UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549










FORM
10-Q





Q
            QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
Quarterly Period Ended June 30, 2009





OR





£
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from ________ to ________





Commission
file number 0-22345





SHORE BANCSHARES,
INC.


(Exact
name of registrant as specified in its charter)





Maryland
                        
                        52-1974638(State or Other Jurisdiction of
                        
                        (I.R.S. EmployerIncorporation or Organization)
                        
                        Identification No.)18 East Dover Street, Easton, Maryland
                        
                        21601(Address of Principal Executive Offices)
                        
                        (Zip Code)





(410)
822-1400


Registrant’s
Telephone Number, Including Area Code





N/A


Former
name, former address and former fiscal year, if changed since last
report.





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter periods that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes R No £





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  Yes £ No £ (Not
Applicable)





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting company. See
the definitions of “large accelerated filer”, “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.  (Check
one):





Large
      accelerated filer
            £
            Accelerated
      filer
            RNon-accelerated
      filer
            £
            Smaller
      reporting company
            £(Do
      not check if a smaller reporting company)





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). Yes £ No R





APPLICABLE
ONLY TO CORPORATE ISSUERS





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date:  8,418,963 shares of common
stock outstanding as of July 31, 2009.





INDEX





PagePart
      I.Financial Information
                      2Item
      1.  Financial Statements
                      2Consolidated
      Balance Sheets -June
      30, 2009 (unaudited) and December 31, 2008
                      2Consolidated
      Statements of Income -For
      the three and six months ended June 30, 2009 and 2008
      (unaudited)
                      3Consolidated
      Statements of Changes in Stockholders’ Equity -For
      the six months ended June 30, 2009 and 2008 (unaudited)
                      4Consolidated
      Statements of Cash Flows -For
      the six months ended June 30, 2009 and 2008 (unaudited)
                      5Notes
      to Consolidated Financial Statements (unaudited)
                      6Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                      17Item
      3.  Quantitative and Qualitative Disclosures about Market
      Risk
                      26Item
      4.  Controls and Procedures
                      26Part
      II.  Other Information
                      27Item
      1A.  Risk Factors
                      27Item
      4.  Submission of Matters to Vote of Security
      Holders
                      27Item
      6.  Exhibits
                      28Signatures
                      28Exhibit
      Index
                      29




1


PART
I – FINANCIAL INFORMATION


Item
1.  Financial Statements.


SHORE
BANCSHARES, INC.


CONSOLIDATED
BALANCE SHEETS


(Dollars
in thousands, except per share amounts)





June 30,
                    
                    
                    December 31,2009
                    
                    
                    2008(Unaudited)ASSETSCash
      and due from banks
                    
                    $
                    20,498
                    
                    
                    $
                    16,803Interest
      bearing deposits with other banks
                    
                    
                    1,622
                    
                    
                    
                    481Federal
      funds sold
                    
                    
                    85,242
                    
                    
                    
                    10,010Investment
      securities:Available
      for sale, at fair value
                    
                    
                    80,278
                    
                    
                    
                    79,204Held
      to maturity, at amortized cost – fair value of $9,111 (2009) and $10,390
      (2008)
                    
                    
                    8,994
                    
                    
                    
                    10,252Loans
                    
                    
                    919,088
                    
                    
                    
                    888,528Less:  allowance
      for credit losses
                    
                    
                    (10,784
                    )
                    
                    
                    (9,320
                    )Loans,
      net
                    
                    
                    908,304
                    
                    
                    
                    879,208Insurance
      premiums receivable
                    
                    
                    1,391
                    
                    
                    
                    1,348Premises
      and equipment, net
                    
                    
                    14,018
                    
                    
                    
                    13,855Accrued
      interest receivable
                    
                    
                    4,355
                    
                    
                    
                    4,606Goodwill
                    
                    
                    15,954
                    
                    
                    
                    15,954Other
      intangible assets, net
                    
                    
                    5,663
                    
                    
                    
                    5,921Deferred
      income taxes
                    
                    
                    2,579
                    
                    
                    
                    1,579Other
      real estate owned
                    
                    
                    2,212
                    
                    
                    
                    148Other
      assets
                    
                    
                    7,102
                    
                    
                    
                    5,272TOTAL
      ASSETS
                    
                    $
                    1,158,212
                    
                    
                    $
                    1,044,641LIABILITIESDeposits:Noninterest
      bearing demand
                    
                    $
                    113,111
                    
                    
                    $
                    102,584Interest
      bearing demand
                    
                    
                    126,859
                    
                    
                    
                    125,370Money
      market and savings
                    
                    
                    244,233
                    
                    
                    
                    150,958Certificates
      of deposit $100,000 or more
                    
                    
                    259,348
                    
                    
                    
                    235,235Other
      time
                    
                    
                    237,783
                    
                    
                    
                    231,224Total
      deposits
                    
                    
                    981,334
                    
                    
                    
                    845,371Accrued
      interest payable
                    
                    
                    2,368
                    
                    
                    
                    2,350Short-term
      borrowings
                    
                    
                    28,096
                    
                    
                    
                    52,969Long-term
      debt
                    
                    
                    7,947
                    
                    
                    
                    7,947Other
      liabilities
                    
                    
                    10,591
                    
                    
                    
                    8,619TOTAL
      LIABILITIES
                    
                    
                    1,030,336
                    
                    
                    
                    917,256STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01; shares authorized – 35,000,000; shares issued and
      outstanding – 8,418,963 (2009) and 8,404,684 (2008)
                    
                    
                    84
                    
                    
                    
                    84Warrants
                    
                    
                    1,543
                    
                    
                    
                    -Additional
      paid in capital
                    
                    
                    29,816
                    
                    
                    
                    29,768Retained
      earnings
                    
                    
                    95,679
                    
                    
                    
                    96,140Accumulated
      other comprehensive income
                    
                    
                    754
                    
                    
                    
                    1,393TOTAL
      STOCKHOLDERS’ EQUITY
                    
                    
                    127,876
                    
                    
                    
                    127,385TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                    
                    $
                    1,158,212
                    
                    
                    $
                    1,044,641





See
accompanying notes to Consolidated Financial Statements.


2


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME (Unaudited)


(Dollars
in thousands, except per share amounts)





For the Three Months Ended
                    June 30,
                  
                  
                  For the Six Months Ended
                    June 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008INTEREST
      INCOMEInterest
      and fees on loans
                  
                  $
                  13,754
                  
                  
                  $
                  13,961
                  
                  
                  $
                  27,371
                  
                  
                  $
                  28,521Interest
      and dividends on investment securities:Taxable
                  
                  
                  768
                  
                  
                  
                  945
                  
                  
                  
                  1,524
                  
                  
                  
                  2,025Tax-exempt
                  
                  
                  79
                  
                  
                  
                  109
                  
                  
                  
                  164
                  
                  
                  
                  232Interest
      on federal funds sold
                  
                  
                  23
                  
                  
                  
                  83
                  
                  
                  
                  30
                  
                  
                  
                  205Interest
      on deposits with other banks
                  
                  
                  6
                  
                  
                  
                  29
                  
                  
                  
                  7
                  
                  
                  
                  67Total
      interest income
                  
                  
                  14,630
                  
                  
                  
                  15,127
                  
                  
                  
                  29,096
                  
                  
                  
                  31,050INTEREST
      EXPENSEInterest
      on deposits
                  
                  
                  4,441
                  
                  
                  
                  4,997
                  
                  
                  
                  8,726
                  
                  
                  
                  10,340Interest
      on short-term borrowings
                  
                  
                  28
                  
                  
                  
                  316
                  
                  
                  
                  77
                  
                  
                  
                  682Interest
      on long-term debt
                  
                  
                  75
                  
                  
                  
                  182
                  
                  
                  
                  149
                  
                  
                  
                  366Total
      interest expense
                  
                  
                  4,544
                  
                  
                  
                  5,495
                  
                  
                  
                  8,952
                  
                  
                  
                  11,388NET
      INTEREST INCOME
                  
                  
                  10,086
                  
                  
                  
                  9,632
                  
                  
                  
                  20,144
                  
                  
                  
                  19,662Provision
      for credit losses
                  
                  
                  1,681
                  
                  
                  
                  615
                  
                  
                  
                  3,616
                  
                  
                  
                  1,077NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                  
                  
                  8,405
                  
                  
                  
                  9,017
                  
                  
                  
                  16,528
                  
                  
                  
                  18,585NONINTEREST
      INCOMEService
      charges on deposit accounts
                  
                  
                  888
                  
                  
                  
                  917
                  
                  
                  
                  1,697
                  
                  
                  
                  1,788Other
      service charges and fees
                  
                  
                  774
                  
                  
                  
                  765
                  
                  
                  
                  1,512
                  
                  
                  
                  1,501Investment
      securities gains
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  49
                  
                  
                  
                  -Insurance
      agency commissions
                  
                  
                  2,893
                  
                  
                  
                  3,219
                  
                  
                  
                  6,228
                  
                  
                  
                  6,750Other
      noninterest income
                  
                  
                  792
                  
                  
                  
                  293
                  
                  
                  
                  1,211
                  
                  
                  
                  657Total
      noninterest income
                  
                  
                  5,347
                  
                  
                  
                  5,194
                  
                  
                  
                  10,697
                  
                  
                  
                  10,696NONINTEREST
      EXPENSESalaries
      and wages
                  
                  
                  4,759
                  
                  
                  
                  4,568
                  
                  
                  
                  9,299
                  
                  
                  
                  9,175Employee
      benefits
                  
                  
                  1,200
                  
                  
                  
                  1,191
                  
                  
                  
                  2,580
                  
                  
                  
                  2,568Occupancy
      expense
                  
                  
                  587
                  
                  
                  
                  537
                  
                  
                  
                  1,136
                  
                  
                  
                  1,036Furniture
      and equipment expense
                  
                  
                  302
                  
                  
                  
                  298
                  
                  
                  
                  616
                  
                  
                  
                  584Data
      processing
                  
                  
                  580
                  
                  
                  
                  550
                  
                  
                  
                  1,190
                  
                  
                  
                  1,118Directors’
      fees
                  
                  
                  117
                  
                  
                  
                  130
                  
                  
                  
                  285
                  
                  
                  
                  295Amortization
      of other intangible assets
                  
                  
                  129
                  
                  
                  
                  129
                  
                  
                  
                  258
                  
                  
                  
                  258Insurance
      agency commissions expense
                  
                  
                  537
                  
                  
                  
                  712
                  
                  
                  
                  1,087
                  
                  
                  
                  1,323FDIC
      insurance premium expense
                  
                  
                  919
                  
                  
                  
                  60
                  
                  
                  
                  1,163
                  
                  
                  
                  74Other
      noninterest expenses
                  
                  
                  1,563
                  
                  
                  
                  1,554
                  
                  
                  
                  2,962
                  
                  
                  
                  2,889Total
      noninterest expense
                  
                  
                  10,693
                  
                  
                  
                  9,729
                  
                  
                  
                  20,576
                  
                  
                  
                  19,320INCOME
      BEFORE INCOME TAXES
                  
                  
                  3,059
                  
                  
                  
                  4,482
                  
                  
                  
                  6,649
                  
                  
                  
                  9,961Income
      tax expense
                  
                  
                  1,166
                  
                  
                  
                  1,716
                  
                  
                  
                  2,543
                  
                  
                  
                  3,823NET
      INCOME
                  
                  
                  1,893
                  
                  
                  
                  2,766
                  
                  
                  
                  4,106
                  
                  
                  
                  6,138Preferred
      stock dividends and discount accretion
                  
                  
                  1,539
                  
                  
                  
                  -
                  
                  
                  
                  1,876
                  
                  
                  
                  -Net
      income available to common shareholders
                  
                  $
                  354
                  
                  
                  $
                  2,766
                  
                  
                  $
                  2,230
                  
                  
                  $
                  6,138Basic
      earnings per common share
                  
                  $
                  0.04
                  
                  
                  $
                  0.33
                  
                  
                  $
                  0.27
                  
                  
                  $
                  0.73Diluted
      earnings per common share
                  
                  $
                  0.04
                  
                  
                  $
                  0.33
                  
                  
                  $
                  0.27
                  
                  
                  $
                  0.73Dividends
      paid per common share
                  
                  $
                  0.16
                  
                  
                  $
                  0.16
                  
                  
                  $
                  0.32
                  
                  
                  $
                  0.32




See
accompanying notes to Consolidated Financial Statements.


3





SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)


For the
Six Months Ended June 30, 2009 and 2008


(Dollars
in thousands, except per share amounts)





AccumulatedAdditional
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalPreferred
                  
                  
                  Common
                  
                  
                  
                  
                  
                  Paid in
                  
                  
                  Retained
                  
                  
                  Comprehensive
                  
                  
                  Stockholders’Stock
                  
                  
                  Stock
                  
                  
                  Warrants
                  
                  
                  Capital
                  
                  
                  Earnings
                  
                  
                  Income (Loss)
                  
                  
                  EquityBalances,
      January 1, 2009
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  -
                  
                  
                  $
                  29,768
                  
                  
                  $
                  96,140
                  
                  
                  $
                  1,393
                  
                  
                  $
                  127,385Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  4,106
                  
                  
                  
                  -
                  
                  
                  
                  4,106Unrealized
      losses on available-for-sale securities, net of taxes
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (639
                  )
                  
                  
                  (639
                  )Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,467Warrants
      issued
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,543
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,543Preferred
      shares issued pursuant to TARP
                  
                  
                  25,000
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  25,000Discount
      from issuance of preferred stock
                  
                  
                  (1,543
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,543
                  )Discount
      accretion
                  
                  
                  68
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (68
                  )
                  
                  
                  -
                  
                  
                  
                  -Repurchase
      of preferred stock
                  
                  
                  (23,525
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (23,525
                  )Common
      shares issued for employee stock-based awards
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  46
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  46Preferred
      stock dividends
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )Cash
      dividends paid ($0.32 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,691
                  )
                  
                  
                  -
                  
                  
                  
                  (2,691
                  )Balances,
      June 30, 2009
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  1,543
                  
                  
                  $
                  29,816
                  
                  
                  $
                  95,679
                  
                  
                  $
                  754
                  
                  
                  $
                  127,876Balances,
      January 1, 2008
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  -
                  
                  
                  $
                  29,539
                  
                  
                  $
                  90,365
                  
                  
                  $
                  247
                  
                  
                  $
                  120,235Adjustment
      to initially apply EITF Issue 06-4
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (318
                  )
                  
                  
                  -
                  
                  
                  
                  (318
                  )Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  6,138
                  
                  
                  
                  -
                  
                  
                  
                  6,138Unrealized
      losses on available-for-sale securities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (454
                  )
                  
                  
                  (454
                  )Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,684Shares
      issued for employee stock-based awards
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  77
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  77Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  47
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  47Cash
      dividends paid ($0.32 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,687
                  )
                  
                  
                  -
                  
                  
                  
                  (2,687
                  )Balances,
      June 30, 2008
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  -
                  
                  
                  $
                  29,663
                  
                  
                  $
                  93,498
                  
                  
                  $
                  (207
                  )
                  
                  $
                  123,038




See
accompanying notes to Consolidated Financial Statements.


4





SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited)


(Dollars
in thousands)





For the Six Months Ended June 30,2009
                
                
                2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                
                $
                4,106
                
                
                $
                6,138Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for credit losses
                
                
                3,616
                
                
                
                1,077Depreciation
      and amortization
                
                
                890
                
                
                
                889Discount
      accretion on debt securities
                
                
                (131
                )
                
                
                (116
                )Stock-based
      compensation expense
                
                
                46
                
                
                
                47Gain
      on sales of securities
                
                
                (49
                )
                
                
                -Loss
      on disposals of premises and equipment
                
                
                -
                
                
                
                9Loss
      on sales of other real estate owned
                
                
                -
                
                
                
                50Net
      changes in:Insurance
      premiums receivable
                
                
                (43
                )
                
                
                (520
                )Accrued
      interest receivable
                
                
                251
                
                
                
                165Other
      assets
                
                
                (2,384
                )
                
                
                (1,598
                )Accrued
      interest payable
                
                
                18
                
                
                
                (920
                )Other
      liabilities
                
                
                1,973
                
                
                
                1,021Net
      cash provided by operating activities
                
                
                8,293
                
                
                
                6,242CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                
                
                30,828
                
                
                
                39,193Proceeds
      from sales of investment securities available for sale
                
                
                2,048
                
                
                
                -Purchases
      of securities available for sale
                
                
                (34,933
                )
                
                
                (23,477
                )Proceeds
      from maturities and principal payments of securities held to
      maturity
                
                
                2,080
                
                
                
                2,785Purchases
      of securities held to maturity
                
                
                (824
                )
                
                
                (1,012
                )Net
      increase in loans
                
                
                (34,776
                )
                
                
                (65,734
                )Purchases
      of premises and equipment
                
                
                (715
                )
                
                
                (193
                )Proceeds
      from sales of premises and equipment
                
                
                -
                
                
                
                1,318Proceeds
      from sales of other real estate owned
                
                
                -
                
                
                
                264Net
      cash used in investing activities
                
                
                (36,292
                )
                
                
                (46,856
                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      increase in demand, money market and savings deposits
                
                
                105,291
                
                
                
                19,022Net
      increase in certificates of deposit
                
                
                30,672
                
                
                
                33,739Net
      (decrease) increase in short-term borrowings
                
                
                (24,874
                )
                
                
                10,569Proceeds
      from issuance of long-term debt
                
                
                -
                
                
                
                3,000Repayment
      of long-term debt
                
                
                -
                
                
                
                (7,000
                )Proceeds
      from issuance of preferred stock and warrants
                
                
                25,000
                
                
                
                -Repurchase
      of preferred stock
                
                
                (23,525
                )
                
                
                -Proceeds
      from issuance of common stock
                
                
                2
                
                
                
                77Preferred
      stock dividends paid
                
                
                (1,808
                )
                
                
                -Common
      stock dividends paid
                
                
                (2,691
                )
                
                
                (2,687
                )Net
      cash provided by financing activities
                
                
                108,067
                
                
                
                56,720Net
      increase in cash and cash equivalents
                
                
                80,068
                
                
                
                16,106Cash
      and cash equivalents at beginning of period
                
                
                27,294
                
                
                
                26,880Cash
      and cash equivalents at end of period
                
                $
                107,362
                
                
                $
                42,986Supplemental
      cash flows information:Interest
      paid
                
                $
                8,934
                
                
                $
                12,309Income
      taxes paid
                
                $
                3,123
                
                
                $
                4,979Transfers
      from loans to other real estate owned
                
                $
                2,064
                
                
                $
                138





See
accompanying notes to Consolidated Financial Statements.


5




Shore
Bancshares, Inc.


Notes to
Consolidated Financial Statements


For the
Three and Six Months Ended June 30, 2009 and 2008


(Unaudited)





Note 1 - Basis of
Presentation





The
consolidated financial statements include the accounts of Shore Bancshares, Inc.
and its subsidiaries with all significant intercompany transactions
eliminated.The consolidated financial statements conform to accounting
principles generally accepted in the United States of America (“GAAP”) and to
prevailing practices within the banking industry.  The accompanying
interim financial statements are unaudited; however, in the opinion of
management all adjustments necessary to present fairly the consolidated
financial position at June 30, 2009, the consolidated results of operations for
the three and six months ended June 30, 2009 and 2008, changes in stockholders’
equity for the six months ended June 30, 2009 and 2008, and cash flows for the
six months ended June 30, 2009 and 2008, have been included.  All such
adjustments are of a normal recurring nature.  The amounts as of
December 31, 2008 were derived from the 2008 audited financial
statements.  The results of operations for the three and six months
ended June 30, 2009 are not necessarily indicative of the results to be expected
for any other interim period or for the full year.  This Quarterly
Report on Form 10-Q should be read in conjunction with the Annual Report of
Shore Bancshares, Inc. on Form 10-K for the year ended December 31,
2008.  Further, in connection with preparation of the consolidated
financial statements and in accordance with the recently issued Statement of
Financial Accounting Standards (“SFAS”) No. 165, “Subsequent Events,” the
Company evaluated subsequent events after the balance sheet date of June 30,
2009 through August 10, 2009, the date the consolidated financial statements
included in this Form 10-Q were issued.





When used
in these notes, the term “the Company” refers to Shore Bancshares, Inc. and,
unless the context requires otherwise, its consolidated
subsidiaries.





Note 2 – Earnings Per
Share





Basic
earnings per common share are calculated by dividing net income available to
common stockholders by the weighted average number of common shares outstanding
during the period.  Diluted earnings per common share are calculated
by dividing net income available to common stockholders by the weighted average
number of common shares outstanding during the period, adjusted for the dilutive
effect of stock-based awards.  The following table provides
information relating to the calculation of earnings per common
share:





For the Three Months Ended
                  
                  
                  For the Six Months EndedJune 30,
                  
                  
                  June 30,(In thousands, except per share
      data)
                  
                  2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Net
      income available to common shareholders
                  
                  $
                  354
                  
                  
                  $
                  2,766
                  
                  
                  $
                  2,230
                  
                  
                  $
                  6,138Weighted
      average shares outstanding - Basic
                  
                  
                  8,413
                  
                  
                  
                  8,398
                  
                  
                  
                  8,409
                  
                  
                  
                  8,394Dilutive
      effect of stock-based awards
                  
                  
                  4
                  
                  
                  
                  7
                  
                  
                  
                  4
                  
                  
                  
                  8Weighted
      average shares outstanding - Diluted
                  
                  
                  8,417
                  
                  
                  
                  8,405
                  
                  
                  
                  8,413
                  
                  
                  
                  8,402Earnings
      per common share - Basic
                  
                  $
                  0.04
                  
                  
                  $
                  0.33
                  
                  
                  $
                  0.27
                  
                  
                  $
                  0.73Earnings
      per common share - Diluted
                  
                  $
                  0.04
                  
                  
                  $
                  0.33
                  
                  
                  $
                  0.27
                  
                  
                  $
                  0.73





There
were 173 thousand antidilutive weighted average warrants and no antidilutive
weighted average stock-based awards excluded from the diluted earnings per share
calculation for the three months ended June 30, 2009.  There were 165
thousand antidilutive weighted average warrants and no antidilutive weighted
average stock-based awards excluded from the diluted earnings per share
calculation for the six months ended June 30, 2009.  There were 22
thousand and 20 thousand antidilutive weighted average stock-based awards
excluded from the diluted earnings per share calculation for the three and six
months ended June 30, 2008, respectively.


6


Note 3 – Significant
Accounting Policy





Under the
provisions of SFAS Nos. 114 and 118, "Accounting by Creditors for Impairment of
a Loan," a loan is considered impaired if it is probable that the Company will
not collect all principal and interest payments according to the loan’s
contracted terms.  The impairment of a loan is measured at the present
value of expected future cash flows using the loan’s effective interest rate, or
at the loan’s observable market price or the fair value of the collateral if the
loan is collateral dependent.  Interest income generally is not
recognized on specific impaired loans unless the likelihood of further loss is
remote.  Interest payments received on such loans are applied as a
reduction of the loan’s principal balance. Interest income on other nonaccrual
loans is recognized only to the extent of interest payments
received.





Information
with respect to impaired loans and the related valuation allowance is shown
below:





June 30,
                
                
                December 31,
                
                
                June 30,(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2008Impaired
      loans with a valuation allowance
                
                $
                1,093
                
                
                $
                2,550
                
                
                $
                4,520Impaired
      loans with no valuation allowance
                
                
                12,602
                
                
                
                5,565
                
                
                
                277Total
      impaired loans
                
                $
                13,695
                
                
                $
                8,115
                
                
                $
                4,797Allowance
      for credit losses applicable to impaired loans
                
                $
                454
                
                
                $
                341
                
                
                $
                991Allowance
      for credit losses applicable to other than impaired loans
                
                
                10,330
                
                
                
                8,979
                
                
                
                7,291Total
      allowance for credit losses
                
                $
                10,784
                
                
                $
                9,320
                
                
                $
                8,282Average
      recorded investment in impaired loans
                
                $
                4,817
                
                
                $
                5,477
                
                
                $
                3,924





Gross
interest income of $327 thousand for the first six months of 2009, $476 thousand
for fiscal year 2008 and $187 thousand for the first six months of 2008 would
have been recorded if nonaccrual loans had been current and performing in
accordance with their original terms.  Interest actually recorded on
such loans was $4 thousand for the first six months of 2009, $193 thousand for
fiscal year 2008 and $190 thousand for the first six months of
2008.





Impaired
loans do not include groups of smaller balance homogenous loans such as
residential mortgage and consumer installment loans that are evaluated
collectively for impairment.  Reserves for probable credit losses
related to these loans are based upon historical loss ratios and are included in
the allowance for credit losses.





Note 4 – Investment
Securities





The
amortized cost and estimated fair values of investment securities are as
follows:





Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                Fair(Dollars in thousands)
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueAvailable-for-sale
      securities:June
      30, 2009:Obligations
      of U.S. Treasury
                
                $
                6,990
                
                
                $
                1
                
                
                $
                -
                
                
                $
                6,991Obligations
      of U.S. Government agencies and corporations
                
                
                47,026
                
                
                
                975
                
                
                
                281
                
                
                
                47,720Mortgage-backed
      securities
                
                
                21,316
                
                
                
                625
                
                
                
                62
                
                
                
                21,879Federal
      Home Loan Bank stock
                
                
                2,822
                
                
                
                -
                
                
                
                -
                
                
                
                2,822Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                561
                
                
                
                3
                
                
                
                -
                
                
                
                564$
                79,017
                
                
                $
                1,604
                
                
                $
                343
                
                
                $
                80,278December
      31, 2008:Obligations
      of U.S. Treasury
                
                $
                1,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,000Obligations
      of U.S. Government agencies and corporations
                
                
                49,996
                
                
                
                1,451
                
                
                
                -
                
                
                
                51,447Mortgage-backed
      securities
                
                
                22,028
                
                
                
                879
                
                
                
                8
                
                
                
                22,899Federal
      Home Loan Bank stock
                
                
                3,003
                
                
                
                -
                
                
                
                -
                
                
                
                3,003Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                551
                
                
                
                2
                
                
                
                -
                
                
                
                553$
                76,880
                
                
                $
                2,332
                
                
                $
                8
                
                
                $
                79,204Held-to-maturity
      securities:June
      30, 2009:Obligations
      of states and political subdivisions
                
                $
                8,994
                
                
                $
                139
                
                
                $
                22
                
                
                $
                9,111December
      31, 2008:Obligations
      of states and political subdivisions
                
                $
                10,252
                
                
                $
                159
                
                
                $
                21
                
                
                $
                10,390




7





Gross
unrealized losses and fair value by length of time that the individual
available-for-sale securities have been in a continuous unrealized loss position
at June 30, 2009, are as follows:





Less than
                  12 Months
                
                
                More than
                  12 Months
                
                
                Total(Dollars in thousands)
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  LossesAvailable-for-sale
      securities:U.S.
      Gov’t. agencies and corporations
                
                $
                17,651
                
                
                $
                281
                
                
                $
                -
                
                
                $
                -
                
                
                $
                17,651
                
                
                $
                281Mortgage-backed
      securities
                
                
                3,095
                
                
                
                62
                
                
                
                -
                
                
                
                -
                
                
                
                3,095
                
                
                
                62Total
                
                $
                20,746
                
                
                $
                343
                
                
                $
                -
                
                
                $
                -
                
                
                $
                20,746
                
                
                $
                343





The
available-for-sale securities have a fair value of approximately $80.3 million,
of which approximately $20.7 million of these securities have unrealized losses
when compared to their purchase price.  The securities with the
unrealized losses in the available-for-sale portfolio all have modest duration
risk, low credit risk, and minimal losses (approximately 0.43%) when compared to
amortized cost.  The unrealized losses that exist are the result of
market changes in interest rates since the original purchase.  Because
the Company does not intend to sell these securities and it is not more likely
than not that the Company will be required to sell these securities before
recovery of their amortized cost bases, which may be at maturity, the Company
considers that the unrealized losses in the available-for-sale portfolio are
temporary.





Gross
unrealized losses and fair value by length of time that the individual
held-to-maturity securities have been in a continuous unrealized loss position
at June 30, 2009, are as follows:





Less than
                  12 Months
                
                
                More than
                  12 Months
                
                
                Total(Dollars in thousands)
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  LossesHeld-to-maturity
      securities::Obligations
      of states and political subdivisions
                
                $
                817
                
                
                $
                6
                
                
                $
                798
                
                
                $
                16
                
                
                $
                1,615
                
                
                $
                22





The
held-to-maturity securities have a fair value of approximately $9.1 million, of
which approximately $1.6 million of these securities have unrealized losses when
compared to their purchase price.  All of the securities with
unrealized losses are municipal securities with modest duration risk, low credit
risk, and minimal losses (approximately 0.24%) when compared to amortized
cost.  The unrealized losses that exist are the result of market
changes in interest rates since the original purchase.  Because the
Company does not intend to sell these securities and it is not more likely than
not that the Company will be required to sell these securities before recovery
of their amortized cost bases, which may be at maturity, the Company considers
that the unrealized losses in the held-to-maturity portfolio are
temporary.


8


Note 5 –
Commitments





In the
normal course of business, to meet the financial needs of its customers, the
Company’s bank subsidiaries are parties to financial instruments with
off-balance sheet risk.  These financial instruments include
commitments to extend credit and standby letters of credit.  At June
30, 2009, total commitments to extend credit were approximately $173.7
million.  The comparable amount was $211.4 million at December 31,
2008.  Outstanding letters of credit were approximately $18.6 million
at June 30, 2009 and $12.5 million at December 31, 2008.





Note 6 - Stock-Based
Compensation





At June
30, 2009, Shore Bancshares, Inc. had three equity compensation
plans:  (i) the Shore Bancshares, Inc. 2006 Stock and Incentive
Compensation Plan (“2006 Equity Plan”); (ii) the Shore Bancshares, Inc. Employee
Stock Purchase Plan (“ESPP”); and (iii) the Shore Bancshares, Inc. 1998 Stock
Option Plan (the “1998 Option Plan”).  The plans are described in
detail in Note 13 to the audited financial statements contained in the Annual
Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31,
2008.  The ability of Shore Bancshares, Inc. to grant options under
the 1998 Option Plan terminated by its terms on March 3, 2008, but stock options
granted under the 1998 Option Plan were outstanding at June 30,
2009.





Stock-based
awards granted to date are generally time-based, vesting on each anniversary of
the grant date over a three to five-year period of time and, in the case of
stock options, expiring 10 years from the grant date.  ESPP awards
allow employees to purchase shares of Shore Bancshares, Inc. common stock at 85%
of the fair market value on the date of grant.  ESPP grants are 100%
vested at date of grant and have a 27-month term.





During
the three and six months ended June 30, 2009, the Company recognized pre-tax
stock-based compensation expense of $25 thousand and $46 thousand, respectively,
compared to $24 thousand and $47 thousand, respectively, for the same periods
last year.  Stock-based compensation expense is recognized ratably
over the requisite service period for all awards and is based on the grant-date
fair value.  Unrecognized stock-based compensation expense related to
nonvested share-based compensation arrangements was $510 thousand as of June 30,
2009.  The weighted-average period over which this unrecognized
expense was expected to be recognized was 2.9 years.





The
following table summarizes restricted stock award activity for the Company under
the 2006 Equity Plan for the six months ended June 30, 2009:





Number
                  
                  
                  Weighted Average Grantof Shares
                  
                  
                  Date Fair ValueNonvested
      at January 1, 2009
                  
                  
                  16,859
                  
                  
                  $
                  22.55Granted
                  
                  
                  14,254
                  
                  
                  
                  18.12Vested
                  
                  
                  (3,708
                  )
                  
                  
                  22.63Cancelled
                  
                  
                  -
                  
                  
                  
                  -Nonvested
      at June 30, 2009
                  
                  
                  27,405
                  
                  
                  $
                  20.23





The
Company estimates the fair value of stock options using the Black-Scholes
valuation model with weighted average assumptions for dividend yield, expected
volatility, risk-free interest rate and expected lives (in
years).  The expected dividend yield is calculated by dividing the
total expected annual dividend payout by the average stock price.  The
expected volatility is based on historical volatility of the underlying
securities.  The risk-free interest rate is based on the Federal
Reserve Bank’s constant maturities daily interest rate in effect at grant
date.  The expected life of the options represents the period of time
that the Company expects the awards to be outstanding based on historical
experience with similar awards.  Stock-based compensation expense
recognized in the consolidated statements of income for the six months ended
June 30, 2009 and 2008 reflected forfeitures as they occurred.





No
options were granted during the first six months of 2009 or
2008.


9


The
following table summarizes stock option activity for the Company under all plans
for the six months ended June 30, 2009:





Weighted
                  
                  
                  AggregateNumber
                  
                  
                  Average
                  
                  
                  Intrinsicof Shares
                  
                  
                  Exercise Price
                  
                  
                  ValueOutstanding
      at beginning of year
                  
                  
                  18,550
                  
                  
                  $
                  15.52Granted
                  
                  
                  -
                  
                  
                  
                  -Exercised
                  
                  
                  (25
                  )
                  
                  
                  21.33Expired/Cancelled
                  
                  
                  (4,975
                  )
                  
                  
                  21.33Outstanding
      at end of period
                  
                  
                  13,550
                  
                  
                  
                  13.37
                  
                  
                  $
                  61,932Exercisable
      at end of period
                  
                  
                  13,550
                  
                  
                  $
                  13.37
                  
                  
                  $
                  61,932





The
following summarizes information about options outstanding at June 30,
2009:





Options Outstanding and ExercisableOptions Outstanding
                        
                        
                        
                        
                        
                        Weighted AverageRemainingExercise Price
                        
                        Number
                        
                        
                        Number
                        
                        
                        Contract Life (in years)$
                        14.00
                        
                        
                        3,255
                        
                        
                        
                        3,255
                        
                        
                        
                        0.713.17
                        
                        
                        10,295
                        
                        
                        
                        10,295
                        
                        
                        
                        2.913,550
                        
                        
                        
                        13,550





The total
intrinsic value of stock options exercised during the six months ended June 30,
2009 was less than $1 thousand. The comparable amount for the six months ended
June 30, 2008 was approximately $58 thousand.  Cash received upon
exercise of options during the first six months of 2009 and 2008 was
approximately $1 thousand and $77 thousand, respectively.





Note 7 – Segment
Reporting





The
Company operates in two primary business segments:  Community Banking
and Insurance Products and Services.  Through the Community Banking
business, the Company provides services to consumers and small businesses on the
Eastern Shore of Maryland and Delaware through its 19-branch
network.  Community banking activities include small business
services, retail brokerage, and consumer banking products and
services.  Loan products available to consumers include mortgage, home
equity, automobile, marine, and installment loans, credit cards and other
secured and unsecured personal lines of credit.  Small business
lending includes commercial mortgages, real estate development loans, equipment
and operating loans, as well as secured and unsecured lines of credit, credit
cards, accounts receivable financing arrangements, and merchant card
services.





Through
the Insurance Products and Services business, the Company provides a full range
of insurance products and services to businesses and consumers in the Company’s
market areas.  Products include property and casualty, life, marine,
individual health and long-term care insurance.  Pension and profit
sharing plans and retirement plans for executives and employees are available to
suit the needs of individual businesses.


10


Selected
financial information by line of business for the first six months of 2009 and
2008 is included in the following table:





Community
                    
                    
                    Insurance Products
                    
                    
                    Parent(Dollars in thousands)
                    
                    Banking
                    
                    
                    and Services
                    
                    
                    Company
                    
                    
                    Total2009Interest
      income
                    
                    $
                    29,063
                    
                    
                    $
                    33
                    
                    
                    $
                    -
                    
                    
                    $
                    29,096Interest
      expense
                    
                    
                    (8,912
                    )
                    
                    
                    -
                    
                    
                    
                    (40
                    )
                    
                    
                    (8,952
                    )Provision
      for credit losses
                    
                    
                    (3,616
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (3,616
                    )Noninterest
      income
                    
                    
                    4,134
                    
                    
                    
                    6,563
                    
                    
                    
                    -
                    
                    
                    
                    10,697Noninterest
      expense
                    
                    
                    (11,837
                    )
                    
                    
                    (5,666
                    )
                    
                    
                    (3,073
                    )
                    
                    
                    (20,576
                    )Net
      intersegment income (expense)
                    
                    
                    (2,799
                    )
                    
                    
                    (238
                    )
                    
                    
                    3,037
                    
                    
                    
                    -Income
      (loss) before taxes
                    
                    
                    6,033
                    
                    
                    
                    692
                    
                    
                    
                    (76
                    )
                    
                    
                    6,649Income
      tax (expense) benefit
                    
                    
                    (2,308
                    )
                    
                    
                    (264
                    )
                    
                    
                    29
                    
                    
                    
                    (2,543
                    )Net
      income
                    
                    $
                    3,725
                    
                    
                    $
                    428
                    
                    
                    $
                    (47
                    )
                    
                    $
                    4,106Total
      assets
                    
                    $
                    1,134,421
                    
                    
                    $
                    20,012
                    
                    
                    $
                    3,779
                    
                    
                    $
                    1,158,2122008Interest
      income
                    
                    $
                    31,018
                    
                    
                    $
                    32
                    
                    
                    $
                    -
                    
                    
                    $
                    31,050Interest
      expense
                    
                    
                    (11,320
                    )
                    
                    
                    -
                    
                    
                    
                    (68
                    )
                    
                    
                    (11,388
                    )Provision
      for credit losses
                    
                    
                    (1,077
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (1,077
                    )Noninterest
      income
                    
                    
                    3,607
                    
                    
                    
                    7,089
                    
                    
                    
                    -
                    
                    
                    
                    10,696Noninterest
      expense
                    
                    
                    (10,306
                    )
                    
                    
                    (6,189
                    )
                    
                    
                    (2,825
                    )
                    
                    
                    (19,320
                    )Net
      intersegment income (expense)
                    
                    
                    (2,431
                    )
                    
                    
                    (194
                    )
                    
                    
                    2,625
                    
                    
                    
                    -Income
      (loss) before taxes
                    
                    
                    9,491
                    
                    
                    
                    738
                    
                    
                    
                    (268
                    )
                    
                    
                    9,961Income
      tax (expense) benefit
                    
                    
                    (3,643
                    )
                    
                    
                    (283
                    )
                    
                    
                    103
                    
                    
                    
                    (3,823
                    )Net
      income
                    
                    $
                    5,848
                    
                    
                    $
                    455
                    
                    
                    $
                    (165
                    )
                    
                    $
                    6,138Total
      assets
                    
                    $
                    995,389
                    
                    
                    $
                    20,719
                    
                    
                    $
                    3,355
                    
                    
                    $
                    1,019,463





Note 8 – Disclosures about
Fair Value of Financial Instruments





The
following methods and assumptions were used to estimate the fair value of each
class of financial instruments for which it is practicable to estimate that
value:





Cash and Cash
Equivalents


For
short-term instruments, the carrying amount is a reasonable estimate of fair
value.





Investment
Securities


For all
investments in debt securities, fair values are based on quoted market
prices.  If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities.





Loan
Receivables


The fair
values of categories of fixed rate loans, such as commercial loans, residential
mortgage, and other consumer loans are estimated by discounting the future cash
flows using the current rates at which similar loans would be made to borrowers
with similar credit ratings and for the same remaining
maturities.  Other loans, including variable rate loans, are adjusted
for differences in loan characteristics.





Financial
Liabilities


The fair
values of demand deposits, savings accounts, and certain money market deposits
is the amount payable on demand at the reporting date.  The fair
values of fixed-maturity certificates of deposit is estimated using the rates
currently offered for deposits of similar remaining maturities.  These
estimates do not take into consideration the value of core deposit
intangibles.  The fair values of securities sold under agreements to
repurchase and long-term debt is estimated using the rates offered for similar
borrowings.





Commitments to Extend Credit
and Standby Letters of Credit


The
majority of the Company’s commitments to grant loans and standby letters of
credit are written to carry current market interest rates if converted to
loans.  Because commitments to extend credit and letters of credit are
generally unassignable by the Company or the borrower, they only have value to
the Company and the borrower and therefore it is impractical to assign any value
to these commitments.


11





The
estimated fair values of the Company’s financial instruments, excluding
goodwill, as of June 30, 2009 and December 31, 2008 are as follows:





June 30, 2009
                
                
                December 31, 2008Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      assets:Cash
      and cash equivalents
                
                $
                107,362
                
                
                $
                107,362
                
                
                $
                27,294
                
                
                $
                27,294Investment
      securities
                
                
                89,272
                
                
                
                89,389
                
                
                
                89,456
                
                
                
                89,594Loans
                
                
                919,088
                
                
                
                939,575
                
                
                
                888,528
                
                
                
                914,695Less:  allowance
      for loan   losses
                
                
                (10,784
                )
                
                -
                
                
                
                (9,320
                )
                
                _ -$
                1,104,938
                
                
                $
                1,136,326
                
                
                $
                995,958
                
                
                $
                1,031,583Financial
      liabilities:Deposits
                
                $
                981,334
                
                
                $
                990,914
                
                
                $
                845,371
                
                
                $
                861,951Short-term
      borrowings
                
                
                28,096
                
                
                
                28,096
                
                
                
                52,969
                
                
                
                52,969Long-term
      debt
                
                
                7,947
                
                
                
                8,011
                
                
                
                7,947
                
                
                
                8,060$
                1,017,377
                
                
                $
                1,027,021
                
                
                $
                906,287
                
                
                $
                922,980




June 30, 2009
                
                
                December 31, 2008Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueUnrecognized
      financial instruments:Commitments
      to extend credit
                
                $
                173,662
                
                
                $
                -
                
                
                $
                211,423
                
                
                $
                -Standby
      letters of credit
                
                
                18,592
                
                
                
                -
                
                
                
                12,508
                
                
                
                -$
                192,254
                
                
                $
                -
                
                
                $
                223,931
                
                
                $
                -





Note 9 – Fair Value
Measurements




SFAS No.
157, “Fair Value
Measurements,” provides a framework for measuring and disclosing fair
value under GAAP. SFAS 157 requires disclosures about the fair values of assets
and liabilities recognized in the balance sheet, whether the measurements are
made on a recurring basis or on a nonrecurring basis.




SFAS 157
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date.  SFAS 157 also
establishes a fair value hierarchy, which requires an entity to maximize the use
of observable inputs and minimize the use of unobservable inputs when measuring
fair value.




The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and liabilities and to determine fair value disclosures.
Securities available for sale and derivative assets and liabilities are recorded
at fair value on a recurring basis. Additionally, from time to time, the Company
may be required to record at fair value other assets on a nonrecurring basis,
such as loans held for investment (impaired loans) and foreclosed assets (other
real estate owned). These nonrecurring fair value adjustments typically involve
application of lower of cost or market accounting or write-downs of individual
assets.




Under
SFAS 157, assets and liabilities are grouped at fair value in three levels,
based on the markets in which the assets and liabilities are traded and the
reliability of the assumptions used to determine their fair values. These
hierarchy levels are:





Level 1
inputs – Unadjusted quoted prices in active markets for identical assets or
liabilities that the entity has the ability to access at the measurement
date.


12





Level 2
inputs – Inputs other than quoted prices included in Level 1 that are observable
for the asset or liability, either directly or indirectly.  These
might include quoted prices for similar assets or liabilities in active markets,
and inputs other than quoted prices that are observable for the asset or
liability, such as interest rates and yield curves that are observable at
commonly quoted intervals.





Level 3
inputs – Unobservable inputs for determining the fair values of assets or
liabilities that reflect an entity’s own assumptions about the assumptions that
market participants would use in pricing the assets or
liabilities.




The
following is a description of valuation methodologies used for the Company’s
assets and liabilities recorded at fair value.





Investment Securities
Available for Sale


Investment
securities available for sale are recorded at fair value on a recurring
basis.  Fair value measurement is based upon quoted prices, if
available.  If quoted prices are not available, fair values are
measured using independent pricing models or other model-based valuation
techniques such as the present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumptions.  Level 1 securities include those traded on
an active exchange such as the New York Stock Exchange, Treasury securities that
are traded by dealers or brokers in active over-the-counter markets and money
market funds.  Level 2 securities include mortgage-backed securities
issued by government sponsored entities, municipal bonds and corporate debt
securities. Securities classified as Level 3 include asset-backed securities in
less liquid markets.





Loans


The
Company does not record loans at fair value on a recurring basis; however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established.  Loans for which it is probable that payment of interest
and principle will not be made in accordance with the contractual terms of the
loan are considered impaired.  Once a loan is identified as
individually impaired, management measures impairment in accordance with SFAS
114, “Accounting by Creditors for Impairment of a Loan.”  The fair
values of impaired loans are estimated using one of several methods, including
the collateral value, market value of similar debt, enterprise value,
liquidation value and discounted cash flows. Those impaired loans not requiring
a specific allowance represent loans for which the fair values of expected
repayments or collateral exceed the recorded investment in such
loans.  At June 30, 2009, substantially all of the impaired loans were
evaluated based upon the fair value of the collateral.  In accordance
with SFAS 157, impaired loans that have an allowance established based on the
fair value of collateral require classification in the fair value
hierarchy.  When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
loan as nonrecurring Level 2.  When an appraised value is not
available or management determines the fair value of the collateral is further
impaired below the appraised value and there is no observable market price, the
Company records the loan as nonrecurring Level 3.





Foreclosed
Assets


Foreclosed
assets are adjusted for fair value upon transfer of loans to foreclosed
assets.  Subsequently, foreclosed assets are carried at the lower of
carrying value and fair value.  Fair value is based upon independent
market prices, appraised value of the collateral or management’s estimation of
the value of the collateral.  When the fair value of the collateral is
based on an observable market price or a current appraised value, the Company
records the foreclosed asset as nonrecurring Level 2.  When an
appraised value is not available or management determines the fair value of the
collateral is further impaired below the appraised value and there is no
observable market price, the Company records the foreclosed asset as
nonrecurring Level 3.





Derivative Assets and
Liabilities


Derivative
instruments held or issued by the Company for risk management purposes are
traded in over-the-counter markets where quoted market prices are not readily
available.  For those derivatives, the Company measures fair value
using models that use primarily market observable inputs, such as yield curves
and option volatilities, and include the value associated with counterparty
credit risk.  The Company classifies derivative instruments held or
issued for risk management purposes as recurring Level 2.  As of June
30, 2009, the Company’s derivative instruments consisted solely of interest rate
swaps.  Derivative assets and liabilities are included in other assets
and liabilities, respectively, in the accompanying consolidated balance
sheet.


13


Assets Recorded at Fair
Value on a Recurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
recurring basis at June 30, 2009.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Securities
      available for sale:U.S.
      Treasury
                  
                  $
                  6,991
                  
                  
                  $
                  6,991
                  
                  
                  $
                  -
                  
                  
                  $
                  -U.S.
      Government agencies
                  
                  
                  47,720
                  
                  
                  
                  -
                  
                  
                  
                  47,720
                  
                  
                  
                  -Mortgage-backed
      securities
                  
                  
                  21,879
                  
                  
                  
                  -
                  
                  
                  
                  21,879
                  
                  
                  
                  -Federal
      Home Loan Bank     stock
                  
                  
                  2,822
                  
                  
                  
                  -
                  
                  
                  
                  2,822
                  
                  
                  
                  -Federal
      Reserve Bank stock
                  
                  
                  302
                  
                  
                  
                  -
                  
                  
                  
                  302
                  
                  
                  
                  -Other
      equity securities
                  
                  
                  564
                  
                  
                  
                  -
                  
                  
                  
                  564
                  
                  
                  
                  -$
                  80,278
                  
                  
                  $
                  6,991
                  
                  
                  $
                  73,287
                  
                  
                  $
                  -Interest
      rate swap
                  
                  $
                  654
                  
                  
                  $
                  -
                  
                  
                  $
                  654
                  
                  
                  $
                  -





Assets Recorded at Fair
Value on a Nonrecurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
nonrecurring basis at June 30, 2009.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Impaired
      loans
                  
                  $
                  12,568
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  12,568Other
      real estate owned
                  
                  
                  2,212
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,212





Impaired
loans had a carrying amount of $13.7 million with a valuation allowance of $1.1
million at June 30, 2009.





Note 10 – Restricted
Investment in Bank Stock





Restricted
stock, which represents required investments in the common stock of two
correspondent banks, is carried at cost and, as of June 30, 2009 and December
31, 2008, consisted of the common stock of the Federal Home Loan Bank (“FHLB”)
of Atlanta and the FHLB of Pittsburgh.





Management
evaluates the restricted stock for impairment in accordance with FASB Statement
of Position (“SOP”) 01-6, “Accounting by Certain Entities (Including Entities
With Trade Receivables) That Lend to or Finance the Activities of
Others.”  Management’s determination of whether these investments are
impaired is based on their assessment of the ultimate recoverability of their
cost rather than by recognizing temporary declines in value.  The
determination of whether a decline affects the ultimate recoverability of the
cost of an investment is influenced by criteria such as (1) the significance of
the decline in net assets of the issuing bank as compared to the capital stock
amount for that bank and the length of time this situation has persisted, (2)
commitments by the issuing bank to make payments required by law or regulation
and the level of such payments in relation to the operating performance of that
bank, and (3) the impact of legislative and regulatory changes on institutions
and, accordingly, on the customer base of the issuing bank.





The FHLB
of Atlanta announced that it would not pay dividends for the fourth quarter of
2008 and will no longer provide dividend guidance prior to the end of each
quarter.  The FHLB of Atlanta also announced that it will no longer
conduct repurchases of excess activity-based stock on a daily basis, but will
make such determinations quarterly.  Similarly, the FHLB of Pittsburgh
announced in December 2008 that it voluntarily suspended the payment of
dividends and the repurchase of excess capital stock from member banks, citing a
significant reduction in the level of core earnings resulting from lower
short-term interest rates, the increased cost of maintaining liquidity and
constrained access to the debt markets at attractive rates and maturities as the
main reasons for the decision to suspend dividends and the repurchase of excess
capital stock. The FHLB of Pittsburgh last paid a dividend in the third quarter
of 2008.





Management
believes that no impairment charge in respect of the restricted stock is
necessary as of June 30, 2009.


14


Note 11 – Derivative
Instruments and Hedging Activities


SFAS No.
133, “Accounting for
Derivative Instruments and Hedging Activities,” as amended, defines
derivatives, requires that derivatives be carried at fair value on the balance
sheet and provides for hedge accounting when certain conditions are
met.  Changes in the fair values of derivative instruments designated
as “cash flow” hedges, to the extent the hedges are highly effective, are
recorded in other comprehensive income, net of taxes.  Ineffective
portions of cash flow hedges, if any, are recognized in current period
earnings.  The Company uses derivative instruments to hedge its
exposure to changes in interest rates.  The Company does not use
derivatives for any trading or other speculative purposes.





During
the second quarter of 2009, the Company entered into 5-year interest rate swap
agreements with notional amounts of $70 million to effectively fix the interest
rate on $70 million of the Company’s money market deposit accounts at
2.97%.  The interest rate swaps did not initially qualify for hedge
accounting.  At June 30, 2009, the aggregate fair value of the
derivatives was an asset of $654 thousand, which is included in other assets in
the accompanying consolidated balance sheet.  The  Company
recorded a gain  relating to the swap transactions of $420 thousand
for the three and six months ended June 30, 2009 and is included in other
noninterest income.





By
entering into derivative instrument contracts, the Company exposes itself, from
time to time, to counterparty credit risk.  Counterparty credit risk
is the failure of the counterparty to perform under the terms of the derivative
contract.  When the fair value of a derivative contract is in an asset
position, the counterparty has a liability to the Company, which creates credit
risk for the Company.  The Company attempts to minimize this risk by
selecting counterparties with investment grade credit ratings, limiting its
exposure to any single counterparty and regularly monitoring its market position
with each counterparty.





Note 12 – Repurchase of
Preferred Stock





On April
15, 2009, the Company completed the repurchase of all 25,000 shares of its Fixed
Rate Cumulative Perpetual Preferred Stock, Series A, with a liquidation value of
$1,000 per share, that were sold to the U.S. Department of Treasury (“Treasury”)
on January 9, 2009 pursuant to the Troubled Asset Relief Program Capital
Purchase Program.  The repurchase price was $25 million, plus accrued
dividends of $208 thousand.  At the time of the repurchase, the
preferred stock had a carrying value of $23.5 million.  The difference
between the repurchase price and carrying value represented an additional
accelerated deemed dividend of $1.5 million.  As a result, total
dividends paid on the preferred stock was $1.8 million for the six months ended
June 30, 2009.  The repurchase was approved by the Treasury following
consultation with and approval from the Federal Reserve Bank of Richmond and the
Federal Deposit Insurance Corporation.





Note 13 – New Accounting
Pronouncements





Pronouncements
adopted


SFAS No. 141(R), “Business
Combinations.”  During December 2007, the FASB issued SFAS
141(R). SFAS 141(R) recognizes and measures the goodwill acquired in a business
combination and defines a bargain purchase, and requires the acquirer to
recognize that excess as a gain attributable to the acquirer. In contrast,
Statement 141 required the “negative goodwill” amount to be allocated as a pro
rata reduction of the amounts assigned to assets acquired. SFAS 141(R) applies
prospectively to business combinations for which the acquisition date is on or
after December 15, 2008. The Company adopted SFAS No. 141R effective January 1,
2009.  This statement will change the Company’s accounting treatment
for business combinations on a prospective basis.





SFAS No. 160, “Noncontrolling
Interests in Consolidated Financial Statements.” During December 2007, the
FASB issued SFAS 160 to establish accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statement, but separate from the parent’s
equity.  SFAS 160 is effective for fiscal years, and interim periods
within those fiscal years, beginning on or after December 15, 2008. Management
adopted this Statement effective January 1, 2009, and adoption did not have a
material impact on the Company’s consolidated financial condition or results of
operations.





SFAS No. 161, “Disclosures about
Derivative Instruments and Hedging Activities – an amendment of FASB Statement
No. 133”.  SFAS 161 is intended to enhance the disclosures
previously required for derivative instruments and hedging activities under SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities”, to
include how and why an entity uses derivative instruments, how derivative
instruments and related hedge items are accounted for and their impact on an
entity’s financial positions, results of operations and cash
flows.  SFAS 161 is effective for financial statements issued for
fiscal years and interim periods beginning after November 15,
2008.  Adoption of SFAS 161 did not have a material impact on the
consolidated financial statements.


15





SFAS No. 165, “Subsequent
Events.”SFAS 165 incorporates accounting guidance that
originated as U.S. auditing standards into the body of authoritative literature
issued by the FASB.  SFAS 165 is based on the same principles as those
that currently exist in the auditing standards.  However, the new
standard does make a few changes such as eliminating Type I and Type II
subsequent events and requiring an entity to disclose the date through which it
evaluated subsequent events.  SFAS 165 is effective for interim or
annual periods ending after June 15, 2009.  The Company adopted SFAS
165 effective June 30, 2009 and adoption did not have a material effect on the
Company’s consolidated financial statements.





Financial Accounting Standards Board
Staff Position (“FSP”)  No. EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities”.This FSP clarifies that instruments granted in
share-based payment transactions can be participating securities prior to the
requisite service having been rendered. A basic principle of the FSP is that
unvested share-based payment awards that contain nonforfeitable rights to
dividends or dividend equivalents (whether paid or unpaid) are participating
securities and are to be included in the computation of EPS pursuant to the
two-class method. The provisions of this FSP are effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those years. All prior-period EPS data presented are
required to be adjusted retrospectively to conform with the provisions of the
FSP. The Company adopted this FSP effective March 31, 2009, and adoption did not
have a material effect on the Company’s consolidated results of operations or
earnings per share.





FSP Nos. FAS 107-1 and APB 28-1, FAS
157-4, FAS 115-2 and FAS 124-2, Other Than Temporary Impairment. FASB has
issued FSPs to address concerns regarding (1) determining whether a market is
not active and a transaction is not orderly, (2) recognition and presentation of
other-than-temporary impairments and (3) interim disclosures of fair values of
financial instruments. The FSPs are effective for interim and annual periods
ending after June 15, 2009, with early adoption permitted for periods ending
after March 15, 2009. The Company adopted the FSPs effective June 30, 2009 and
adoption did not have a material effect on the Company’s consolidated results of
operations.





FSP SFAS 141R-1,
“Accounting for Assets Acquired and Liabilities Assumed in a Business
Combination That Arise from Contingencies.” FSP SFAS 141R-1
amends the guidance in SFAS 141R to require that assets acquired and
liabilities assumed in a business combination that arise from contingencies be
recognized at fair value if fair value can be reasonably estimated. If fair
value of such an asset or liability cannot be reasonably estimated, the asset or
liability would generally be recognized in accordance with SFAS 5,
“Accounting for Contingencies,” and FASB Interpretation (FIN) No. 14,
“Reasonable Estimation of the Amount of a Loss.” FSP SFAS 141R-1
removes subsequent accounting guidance for assets and liabilities arising from
contingencies from SFAS 141R and requires entities to develop a systematic
and rational basis for subsequently measuring and accounting for assets and
liabilities arising from contingencies. FSP SFAS 141R-1 eliminates the
requirement to disclose an estimate of the range of outcomes of recognized
contingencies at the acquisition date. For unrecognized contingencies, entities
are required to include only the disclosures required by SFAS 5.
FSP SFAS 141R-1 also requires that contingent consideration
arrangements of an acquiree assumed by the acquirer in a business combination be
treated as contingent consideration of the acquirer and should be initially and
subsequently measured at fair value in accordance with SFAS 141R.
FSP SFAS 141R-1 is effective for assets or liabilities arising from
contingencies the Company acquires in business combinations occurring after
January 1, 2009.





Pronouncements
issued but not yet effective


SFAS No. 166, “Accounting for
Transfers of Financial Assets, an Amendment of FASB Statement No. 140.”SFAS 166 amends SFAS 140, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities,” to
enhance reporting about transfers of financial assets, including
securitizations, and where companies have continuing exposure to the risks
related to transferred financial assets. SFAS 166 eliminates the concept of
a “qualifying special-purpose entity” and changes the requirements for
derecognizing financial assets. SFAS 166 also requires additional
disclosures about all continuing involvements with transferred financial assets
including information about gains and losses resulting from transfers during the
period. SFAS 166 will be effective January 1, 2010 and is not expected to
have a significant impact on the Company’s financial statements.





SFAS No. 167, “Amendments to
FASB Interpretation No. 46(R).”SFAS 167 amends FIN 46
(Revised December 2003), “Consolidation of Variable Interest
Entities,” to change how a company determines when an entity that is
insufficiently capitalized or is not controlled through voting (or similar
rights) should be consolidated. The determination of whether a company is
required to consolidate an entity is based on, among other things, an entity’s
purpose and design and a company’s ability to direct the activities of the
entity that most significantly impact the entity’s economic performance.
SFAS 167 requires additional disclosures about the reporting entity’s
involvement with variable-interest entities and any significant changes in risk
exposure due to that involvement as well as its affect on the entity’s financial
statements. SFAS 167 will be effective January 1, 2010 and is not
expected to have a significant impact on the Company’s financial
statements.


16





SFAS No. 168, “The FASB
Accounting Standards Codification and the Hierarchy of Generally Accepted
Accounting Principles, a Replacement of FASB Statement No. 162.”SFAS 168 replaces SFAS 162, “The Hierarchy of Generally
Accepted Accounting Principles” and establishes the FASB Accounting Standards
Codification (the “Codification”) as the source of authoritative accounting
principles recognized by the FASB to be applied by non-governmental entities in
the preparation of financial statements in conformity with generally accepted
accounting principles. Rules and interpretive releases of the SEC under
authority of federal securities laws are also sources of authoritative guidance
for SEC registrants. All guidance contained in the Codification carries an equal
level of authority. All non-grandfathered, non-SEC accounting literature not
included in the Codification is superseded and deemed non-authoritative.
SFAS 168 will be effective for the Company’s financial statements for
periods ending after September 15, 2009. SFAS 168 is not expected have
a significant impact on the Company’s financial statements.





Item
2.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations.





Unless
the context clearly suggests otherwise, references to “the Company”, “we”,
“our”, and “us” in the remainder of this report are to Shore Bancshares, Inc.
and its consolidated subsidiaries.





Forward-Looking
Information


Portions
of this Quarterly Report on Form 10-Q contain forward-looking statements within
the meaning of The Private Securities Litigation Reform Act of
1995.  Statements that are not historical in nature, including
statements that include the words “anticipate”, “estimate”, “should”, “expect”,
“believe”, “intend”, and similar expressions, are expressions about our
confidence, policies, and strategies, the adequacy of capital levels, and
liquidity and are not guarantees of future performance.  Such
forward-looking statements involve certain risks and uncertainties, including
economic conditions, competition in the geographic and business areas in which
we operate, inflation, fluctuations in interest rates, legislation, and
governmental regulation.  These risks and uncertainties are described
in detail in the section of the periodic reports that Shore Bancshares, Inc.
files with the Securities and Exchange Commission (the “SEC”) entitled “Risk
Factors” (see Item 1A of Part II of this report).  Actual results may
differ materially from such forward-looking statements, and we assume no
obligation to update forward-looking statements at any time except as required
by law.





Introduction


The
following discussion and analysis is intended as a review of significant factors
affecting the financial condition and results of operations of Shore Bancshares,
Inc. and its consolidated subsidiaries for the periods
indicated.  This discussion and analysis should be read in conjunction
with the unaudited consolidated financial statements and related notes presented
in this report, as well as the audited consolidated financial statements and
related notes included in the Annual Report of Shore Bancshares, Inc. on Form
10-K for the year ended December 31, 2008.





Shore
Bancshares, Inc. is the largest independent financial holding company located on
the Eastern Shore of Maryland.  It is the parent company of The Talbot
Bank of Easton, Maryland located in Easton, Maryland (“Talbot Bank”), The
Centreville National Bank of Maryland located in Centreville, Maryland
(“Centreville National Bank”) and The Felton Bank, located in Felton, Delaware
(“Felton Bank”) (collectively, the “Banks”).  The Banks operate 19
full service branches in Kent County, Queen Anne’s County, Talbot County,
Caroline County and Dorchester County in Maryland and Kent County,
Delaware.  The Company engages in the insurance business through three
insurance producer firms, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance,
LLC and Jack Martin Associates, Inc.; a wholesale insurance company, TSGIA,
Inc.; and two insurance premium finance companies, Mubell Finance, LLC and ESFS,
Inc. (all of the foregoing are collectively referred to as the “Insurance
Subsidiary”) and the mortgage broker business through Wye Mortgage Group, LLC,
all of which are wholly-owned subsidiaries of Shore Bancshares,
Inc.





The
shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global
Select Market under the symbol “SHBI”.





Shore
Bancshares, Inc. maintains an Internet site at www.shbi.net on which
it makes available free of charge its Annual Report on Form 10-K, Quarterly
Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the
foregoing as soon as reasonably practicable after these reports are
electronically filed with, or furnished to, the SEC.


17


Critical
Accounting Policies


Our
financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America (“GAAP”).  The
financial information contained within the financial statements is, to a
significant extent, financial information contained that is based on measures of
the financial effects of transactions and events that have already
occurred.  A variety of factors could affect the ultimate value that
is obtained either when earning income, recognizing an expense, recovering an
asset or relieving a liability.





We
believe that our most critical accounting policy relates to the allowance for
credit losses.  The allowance for credit losses is an estimate of the
losses that may be sustained in the loan portfolio.  The allowance is
based on two basic principles of accounting: (i) SFAS No. 5, Accounting for
Contingencies, which requires that losses be accrued when they are probable of
occurring and estimable, and (ii) SFAS No. 114, Accounting by Creditors for
Impairment of a Loan, which requires that losses be accrued based on the
differences between the loan balance and the value of collateral, present value
of future cash flows or values that are observable in the secondary
market.  Management uses many factors, including economic conditions
and trends, the value and adequacy of collateral, the volume and mix of the loan
portfolio, and our internal loan processes in determining the inherent loss that
may be present in our loan portfolio.  Actual losses could differ
significantly from management’s estimates.  In addition, GAAP itself
may change from one previously acceptable method to another.  Although
the economics of transactions would be the same, the timing of events that would
impact the transactions could change.





Management
has significant discretion in making the adjustments inherent in the
determination of the provision and allowance for credit losses, including in
connection with the valuation of collateral, the borrower’s prospects of
repayment, and in establishing allowance factors on the formula allowance and
unallocated allowance components of the allowance.  The establishment
of allowance factors is a continuing exercise, based on management’s continuing
assessment of the totality of all factors, including, but not limited to,
delinquencies, loss history, trends in volume and terms of loans, effects of
changes in lending policy, the experience and depth of management, national and
local economic trends, concentrations of credit, the quality of the loan review
system and the effect of external factors such as competition and regulatory
requirements, and their impact on the portfolio, and allowance factors may
change from period to period, resulting in an increase or decrease in the amount
of the provision or allowance, based upon the same volume and classification of
loans.  Changes in allowance factors will have a direct impact on the
amount of the provision, and a corresponding effect on net
income.  Errors in management’s perception and assessment of these
factors and their impact on the portfolio could result in the allowance not
being adequate to cover losses in the portfolio, and may result in additional
provisions or charge-offs.





Three
basic components comprise our allowance for credit losses:  (i) a
specific allowance; (ii) a formula allowance; and (iii) a nonspecific
allowance.  Each component is determined based on estimates that can
and do change when the actual events occur.  The specific allowance is
used to individually allocate an allowance to loans identified as
impaired.  An impaired loan may show deficiencies in the borrower’s
overall financial condition, payment history, support available from financial
guarantors and/or the fair market value of collateral.  When a loan is
identified as impaired, a specific allowance is established based on our
assessment of the loss that may be associated with the individual
loan.  The formula allowance is used to estimate the loss on
internally risk rated loans, exclusive of those identified as impaired. Loans
identified as special mention, substandard, doubtful and loss, as well as
impaired, are segregated from performing loans.  Remaining loans are
then grouped by type (commercial, commercial real estate and construction,
residential real estate or consumer).  Each loan type is assigned an
allowance factor based on management’s estimate of the risk, complexity and size
of individual loans within a particular category.  Classified loans
are assigned higher allowance factors than non-rated loans due to management’s
concerns regarding collectibility or management’s knowledge of particular
elements regarding the borrower.  Allowance factors grow with the
worsening of the internal risk rating.  The nonspecific formula is
used to estimate the loss of non-classified loans stemming from more global
factors such as delinquencies, loss history, trends in volume and terms of
loans, effects of changes in lending policy, the experience and depth of
management, national and local economic trends, concentrations of credit, the
quality of the loan review system and the effect of external factors such as
competition and regulatory requirements.  The nonspecific allowance
captures losses that have impacted the portfolio but have yet to be recognized
in either the formula or specific allowance.





RECENT
DEVELOPMENTS





During
the second quarter of 2009, we discovered that The Felton Bank’s calculation of
the allowance for credit losses with respect to several loan relationships did
not reflect the full loss exposure as of March 31, 2009 as calculated pursuant
to SFAS No. 114.  As a result of this error, we filed an amendment to our
Quarterly Report on Form 10-Q for the quarter ended March 31, 2009 to revise the
provision for credit losses and the related allowance for credit losses in our
interim consolidated financial statements for that quarter.  On July 30,
2009, we received a comment letter from the SEC requesting, among other things,
that we further amend the Quarterly Report (specifically, by revising the
section entitled “Management’s Discussion and Analysis of Financial Condition
and Results of Operations”) to provide additional information about the error,
the loans involved, and any related impact on the Company’s policies and
procedures.  We intend to respond to the SEC’s comment letter and further
amend the 10-Q for the quarter ended March 31, 2009 in the near future.  We
do not believe that our responses to the SEC’s comments, including a further
amendment to our Form 10-Q, are material to an understanding of the following
discussion.  For further information, see Item 4 of Part I of this
report.


18





OVERVIEW





Net
income for the second quarter of 2009 was $354 thousand, or diluted earnings per
common share of $0.04, compared to $2.8 million, or diluted earnings per common
share of $0.33, for the second quarter of 2008.  For the first quarter
of 2009, net income was $1.9 million or $0.22 diluted earnings per common
share.  Annualized return on average assets was 0.13% for the three
months ended June 30, 2009, compared to 1.12% for the same period in
2008.  Annualized return on average stockholders’ equity was 1.07% for
the second quarter of 2009, compared to 8.98% for the second quarter of
2008.  For the first quarter of 2009, annualized return on average
assets was 0.72% and return on average equity was 5.05%.





Net
income for the first six months of 2009 was $2.2 million, or diluted earnings
per common share of $0.27, compared to $6.1 million, or diluted earnings per
common share of $0.73, for the first six months of 2008.  Annualized
return on average assets was 0.41% for the six months ended June 30, 2009,
compared to 1.25% for the same period in 2008.  Annualized return on
average stockholders’ equity was 3.18% for the first six months of 2009,
compared to 10.02% for the first six months of 2008.





During
the first six months of 2009, net income available to common stockholders was
negatively impacted by dividends and discount accretion associated with the
January 9, 2009 sale and April 15, 2009 repurchase of preferred stock under the
U.S. Department of the Treasury’s Troubled Asset Relief Program Capital Purchase
Program.  The dividends and accretion for the second quarter of 2009
totaled $1.5 million.  The comparable amount for the first six months
of 2009 was $1.9 million.





RESULTS
OF OPERATIONS





Net
Interest Income


Net
interest income for the three months ended June 30, 2009 was $10.1 million, an
increase of 4.7% when compared to the same period last year.  An
increase in average earning assets and lower rates paid on interest bearing
liabilities were sufficient to offset the decline in yields on earning
assets.  The net interest margin was 3.85% for the second quarter of
2009, a decrease of 32 basis points when compared to the second quarter of
2008.  The 400 basis-point reduction in interest rates by the Federal
Reserve during 2008 had a significant impact on the overall yield on earning
assets.  Net interest income increased slightly from the first quarter
of 2009, mainly due to a higher volume of average earning assets.  The
net interest margin decreased 24 basis points from 4.09% for the first quarter
of 2009.





Interest
income was $14.6 million for the second quarter of 2009, a decrease of 3.3% from
the second quarter of 2008.  Average earning assets increased 13.0%
during the second quarter of 2009 when compared to the same period in 2008,
while yields earned decreased 97 basis points to 5.56%.  Average loans
increased 11.1% while the yield earned on loans decreased 79 basis points. Loans
comprised 86.1% of total average earning assets for the second quarter of 2009,
a decrease from the 87.7% for the second quarter of 2008.  The mix of
earning assets shifted from loans and securities to Federal funds sold which
comprised 5.3% of total earning assets compared to 1.6% for the second quarter
of 2008. Interest income increased 1.1% when compared to the first quarter of
2009.  Average earning assets increased 5.4% during the second quarter
of 2009 when compared to the first quarter of 2009, while yields earned
decreased 31 basis points.





Interest
expense decreased 17.3% for the three months ended June 30, 2009 when compared
to the same period last year. Average interest bearing liabilities increased
14.6%, while rates paid decreased 82 basis points to 2.10%.  During
the second quarter of 2009, the Company began to participate in the Promontory
Insured Network Deposits Program (“IND”).   When comparing the
second quarter of 2009 to the second quarter of 2008, the $137.3 million
increase in average interest bearing deposits included approximately $60.6
million from the IND program.  The Company incurs the largest amount
of interest expense from time deposits.  For the three months ended
June 30, 2009, the average balance of certificates of  deposit
$100,000 or more increased 33.9% when compared to the same period last year,
while the average rate paid decreased 106 basis points to
3.20%.  Average other time deposits increased 9.3%, while the rate
paid on average other time deposits decreased 78 basis points when compared to
the second quarter of 2008.  Interest expense increased 3.1% when
compared to the first quarter of 2009.  Average interest bearing
liabilities increased 9.2% during the quarter ended June 30, 2009 when compared
to the first quarter of 2009, while rates paid decreased 15 basis
points.  When comparing the second quarter of 2009 to the first
quarter of 2009, the $87.3 million increase in average interest bearing deposits
also included the approximately $60.6 million from the IND
program.


19





Net
interest income for the six months ended June 30, 2009 was $20.1 million, an
increase of 2.5% when compared to the same period last year.  An
increase in the volume of average earning assets and a reduction in the cost of
funds were sufficient to offset the decline in yields on earning
assets.  The net interest margin was 3.96% for the first six months of
2009, a decrease of 34 basis points when compared to the first six months of
2008.





Interest
income was $29.1million for the first six months of 2009, a decrease of 6.3%
from the first six months of 2008.  Average earning assets increased
11.1% during the six months ended June 30, 2009 when compared to the same period
in 2008, while yields earned decreased 105 basis points to
5.71%.  Average loans increased 11.9% during the first six months of
2009, while the yield earned on loans decreased 99 basis points when compared to
the same period of 2008.  Loans comprised 87.6% and 87.1% of total
average earning assets for the first six months of 2009 and 2008,
respectively.




Interest
expense decreased 21.4% for the six months ended June 30, 2009 when compared to
the same period last year.  Average interest bearing liabilities
increased 10.4%, while rates paid decreased 87 basis points to
2.18%.  For the six months ended June 30, 2009, the average balance of
certificates of  deposit $100,000 or more increased 33.1% when
compared to the same period last year, while the average rate paid decreased 114
basis points to 3.30%.  Average other time deposits increased 8.1%,
while the rate paid on average other time deposits decreased 83 basis points
when compared to the first six months of 2008.


20


Analysis
of Interest Rates and Interest Differentials


The
following table presents the distribution of the average consolidated balance
sheets, interest income/expense, and annualized yields earned and rates paid for
the three months ended June 30, 2009 and 2008.





For the Three Months Ended
                
                
                For the Three Months EndedJune 30, 2009
                
                
                June 30, 2008Average
                
                
                Income(1)/
                
                
                Yield/
                
                
                Average
                
                
                Income(1)/
                
                
                Yield/(Dollars in thousands)
                
                Balance
                
                
                Expense
                
                
                Rate
                
                
                Balance
                
                
                Expense
                
                
                RateEarning
      assetsLoans
      (2), (3)
                
                $
                913,671
                
                
                $
                13,795
                
                
                
                6.06
                %
                
                $
                822,781
                
                
                $
                14,003
                
                
                
                6.85
                %Investment
      securitiesTaxable
                
                
                75,277
                
                
                
                768
                
                
                
                4.09
                
                
                
                83,654
                
                
                
                945
                
                
                
                4.54Tax-exempt
                
                
                8,110
                
                
                
                122
                
                
                
                6.02
                
                
                
                11,200
                
                
                
                167
                
                
                
                6.01Federal
      funds sold
                
                
                55,699
                
                
                
                23
                
                
                
                0.16
                
                
                
                15,194
                
                
                
                83
                
                
                
                2.21Interest
      bearing deposits
                
                
                8,129
                
                
                
                6
                
                
                
                0.33
                
                
                
                5,812
                
                
                
                29
                
                
                
                2.01Total
      earning assets
                
                
                1,060,886
                
                
                
                14,714
                
                
                
                5.56
                %
                
                
                938,641
                
                
                
                15,227
                
                
                
                6.53
                %Cash
      and due from banks
                
                
                18,705
                
                
                
                
                
                
                
                
                
                
                
                16,618Other
      assets
                
                
                51,595
                
                
                
                
                
                
                
                
                
                
                
                50,315Allowance
      for credit losses
                
                
                (10,848
                )
                
                
                
                
                
                
                
                
                
                
                (8,102
                )Total
      assets
                
                $
                1,120,338
                
                
                
                
                
                
                
                
                
                
                $
                997,472Interest
      bearing liabilitiesDemand
      deposits
                
                $
                125,076
                
                
                
                76
                
                
                
                0.24
                %
                
                $
                109,716
                
                
                
                95
                
                
                
                0.35
                %Money
      market and savings deposits
                
                
                222,825
                
                
                
                351
                
                
                
                0.63
                
                
                
                183,392
                
                
                
                659
                
                
                
                1.45Certificates
      of deposit $100,000 or more
                
                
                245,210
                
                
                
                1,954
                
                
                
                3.20
                
                
                
                183,108
                
                
                
                1,940
                
                
                
                4.26Other
      time deposits
                
                
                239,668
                
                
                
                2,060
                
                
                
                3.45
                
                
                
                219,250
                
                
                
                2,303
                
                
                
                4.23Interest
      bearing deposits
                
                
                832,779
                
                
                
                4,441
                
                
                
                2.14
                
                
                
                695,466
                
                
                
                4,997
                
                
                
                2.89Short-term
      borrowings
                
                
                25,435
                
                
                
                28
                
                
                
                0.45
                
                
                
                45,354
                
                
                
                316
                
                
                
                2.80Long-term
      debt
                
                
                7,947
                
                
                
                75
                
                
                
                3.78
                
                
                
                15,101
                
                
                
                182
                
                
                
                4.85Total
      interest bearing liabilities
                
                
                866,161
                
                
                
                4,544
                
                
                
                2.10
                %
                
                
                755,921
                
                
                
                5,495
                
                
                
                2.92
                %Noninterest
      bearing deposits
                
                
                109,652
                
                
                
                
                
                
                
                
                
                
                
                106,035Other
      liabilities
                
                
                11,918
                
                
                
                
                
                
                
                
                
                
                
                11,686Stockholders’
      equity
                
                
                132,607
                
                
                
                
                
                
                
                
                
                
                
                123,830Total
      liabilities and stockholders’ equity
                
                $
                1,120,338
                
                
                
                
                
                
                
                
                
                
                $
                997,472Net
      interest spread
                
                
                
                
                
                $
                10,170
                
                
                
                3.46
                %
                
                
                
                
                
                $
                9,732
                
                
                
                3.61
                %Net
      interest margin
                
                
                
                
                
                
                
                
                
                
                3.85
                %
                
                
                
                
                
                
                
                
                
                
                4.17
                %




21


The
following table presents the distribution of the average consolidated balance
sheets, interest income/expense, and annualized yields earned and rates paid for
the six months ended June 30, 2009 and 2008.





For the Six Months Ended
                
                
                For the Six Months EndedJune 30, 2009
                
                
                June 30, 2008Average
                
                
                Income(1)/
                
                
                Yield/
                
                
                Average
                
                
                Income(1)/
                
                
                Yield/(Dollars in thousands)
                
                Balance
                
                
                Expense
                
                
                Rate
                
                
                Balance
                
                
                Expense
                
                
                RateEarning
      assetsLoans
      (2), (3)
                
                $
                906,066
                
                
                $
                27,455
                
                
                
                6.11
                %
                
                $
                809,815
                
                
                $
                28,604
                
                
                
                7.10
                %Investment
      securitiesTaxable
                
                
                75,067
                
                
                
                1,524
                
                
                
                4.09
                
                
                
                87,638
                
                
                
                2,025
                
                
                
                4.65Tax-exempt
                
                
                8,605
                
                
                
                253
                
                
                
                5.92
                
                
                
                11,938
                
                
                
                357
                
                
                
                6.01Federal
      funds sold
                
                
                38,873
                
                
                
                30
                
                
                
                0.15
                
                
                
                15,856
                
                
                
                205
                
                
                
                2.61Interest
      bearing deposits
                
                
                5,298
                
                
                
                7
                
                
                
                0.28
                
                
                
                5,013
                
                
                
                67
                
                
                
                2.69Total
      earning assets
                
                
                1,033,909
                
                
                
                29,269
                
                
                
                5.71
                %
                
                
                930,260
                
                
                
                31,258
                
                
                
                6.76
                %Cash
      and due from banks
                
                
                15,395
                
                
                
                
                
                
                
                
                
                
                
                16,482Other
      assets
                
                
                50,487
                
                
                
                
                
                
                
                
                
                
                
                50,855Allowance
      for credit losses
                
                
                (10,259
                )
                
                
                
                
                
                
                
                
                
                
                (7,909
                )Total
      assets
                
                $
                1,089,532
                
                
                
                
                
                
                
                
                
                
                $
                989,688Interest
      bearing liabilitiesDemand
      deposits
                
                $
                123,104
                
                
                
                148
                
                
                
                0.24
                %
                
                $
                112,465
                
                
                
                266
                
                
                
                0.48
                %Money
      market and savings deposits
                
                
                188,165
                
                
                
                525
                
                
                
                0.56
                
                
                
                179,378
                
                
                
                1,364
                
                
                
                1.53Certificates
      of deposit $100,000 or more
                
                
                241,997
                
                
                
                3,966
                
                
                
                3.30
                
                
                
                181,831
                
                
                
                4,010
                
                
                
                4.44Other
      time deposits
                
                
                236,077
                
                
                
                4,087
                
                
                
                3.50
                
                
                
                218,323
                
                
                
                4,700
                
                
                
                4.33Interest
      bearing deposits
                
                
                789,343
                
                
                
                8,726
                
                
                
                2.23
                
                
                
                691,997
                
                
                
                10,340
                
                
                
                3.00Short-term
      borrowings
                
                
                32,469
                
                
                
                77
                
                
                
                0.48
                
                
                
                44,354
                
                
                
                682
                
                
                
                3.09Long-term
      debt
                
                
                7,947
                
                
                
                149
                
                
                
                3.78
                
                
                
                15,013
                
                
                
                366
                
                
                
                4.90Total
      interest bearing liabilities
                
                
                829,759
                
                
                
                8,952
                
                
                
                2.18
                %
                
                
                751,364
                
                
                
                11,388
                
                
                
                3.05
                %Noninterest
      bearing deposits
                
                
                106,968
                
                
                
                
                
                
                
                
                
                
                
                103,508Other
      liabilities
                
                
                11,304
                
                
                
                
                
                
                
                
                
                
                
                11,642Stockholders’
      equity
                
                
                141,501
                
                
                
                
                
                
                
                
                
                
                
                123,174Total
      liabilities and stockholders’ equity
                
                $
                1,089,532
                
                
                
                
                
                
                
                
                
                
                $
                989,688Net
      interest spread
                
                
                
                
                
                $
                20,317
                
                
                
                3.53
                %
                
                
                
                
                
                $
                19,870
                
                
                
                3.71
                %Net
      interest margin
                
                
                
                
                
                
                
                
                
                
                3.96
                %
                
                
                
                
                
                
                
                
                
                
                4.30
                %




(1)
            All
      amounts are reported on a tax equivalent basis computed using the
      statutory federal income tax rate of 35% exclusive of the alternative
      minimum tax rate and nondeductible interest
  expense.


(2)
            Average
      loan balances include nonaccrual
loans.


(3)
            Interest
      income on loans includes amortized loan fees, net of costs, for each loan
      category and yield calculations are stated to include
  all.




Noninterest
Income


Noninterest
income for the second quarter of 2009 increased $153 thousand, or 2.9%, when
compared to the second quarter of 2008. Included in other noninterest income was
a $420 thousand mark-to-market gain on interest rate swaps.  This was
partially offset by a reduction in insurance agency commissions of $326
thousand.  Noninterest income for the second quarter of 2009 remained
relatively unchanged when compared to the first quarter of 2009.





Noninterest
income for both the first six months of 2009 and 2008 was $10.7
million.  The increase in other noninterest income, which included the
$420 thousand mark-to-market gain on interest rate swaps, was mainly offset by
decreases in insurance agency commissions.





Noninterest
Expense


Noninterest
expense for the second quarter of 2009 increased $964 thousand, or 9.9%, when
compared to the second quarter of 2008.  The increase was primarily
attributable to higher FDIC insurance premiums of $860 thousand and increased
salaries of $191 thousand.  The second quarter 2009 FDIC insurance
premium included a special one-time assessment of $513
thousand.  Noninterest expense increased $810 thousand, or 8.2%, from
the first quarter of 2009 primarily due to higher FDIC insurance premiums of
$676 thousand.





Noninterest
expense for the first six months of 2009 increased $1.3 million, or 6.5%, when
compared to the first six months of 2008.  The increase was primarily
attributable to higher FDIC insurance premiums of $1.1 million and increased
salaries of $124 thousand.


22


Income
Taxes


The
effective tax rate was 38.1% for the three months ended June 30, 2009, compared
to 38.3% for the same period last year.  For the six months ended June
30, 2009 and 2008, the effective tax rates were 38.2% and 38.4%,
respectively.  Management believes that currently there are no
additional changes in tax laws or to our tax structure that are likely to have a
material impact on our future effective tax rate.





ANALYSIS
OF FINANCIAL CONDITION





Loans


Loans,
net of unearned income, totaled $919.1 million at June 30, 2009, an increase of
$30.6 million, or 3.4%, since December 31, 2008.  Average loans, net
of unearned income, were $913.7 million for the three months ended June 30,
2009, an increase of $90.9 million, or 11.1%, when compared to the same period
last year.  Average loans, net of unearned income, were $906.1 million
for the six months ended June 30, 2009, an increase of $96.3 million, or 11.9%,
when compared to the same period in 2008.





Allowance
for Credit Losses


We have
established an allowance for credit losses, which is increased by provisions
charged against earnings and recoveries of previously charged-off
debts.  The allowance is decreased by current period charge-offs of
uncollectible debts.  Management evaluates the adequacy of the
allowance for credit losses on a quarterly basis and adjusts the provision for
credit losses based upon this analysis.  The evaluation of the
adequacy of the allowance for credit losses is based on a risk rating system of
individual loans, as well as on a collective evaluation of smaller balance
homogenous loans based on factors such as past credit loss experience, local
economic trends, nonperforming and problem loans, and other factors which may
impact collectibility.  A loan is placed on nonaccrual when it is
specifically determined to be impaired and
principal and interest is delinquent for 90 days or more. Please
refer to the discussion above under the caption “Critical Accounting Policies”
for an overview of the underlying methodology management employs on a quarterly
basis to maintain the allowance.





The
provision for credit losses for the three months ended June 30, 2009 and 2008
was $1.7 million and $615 thousand, respectively. The provision for credit
losses for the first quarter of 2009 was $1.9 million.  The increased
level of provision expense in both the first and second quarters of 2009 were
the result of growth in the loan portfolio, the overall increase in
nonperforming assets and loan charge-offs, as well as overall economic
conditions.  The provision for credit losses for the six months ended
June 30, 2009 and 2008 was $3.6 million and $1.1 million,
respectively.  Management believes that we continue to maintain strong
underwriting guidelines and emphasize credit quality.  If the current
economic recession continues or gets worse, we will likely experience higher
levels of provision expense, nonperforming assets and charge-offs.  As
problem loans are identified, management takes  prompt action to
quantify and minimize losses and also works with the borrowers in an effort to
reach mutually acceptable resolutions.





Net
charge-offs were $1.6 million for the three months ended June 30, 2009, compared
to $259 thousand for the same period last year and $546 thousand for the first
quarter of 2009.  The allowance for credit losses as a percentage of
average loans was 1.18% for the second quarter of 2009, 1.01% for the second
quarter of 2008 and 1.19% for the first quarter of 2009.  Net
charge-offs were $2.2 million for the first six months of 2009, compared to $346
thousand for the same period in 2008. The allowance for credit losses as a
percentage of average loans increased to 1.19% for the first six months of 2009
from 1.02% for the same period last year.  Nonperforming assets were
$15.9 million at June 30, 2009, compared to $8.3 million at December 31, 2008,
with nonaccrual loans increasing $5.6 million and other real estate owned
increasing $2.1 million.  The increase in nonaccrual loans was
primarily in residential real estate.  Loans past due 90 days and
still accruing at June 30, 2009 increased to $8.1 million from $1.4 million at
December 31, 2008.  The increase was primarily related to one $5
million secured participation loan purchased from a regional
bank.  The customer continues to make interest payments, however, the
loan is matured and the lead bank is negotiating a renewal with the
customer.  Based on management’s quarterly evaluation of the adequacy
of the allowance for credit losses, it believes that the allowance for credit
losses and the related provision were adequate at June 30,
2009.


23


The
following table presents a summary of the activity in the allowance for credit
losses:





For the Three Months Ended
                
                
                For the Six Months EndedJune 30,
                
                
                June 30,(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2009
                
                
                2008Allowance
      balance – beginning of period
                
                $
                8,282
                
                
                $
                7,926
                
                
                $
                7,551
                
                
                $
                7,551Charge-offs:Real
      estate – construction
                
                
                (128
                )
                
                
                -
                
                
                
                (215
                )
                
                
                -Real
      estate – residential
                
                
                (611
                )
                
                
                (59
                )
                
                
                (951
                )
                
                
                (71
                )Real
      estate – commercial
                
                
                (173
                )
                
                
                -
                
                
                
                (173
                )
                
                
                -Commercial
                
                
                (629
                )
                
                
                (154
                )
                
                
                (727
                )
                
                
                (196
                )Consumer
                
                
                (88
                )
                
                
                (72
                )
                
                
                (199
                )
                
                
                (135
                )Totals
                
                
                (1,629
                )
                
                
                (285
                )
                
                
                (2,265
                )
                
                
                (402
                )Recoveries:Real
      estate – construction
                
                
                2
                
                
                
                -
                
                
                
                2
                
                
                
                -Real
      estate – residential
                
                
                1
                
                
                
                -
                
                
                
                53
                
                
                
                8Real
      estate – commercial
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Commercial
                
                
                -
                
                
                
                4
                
                
                
                4
                
                
                
                7Consumer
                
                
                20
                
                
                
                22
                
                
                
                54
                
                
                
                41Totals
                
                
                23
                
                
                
                26
                
                
                
                113
                
                
                
                56Net
      charge-offs
                
                
                (1,606
                )
                
                
                (259
                )
                
                
                (2,152
                )
                
                
                (346
                )Provision
      for credit losses
                
                
                1,681
                
                
                
                615
                
                
                
                3,616
                
                
                
                1,077Allowance
      balance – end of period
                
                $
                10,784
                
                
                $
                8,282
                
                
                $
                10,784
                
                
                $
                8,282Average
      loans outstanding during the period
                
                $
                913,671
                
                
                $
                822,781
                
                
                $
                906,066
                
                
                $
                809,815Net
      charge-offs (annualized) as a percentage of average loans outstanding
      during the period
                
                
                0.71
                %
                
                
                0.13
                %
                
                
                0.95
                %
                
                
                0.09
                %Allowance
      for credit losses at period end as a percentage of average
      loans
                
                
                1.18
                %
                
                
                1.01
                %
                
                
                1.19
                %
                
                
                1.02
                %





Because
most of our loans are secured by real estate, weaknesses in the local real
estate market may have a material adverse effect on the performance of our loan
portfolio and the value of the collateral securing that
portfolio.  Although the economy of our market area does not appear to
be as weak as in other parts of the country, we have experienced weakness in the
local real estate market and related construction industry as a result of the
widely-publicized banking crisis and its impact on the global economy, which has
resulted in higher provisions for credit losses and loan charge-offs for
us.





We have a
concentration of commercial real estate loans.  Commercial real estate
loans, excluding construction and land development loans, were approximately
$298.1 million, or 32.4% of total loans, at June 30, 2009, compared to $304.4
million, or 34.3% of total loans, at December 31, 2008.  Construction
and land development loans were $178.9 million, or 19.5% of total loans, at June
30, 2009, compared to $179.8 million, or 20.2% of total loans, at December 31,
2008.  We do not engage in foreign or subprime lending
activities.


24


Nonperforming
Assets


The
following table summarizes our nonperforming and past due assets:





June 30,
                    
                    
                    December 31,(Dollars in thousands)
                    
                    2009
                    
                    
                    2008Nonperforming
      assetsNonaccrual
      loansReal
      estate – construction
                    
                    $
                    5,706
                    
                    
                    $
                    5,277Real
      estate – residential
                    
                    
                    4,611
                    
                    
                    
                    1,015Real
      estate – commercial
                    
                    
                    1,127
                    
                    
                    
                    1,682Commercial
                    
                    
                    2,204
                    
                    
                    
                    137Consumer
                    
                    
                    47
                    
                    
                    
                    4Total
      nonaccrual loans
                    
                    
                    13,695
                    
                    
                    
                    8,115Other
      real estate owned
                    
                    
                    2,212
                    
                    
                    
                    148Total
      nonperforming assets
                    
                    
                    15,907
                    
                    
                    
                    8,263Loans
      90 days past due and still accruing
                    
                    
                    8,055
                    
                    
                    
                    1,381Total
      nonperforming assets and past due loans
                    
                    $
                    23,962
                    
                    
                    $
                    9,644





Investment
Securities


Investment
securities totaled $89.3 million at June 30, 2009, relatively unchanged from the
$89.5 million at December 31, 2008.  The average balance of investment
securities was $83.4 million for the three months ended June 30, 2009, compared
to $94.6 million for the same period in 2008.  The tax equivalent
yields on investment securities were 4.28% and 4.72% for the three months ended
June 30, 2009 and 2008, respectively.  The average balance of
investment securities was $83.7 million for the six months ended June 30, 2009,
compared to $99.6 million for the same period in 2008.  The tax
equivalent yields on investment securities were 4.28% and 4.81% for the six
months ended June 30, 2009 and 2008, respectively. The decrease in average
balances for both the three and six month periods compared to one year ago
reflected the use of proceeds from maturing securities to fund loan
growth.





Deposits


Total
deposits at June 30, 2009 were $981.3 million, compared to $845.4 million at
December 31, 2008.  All categories of deposits grew from the
comparable amounts at the end of 2008.  The largest growth was in
money market and savings which increased $93.3 million, or 61.8%, of which
approximately $80 million of the increase was from participation in the IND
program which began in the second quarter of 2009.





Short-Term
Borrowings


Short-term
borrowings at June 30, 2009 and December 31, 2008 were $28.1 million and $53.0
million, respectively.  Short-term borrowings consisted of securities
sold under agreements to repurchase, overnight borrowings from correspondent
banks and short-term advances from the Federal Home Loan Bank (the
“FHLB”).  Short-term advances are defined as those with original
maturities of one year or less.  The decline in short-term borrowings
is primarily due to the repayment of advances from the FHLB since December 31,
2008.





Long-Term
Debt


At June
30, 2009 and December 31, 2008, the Company had the following long-term
debt:





June 30,
                
                
                December 31,(Dollars in thousands)
                
                2009
                
                
                2008FLHB
      4.17% Advance due November 2009
                
                $
                3,000
                
                
                $
                3,000FHLB
      3.09% Advance due January 2010
                
                
                3,000
                
                
                
                3,000Acquisition-related
      debt, 4.08% interest, annual installments for five years
                
                
                1,947
                
                
                
                1,947$
                7,947
                
                
                $
                7,947





Liquidity
and Capital Resources


We derive
liquidity through increased customer deposits, maturities in the investment
portfolio, loan repayments and income from earning assets.  During the
second quarter of 2009 we began participating in the IND program which resulted
in increased deposits and liquidity.  The program was entered into for
a five year period and has a guaranteed minimum funding level of $70
million.





25


To the
extent that deposits are not adequate to fund customer loan demand, liquidity
needs can be met in the short-term funds markets through arrangements with
correspondent banks.  Talbot Bank and Centreville National Bank are
also members of the FHLB of Atlanta and Felton Bank is a member of the FHLB of
Pittsburgh to which they have pledged collateral sufficient to permit additional
borrowings of up to approximately $66.7 million in the aggregate at June 30,
2009. Management is not aware of any trends or demands, commitments, events or
uncertainties that are likely to materially affect our future ability to
maintain liquidity at satisfactory levels.





Total
stockholders’ equity was $127.9 million at June 30, 2009, compared to $127.4
million at December 31, 2008.  The slight increase in stockholders’
equity since the end of 2008 included the $1.5 million increase in warrants
partially offset by dividends paid to common stockholder exceeding net income
available to common stockholder by $462 thousand. Also, accumulated other
comprehensive income, which consisted solely of net unrealized gains or losses
on investment securities available for sale, decreased $639 thousand since the
end of 2008, resulting in accumulated other comprehensive income of $754
thousand at June 30, 2009.





Bank
regulatory agencies have adopted various capital standards for financial
institutions, including risk-based capital standards.  The primary
objectives of the risk-based capital framework are to provide a more consistent
system for comparing capital positions of financial institutions and to take
into account the different risks among financial institutions’ assets and
off-balance sheet items.





Risk-based
capital standards have been supplemented with requirements for a minimum Tier 1
capital to average assets ratio (leverage ratio).  In addition,
regulatory agencies consider the published capital levels as minimum levels and
may require a financial institution to maintain capital at higher
levels.  The Company’s capital ratios continued to be well in excess
of regulatory minimums.





A
comparison of the capital ratios of Shore Bancshares, Inc. (on a consolidated
basis) as of June 30, 2009 and December 31, 2008 to the minimum regulatory
requirements is presented below:





MinimumJune
      30,
                  
                  
                  December
      31,
                  
                  
                  Regulatory2009
                  
                  
                  2008
                  
                  
                  RequirementsTier
      1 risk-based capital ratio
                  
                  
                  11.27
                  %
                  
                  
                  11.65
                  %
                  
                  
                  4.00
                  %Total
      risk-based capital ratio
                  
                  
                  12.34
                  %
                  
                  
                  12.74
                  %
                  
                  
                  8.00
                  %Leverage
      ratio
                  
                  
                  9.60
                  %
                  
                  
                  10.27
                  %
                  
                  
                  4.00
                  %





Item
3.  Quantitative and Qualitative Disclosures about Market
Risk.





Our
primary market risk is to interest rate fluctuation and management has
procedures in place to evaluate and mitigate this risk.  This risk and
these procedures are discussed in Item 7 of Part II of the Annual Report of
Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2008 under
the caption “Market Risk Management”.  Management believes that there
have been no material changes in our market risks, the procedures used to
evaluate and mitigate these risks, or our actual and simulated sensitivity
positions since December 31, 2008.





Item
4.  Controls and Procedures.





We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in the reports that Shore Bancshares, Inc.
files under the Securities Exchange Act of 1934 with the SEC, such as this
Quarterly Report, is recorded, processed, summarized and reported within the
time periods specified in those rules and forms, and that such information is
accumulated and communicated to management, including Shore Bancshares, Inc.’s
Chief Executive Officer (“CEO”) and the Principal Accounting Officer (“PAO”), as
appropriate, to allow for timely decisions regarding required
disclosure.  A control system, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met.  Further, the design of a
control system must reflect the fact that there are resource constraints, and
the benefits of controls must be considered relative to their
costs.  These inherent limitations include the realities that
judgments in decision-making can be faulty, and that breakdowns can occur
because of simple error or mistake.  Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the control.  The design of any
system of controls also is based in part upon certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions;
over time, controls may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may
deteriorate.





An
evaluation of the effectiveness of these disclosure controls as of June 30, 2009
was carried out under the supervision and with the participation of management,
including the CEO and the PAO.  Based on that evaluation, the
Company’s management, including the CEO and the PAO, has concluded that our
disclosure controls and procedures are, in fact, effective at the reasonable
assurance level.


26


During
the second quarter of 2009, we discovered that The Felton Bank’s calculation of
the allowance for credit losses with respect to several loan relationships did
not reflect the full loss exposure as of March 31, 2009 as calculated pursuant
to Statement of Financial Accounting Standards No. 114 (“SFAS 114”). As a
result of this error, we filed an amended Quarterly Report on Form 10-Q for the
quarter ended March 31, 2009 to revise the provision for credit losses and the
related allowance for credit losses in our interim consolidated financial
statements for that quarter.  Management believes that the miscalculation,
which was discovered as a result of an examination of The Felton Bank by the
FDIC, was the result of an error
in the preparation and review of The Felton Bank's calculation of the allowance
for credit losses. Management implemented the following changes in
our controls during the second quarter of 2009 to help ensure, to the
extent reasonably possible, that such error does not re-occur in the
future:





·
              Appointed
      three senior officers from The Centreville National Bank of Maryland
      (“CNB”) to The Felton Bank’s loan committee to assist in credit
      underwriting and loan relationship management;
  and


·
              These
      three senior officers, along with other members of CNB’s loan
      administration staff, began assisting The Felton Bank in the preparation
      and review of its methodology for determining the adequacy of the
      allowance for credit losses, including analysis of impaired loans under
      SFAS 114.





Other
than as discussed above, there was no change in our internal control over
financial reporting during the second quarter of 2009 that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.





PART
II – OTHER INFORMATION





Item
1A.  Risk Factors.





The risks
and uncertainties to which our financial condition and operations are subject
are discussed in detail in Item 1A of Part I of the Annual Report of Shore
Bancshares, Inc. on Form 10-K for the year ended December 31,
2008.  Management does not believe that any material changes in our
risk factors have occurred since they were last disclosed.





Item
4.  Submission of Matters to Vote of Security Holders.





At the
Annual Meeting of Stockholders held on April 29, 2009, the stockholders of Shore
Bancshares, Inc. voted on the election of directors, the ratification of the
appointment of the Company’s auditors for fiscal year 2009 and the approval of
the Company’s executive compensation program.  The Board of Directors
submitted these matters to a vote through the solicitation of
proxies.  The results of the votes are set forth below:





Proposal
1 - To elect five individuals to serve as Class III Directors until the 2012
Annual Meeting of Stockholders and until their successors are duly elected and
qualify, and one individual to serve as Class I Director until the 2010 Annual
Meeting of Stockholders and until his successor is duly elected and
qualifies.





Class III Directors
                            
                            For
                            
                            
                            Withheld
                            
                            
                            Abstain
                            
                            
                            Broker Non-VotesLloyd
      L. Beatty, Jr.
                            
                            6,749,878
                            
                            
                            
                            37,333
                            
                            
                            
                            -
                            
                            
                            
                            -Paul
      M. Bowman
                            
                            6,758,315
                            
                            
                            
                            28,896
                            
                            
                            
                            -
                            
                            
                            
                            -Jerry
      F. Pierson
                            
                            6,763,075
                            
                            
                            
                            24,136
                            
                            
                            
                            -
                            
                            
                            
                            -W.
      Moorhead Vermilye
                            
                            6,749,284
                            
                            
                            
                            37,927
                            
                            
                            
                            -
                            
                            
                            
                            -James
      A. Judge
                            
                            6,756,608
                            
                            
                            
                            30,603
                            
                            
                            
                            -
                            
                            
                            
                            -





Class I Director
                  
                  For
                  
                  
                  Withheld
                  
                  
                  Abstain
                  
                  
                  Broker Non-VotesJohn
      H. Wilson
                  
                  
                  6,753,934
                  
                  
                  
                  33,277
                  
                  
                  
                  -
                  
                  
                  
                  -


27


Proposal
2 - To ratify the appointment of Stegman & Company as the Company’s
independent registered public accounting firm for fiscal year 2009.





For
                  
                  Against
                  
                  
                  Abstain
                  
                  
                  Broker Non-Votes6,768,762
                  
                  
                  12,735
                  
                  
                  
                  5,714
                  
                  
                  
                  -





Proposal
3 - To approve the Company’s executive compensation program.





For
                  
                  Against
                  
                  
                  Abstain
                  
                  
                  Broker Non-Votes6,326,858
                  
                  
                  343,444
                  
                  
                  
                  116,909
                  
                  
                  
                  -





Item 6.  Exhibits.





The
exhibits filed or furnished with this quarterly report are shown on the Exhibit
List that follows the signatures to this report, which list is incorporated
herein by reference.





SIGNATURES





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





SHORE
      BANCSHARES, INC.Date:
      August 10, 2009
                            BY:
                            /s/ W. Moorhead VermilyeW.
      Moorhead VermilyePresident/Chief
      Executive OfficerDate:
      August 10, 2009
                            BY:
                            /s/ Susan E. LeavertonSusan
      E. Leaverton, CPATreasurer/Principal
      Accounting
Officer


28


EXHIBIT
INDEX





ExhibitNumber
              
              Description31.1
              
              Certifications
      of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act (filed
      herewith).31.2
              
              Certifications
      of the PAO pursuant to Section 302 of the Sarbanes-Oxley Act (filed
      herewith).32
              
              Certification
      pursuant to Section 906 of the Sarbanes-Oxley Act (furnished
      herewith).


29