair value on the date of acquisition or transfer from loans.Write-downs to fair value at the date of acquisition are charged to theallowance for credit losses. Subsequent to transfer, these assets are adjustedthrough a valuation allowance to the lower of the net carrying value or thefair value (net of estimated selling expenses) based on periodic appraisals

 

Loans contractually past due 90 days or more as to interest orprincipal, but not included in nonaccrual loans are both well-secured and inthe process of collection.

 

ALLOWANCE FOR CREDIT LOSSES

 
|                                                                         |   | **Quarter ended**  |       | **Six months ended** |   |
|------------------------------------------------------------------------------|--------|--------------------|------------|----------------------|--------|
| **(in thousands)**                                                           |   | **June 30,  2003** |       | **June 30,  2002**   |   | **June 30,  2003** |   | **June 30,  2002** |   |
|                                                                         |   |               | ** ** |                 |   |   | ** ** |   |   |
| Balance, beginning of period                                                 |   | **$**              | **13,673** | ** **           | $      | 14,132 |   | **$** | **13,668** | ** ** | $ | 13,947 |   |
| Provision for credit losses                                                  |   | **700**            | ** ** | 150                  |   | **1,225** | ** ** | 975 |   |
| Loan charge-offs:                                                            |   |               | ** ** |                 |   |   | ** ** |   |   |
| Commercial                                                                   |   | **853**            | ** ** | 37                   |   | **915** | ** ** | 110 |   |
| Residential mortgage                                                         |   | **35**             | ** ** | 46                   |   | **168** | ** ** | 54 |   |
| Commercial mortgage                                                          |   | **—**         | ** ** | 9                    |   | **—** | ** ** | 9 |   |
| Real estate construction                                                     |   | **—**         | ** ** | —               |   | **—** | ** ** | — |   |
| Consumer                                                                     |   | **913**            | ** ** | 860                  |   | **1,858** | ** ** | 2,121 |   |
| Total loans charged-off                                                      |   | **1,801**          | ** ** | 952                  |   | **2,941** | ** ** | 2,294 |   |
| Loan recoveries:                                                             |   |               | ** ** |                 |   |   | ** ** |   |   |
| Commercial                                                                   |   | **2**              | ** ** | 165                  |   | **127** | ** ** | 191 |   |
| Residential mortgage                                                         |   | **—**         | ** ** | 3                    |   | **2** | ** ** | 3 |   |
| Commercial mortgage                                                          |   | **—**         | ** ** | 1                    |   | **1** | ** ** | 2 |   |
| Real estate construction                                                     |   | **—**         | ** ** | —               |   | **—** | ** ** | — |   |
| Consumer                                                                     |   | **406**            | ** ** | 500                  |   | **898** | ** ** | 1,175 |   |
| Total loan recoveries                                                        |   | **408**            | ** ** | 669                  |   | **1,028** | ** ** | 1,371 |   |
| Net charge-offs                                                              |   | **1,393**          | ** ** | 283                  |   | **1,913** | ** ** | 923 |   |
| Balance, end of period                                                       |   | **$**              | **12,980** | ** **           | $      | 13,999 |   | **$** | **12,980** | ** ** | $ | 13,999 |   |
| Total net loan charge-offs as a percent of average total loans  (annualized) |   | **0.40**           | **%**      | 0.10                 | %      | **0.40** | **%** | 0.10 | % |
| Allowance as a percentage of total loans                                     |   | **0.97**           | **%**      | 1.20                 | %      | **0.97** | **%** | 1.20 | % |

 

The Bancorp considers the allowance for loan losses of $13.0 millionadequate to cover losses inherent in loans, loan commitments and standby andother letters of credit at June 30, 2003. During the quarter a comprehensivereview of the allowance is performed considering such factors as the levels ofloans outstanding, loss experience, delinquency levels, certain individual loanreviews, and an evaluation of the regional and national

 

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economic environment. The credit quality of the loan portfolio remainsexceptionally strong with very low levels of impaired loans and declining historicalloss ratios, which are the primary drivers of the necessary allowance forcredit losses.

 

DEPOSITS

 

The following table shows comparative detail of deposits.

 
| **(in thousands)**                  |   | **June 30,  2003** |          | **December 31,  2002** |   | **June 30,  2002** |   |
|-------------------------------------|--------|--------------------|---------------|------------------------|--------|--------------------|--------|
|                                |   |               |          |                   |   |               |   |
| Noninterest-bearing demand deposits |   | **$**              | **307,694**   |                   | $      | 264,965            |   | $ | 260,082 |   |
| Interest-bearing deposits:          |   |               |          |                   |   |               |   |
| Checking                            |   | **221,480**        |          | 220,509                |   | 216,284            |   |
| Savings                             |   | **243,048**        |          | 217,342                |   | 213,520            |   |
| Money market                        |   | **294,708**        |          | 271,409                |   | 269,664            |   |
| Certificates of deposit             |   | **627,527**        |          | 620,914                |   | 589,691            |   |
| Total deposits                      |   | **$**              | **1,694,457** |                   | $      | 1,595,139          |   | $ | 1,549,241 |   |

 

CAPITALADEQUACY/RATIOS

 

The Bancorp and its subsidiary bank are subject to various regulatorycapital adequacy requirements administered by the Federal Reserve Board. Risk-basedcapital (RBC) guidelines establish a risk-adjusted ratio relating capital todifferent categories of assets and off-balance sheet exposures.

 
|                                     |   | **Actual** |   | **For capital  adequacy purposes** |   | **To be well  capitalized under  the FDICIA  prompt corrective  action provisions** |   |
|------------------------------------------|--------|------------|--------|------------------------------------|--------|-------------------------------------------------------------------------------------|--------|
| **(in thousands)**                       |   | **Amount** |   | **Ratio**                          |   | **Amount**                                                                          |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                     |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| As of June 30, 2003:                     |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                          |   | $          | 197    |                               | 13.12  | %                                                                                   | $      | 120 |   | 8.00 | % | $ | 150 |   | 10.00 | % |
| Farmers & Mechanics Bank             |   | $          | 188    |                               | 12.51  |                                                                                | $      | 120 |   | 8.00 |   | $ | 150 |   | 10.00 |   |
|                                     |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Tier 1 capital (to risk-weighted assets) |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                          |   | $          | 183    |                               | 12.19  | %                                                                                   | $      | 60 |   | 4.00 | % | $ | 90 |   | 6.00 | % |
| Farmers & Mechanics Bank             |   | $          | 175    |                               | 11.65  |                                                                                | $      | 60 |   | 4.00 |   | $ | 90 |   | 6.00 |   |
|                                     |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| Tier 1 capital (to average assets)       |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| (Leverage ratio)                         |   |       |   |                               |   |                                                                                |   |   |   |   |   |   |   |
| F&M Bancorp                          |   | $          | 183    |                               | 8.73   | %                                                                                   | $      | 84 |   | 4.00 | %(1) | $ | 105 |   | 5.00 | % |
| Farmers & Mechanics Bank             |   | $          | 175    |                               | 8.44   |                                                                                | $      | 83 |   | 4.00 | (1) | $ | 104 |   | 5.00 |   |

 

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(1)          The leverage ratioconsists of Tier 1 capital divided by quarterly average total assets, excludinggoodwill and certain other items. The minimum leverage ratio guideline is 3%for banking organizations that do not anticipate significant growth and thathave well-diversified risk, excellent asset quality, high liquidity, goodearnings, effective management and monitoring of market risk and, in general,are considered top-rated, strong banking organizations.

 

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CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS

 

Through the normal course of operations, the Bancorp has entered intocertain contractual obligations and commitments. Such obligations generallyrelate to the funding of operations as well as leases for premises andequipment. As a financial services provider, the Bancorp routinely enters intocommitments to extend credit, including loan commitments, standby letters ofcredit and financial guarantees. While contractual obligations represent futurecash requirements of the Bancorp, a portion of commitments to extend credit arelikely to expire without being drawn upon. Such commitments are subject to thesame credit policies and approval processes accorded to loans made in the regularcourse of business.

 

ASSET/LIABILITY AND MARKET RISK MANAGEMENT

 

Asset/liability management comprises the evaluation, monitoring, andmanagement of the Bancorp’s interest rate risk, market risk and liquidity andfunding. The Asset/Liability Management Committee (ALCO) maintains oversight ofthese risks. The Committee is comprised of senior financial and senior businessexecutives.

 

INTEREST RATE RISK

 

Interest rate risk, one of the more prominent risks in terms ofpotential earnings impact, is an inevitable part of being a financialintermediary. For more information, see “Market Risk and Asset/LiabilityManagement” in the Bancorp’s 2002 Annual Report on Form 10-K.

 

Management believes that medium term (12-month horizon) interest raterisk is best measured by simulation modeling. This analysis calculates expected net interest income based uponhistorical trends, spreads to market rates, historical market relationships,prepayment behavior and current and expected product offerings. As of June 30,2003, the simulation analysis indicated that the Bancorp’s net interest incomewould tend to increase if rates were to rise over the next 12 months. Forexample, if rates were to rise 1.00% or 2.00% over the next 12 months, netinterest income would increase by 0.1% and fall by 1.7%, respectively.Conversely, if rates were to decline over the next 12 months, net interestincome would decline by 1.6% and 8.4%, respectively. The principal source ofnet interest income risk in a falling rate scenario is that certain short-termmarket rates and a majority of the Bank’s deposit rates are equal to or below1.0%. Therefore, these rates cannot decline below a floor rate of 0%.

 

Computations of prospective effects of hypothetical interest ratechanges are based on many assumptions, including relative levels of marketinterest rates, loan prepayments and changes in deposit levels.  They are not intended to be a forecast andshould not be relied upon as indicative of actual results.  Further, the computations do not contemplatecertain actions that management could take in response to changes in interestrates.

 

LIQUIDITY AND FUNDING

 

The objective of effective liquidity management is to ensure that theBancorp can meet customer loan requests, customer deposit maturities/withdrawalsand other cash commitments efficiently under both normal operating conditionsas well as under unforeseen and unpredictable circumstances of industry ormarket stress. To achieve this objective, ALCO establishes and monitorsliquidity guidelines requiring sufficient asset based liquidity to coverpotential funding requirements and to avoid over-dependence on volatile, lessreliable funding sources. The Bancorp manages liquidity at both the parent andsubsidiary levels through active management of the balance sheet.

 

In addition to the immediately liquid resources of cash and due frombanks and federal funds sold, asset liquidity is provided by the debtsecurities in the securities available for sale portfolio. Asset liquidity isfurther enhanced by the Bancorp’s ability to sell loans in secondary marketsthrough whole-loan sales.

 

24

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Core customer deposits have historically provided the Bancorp with asizeable source of relatively stable and low-cost funds.

 

Long-term debt, and short-term borrowings (federal funds purchased andsecurities sold under repurchase agreements and other short-term borrowings)mostly provide the remaining funding of assets. The Bank also has extensiveaccess to funds from its membership in the Federal Home Loan Bank of Atlanta.

 

CAPITAL MANAGEMENT

 

The Bancorp has an active program for managing shareholders’ equity.The objective of effective capital management is to produce long-term returnsby opportunistically utilizing capital when returns are perceived to be highand issuing/accumulating capital when the costs of doing so is perceived to below.

 

Uses of capital include investments for organic growth, acquisitions ofbanks and other financial services companies, dividends and share repurchases.During the first six months of 2003, the Bancorp’s consolidated assetsincreased by $53.8 million, or 3%. During 2002, the Board of Directorsauthorized the repurchase of up to 500,000 shares of the Bancorp’s outstandingcommon stock. With the announcement of the merger agreement between Bancorp andMercantile Bankshares this share repurchase program was discontinued.

 

Sources of capital include retained earnings and common stock issuance.In the first six months of 2003, total net income was $14.7 million and thechange in retained earnings was $8.2 million after payment of $6.2 million incommon stock dividends.

 

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Information required by this item as of June 30, 2003 is set forth in “*AssetLiability and Market Risk Management”* on pages 32-34 of theregistrant’s 2002 Annual Report on Form 10-K for the year ended December 31,2002. There was no material change in such information as of June 30, 2003.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

Within the ninety days prior to the filing of this report, theBancorp’s management, under the supervision and with the participation of theCompany’s Chief Executive Officer and Chief Financial Officer, evaluated theeffectiveness of the design and operation of the Bancorp’s disclosure controlsand procedures. Based on the evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Bancorp’s disclosure controls andprocedures were effective. There were no significant changes in the Bancorp’sinternal controls or in other factors subsequent to the date of the evaluationthat could significantly affect those controls.

 

FACTORS THAT MAY AFFECTFUTURE RESULTS

 

We make forward-looking statements in this report and from time to timein other reports and proxy statements we file with the SEC. Also, our seniormanagement might make forward-looking statements orally to analysts, investorsand others. Broadly speaking, forward-looking statements include:

•                  descriptions ofplans or objectives of our management for future operations, products orservices;

•                  descriptions ofassumptions underlying or relating to critical accounting estimates andprojections.

 

In this report, for example, we make forward-looking statements about:

•                  future creditlosses and non-performing assets;

•                  future cashrequirements relating to commitments to extend credit;

•                  futureamortization expense;

•                  the impact ofnew accounting standards;

•                  and the impactof interest rate changes on our net interest income.

 

Forward-looking statements discuss matters that are not historicalfacts. These forward-looking statements may sometimes be identified by wordssuch as “expect”, “may”. “looking forward”, “we plan”, “we believe”, “areplanned”, “could be”, and “currently anticipate”. Although we believe thesestatements, as well as other oral and

 

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written forward-looking statements made by us from time to time, to betrue and reasonable, we can give no assurance that these plans, intentions orexpectations will be achieved. Actual results, performance or achievementscould differ materially from those contemplated, expressed or implied by theforward-looking statements.

 

There are several factors—many beyond our control—that could causeresults to differ significantly from our expectations. Some of these factorsare described below. Other factors, such as credit, market, operational,liquidity, interest rate and other risks, are described elsewhere in thisreport (see, for example, “Item 2—Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Balance Sheet Analysis” and –Asset/Liability and Market Risk Management”). Factors relating to regulationand supervision of the Bancorp are described in our Annual Report on Form 10-Kfor the year ended December 31, 2002.

 

**Industry Factors**

 

**As afinancial services company, our earnings are significantly affected by businessand economic conditions.**

 

Our earnings are impacted by business and economic conditions in theUnited States and the Maryland economic region. These conditions includeshort-term and long-term interest rates, inflation, monetary supply, and thestrength of the U.S. economy and Maryland economies in which we operate.Business and economic conditions that negatively impact household or businessincomes could decrease demand for the Bancorp’s products and increase thenumber of customers who fail to pay their loans.

 

**Ourearnings are significantly affected by the fiscal and monetary polices of thefederal government and its agencies.**

 

The Board of Governors of the Federal Reserve System regulates thesupply of money and credit in the United States. Its policies significantlyimpact our cost of funds for lending and investing and the return we earn onthose loans and investments, both of which impact our net interest margin, andcan materially affect the value of financial instruments we hold. Its policiesalso can affect our borrowers, potentially increasing the risk that they mayfail to repay their loans. Changes in Federal Reserve Board policies are beyondour control and hard to predict or anticipate.

 

**Thefinancial services industry is highly competitive.**

 

We operate in a highly competitive industry which could become evenmore competitive as a result of legislative, regulatory and technologicalchanges and continued consolidation of banks. Banks, securities firms andinsurance companies can now merge by creating a new type of financial servicescompany called a “financial holding company”, which can offer virtually anytype of financial service. Many of our competitors have fewer regulatoryconstraints and some have lower cost structures.

 

**We areheavily regulated by federal and state agencies.**

 

The holding company and its subsidiaries are heavily regulated at thefederal and state levels. This regulation is to protect customers, federaldeposit insurance funds and the banking system as a whole, not securityholders. Changes to statutes, regulations and regulatory policies, could affectus in substantial and unpredictable ways including limiting the types offinancial services and products we may offer and increasing the ability ofnon-banks to offer competing financial services and products. Also, our failureto comply with laws, regulations and policies could result in sanctions byregulatory agencies and damage our reputation. For more information, refer tothe “Regulation and Supervision” section in our Annual Report on Form 10-K forthe year ended December 31, 2002.

 

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**CompanyFactors**

 

**Maintainingor increasing our market share depends on market acceptance and regulatoryapproval of new products and services.**

 

Our success depends, in part, on our ability to adapt our products andservices to evolving industry standards and the changing need of our customers.There is increasing pressure on financial service companies to provide productsand services at lower prices. This can reduce our net interest margin andrevenues from our fee-based products and services. Also, the wide-spreadadoption of new technologies, including internet-based services, could requireus to make substantial investments to modify or adapt our existing products andservices.

 

**Theholding company relies on dividends from its subsidiaries for most of itsrevenues.**

 

The holding company is a separate and distinct legal entity from itssubsidiaries. It receives substantially all of its revenue from dividends fromits subsidiaries. These dividends are the principal source of funds to paydividends on the holding company’s common stock. Various federal and state lawsand regulations limit the amount of dividends that our bank and certainnon-bank subsidiaries may pay to the holding company. For more information,refer to “Dividend Restrictions” in our Annual Report on Form 10-K as ofDecember 31, 2002.

 

**We havebusinesses other than banking.**

 

We are a diversified financial services company. In addition tobanking, we provide insurance, wealth management, and mortgages. Although webelieve our diversity helps mitigate the impact to the Bancorp when downturnsaffect any one-business line, it also means that our earnings could be subjectto different risks and uncertainties. We discuss some examples below.

 

*MortgageBanking*. The impact of interest rates on our mortgage bankingbusiness can be large and complex. Changes in interest rates can impact loanorigination fees and gains on mortgage loans sold. A decline in mortgage ratesmight be expected to increase the demand for mortgages as borrowers refinance.Conversely, in a constant or increasing rate environment, we would expect fewerloans to be refinanced and a decline in our fee income.

 

*WealthManagement.* The impact of changes in the U.S. stock market onour wealth management business can be large. As much of our fee income isderived based on assets under management, the loss in value of those assets dueto stock market declines can significantly reduce our fee income. Also, ifmarket conditions are volatile many of our investors limit their mutual fundinvestments and in some cases withdraw their funds to invest in saferinvestment alternatives.

 

**LegislativeRisk**

 

Our business model relies heavily on our ability to share informationbetween the team of companies owned by F&M Bancorp to better satisfy ourcustomers’ needs. Future laws that restrict our ability to share informationabout customers could negatively impact our revenue and profit.

 

**Ourstock price can be volatile.**

 

Our stock price can fluctuate widely in response to a variety offactors including:

•                  actual oranticipated variations in our quarterly operating results;

•                  recommendationsby security analysts;

•                  operating andstock price performance of other companies that investors deem comparable tous:

•                  significant acquisitionsor business combinations by or involving us or our competitors;

•                  news reportsrelating to trends, concerns and other issues in the financial servicesindustry; and

•                  changes ingovernment regulations.

 

General market fluctuations, industry factors and general economictrends, interest rate changes, or credit loss trends, also could cause ourstock price to decrease regardless of our operating results.

 

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**PART II - Other Information**

 

**Item 6****.****           Exhibitsand Reports on Form 8-K**

 

(a)                                  Exhibits

 

32.1 CEO Certification of corporate responsibility forfinancial reports. Filed as an exhibit hereto and incorporated herein byreference

 

32.2 CFO Certification of corporate responsibility forfinancial reports. Filed as an exhibit hereto and incorporated herein byreference

 

(b)                                 Reportson Form 8-K

 

1.                                       Item5. Other Event and Regulation FD Disclosure, was filed April 21, 2003.Announced first quarter earnings.

 

2.                                       Item5. Other Event and Regulation FD Disclosure, was filed April 28, 2003.Announced bank name and management teams for Mercantile’s Frederick &Western Maryland affiliates.

 

**Signatures**

 

Pursuant to the requirements of the Securities Exchange Act of 1934 theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|            |   |            | F&M BANCORP      |
|-----------------|--------|-----------------|----------------------|
|            |   |            | (Registrant)         |
|            |   |            |                 |
| August 06, 2003 |   |            | /s/ Faye E.  Cannon  |
|            |   |            |                 |
| Date            |   | FAYE E. CANNON  |
|            |   |            | PRESIDENT AND  CEO   |
|            |   |            |                 |
| August 06, 2003 |   |            | /s/ Kaye A.  Simmons |
|            |   |            |                 |
| Date            |   | KAYE A. SIMMONS |
|            |   |            | CFO AND  TREASURER   |
|                 |        |                 |                      |  |

 

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