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 September 30, 2010





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:  8,443,436 shares of common
stock outstanding as of October 29, 2010.







INDEX








PagePart
      I. Financial Information
                            2Item
      1.  Financial Statements
                            2Consolidated
      Balance Sheets -September
      30, 2010 (unaudited) and December 31, 2009
                            2Consolidated
      Statements of Income (Loss) -For
      the three and nine months ended September 30, 2010 and 2009
      (unaudited)
                            3Consolidated
      Statements of Changes in Stockholders’ Equity -For
      the nine months ended September 30, 2010 and 2009
    (unaudited)
                            4Consolidated
      Statements of Comprehensive Income (Loss) -For
      the three and nine months ended September 30, 2010 and 2009
      (unaudited)
                            5Consolidated
      Statements of Cash Flows -For
      the nine months ended September 30, 2010 and 2009
    (unaudited)
                            6Notes
      to Consolidated Financial Statements (unaudited)
                            7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                            17Item
      3.  Quantitative and Qualitative Disclosures about Market
      Risk
                            27Item
      4.  Controls and Procedures
                            27Part
      II.  Other Information
                            27Item
      1A.  Risk Factors
                            27Item
      6.  Exhibits
                            27Signatures
                            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)





September 30,
                    
                    
                    December 31,2010
                    
                    
                    2009(Unaudited)ASSETSCash
      and due from banks
                    
                    $
                    21,764
                    
                    
                    $
                    14,411Interest-bearing
      deposits with other banks
                    
                    
                    18,014
                    
                    
                    
                    598Federal
      funds sold
                    
                    
                    35,161
                    
                    
                    
                    60,637Investment
      securities:Available
      for sale, at fair value
                    
                    
                    96,219
                    
                    
                    
                    97,595Held
      to maturity, at amortized cost – fair value of $8,125 (2010) and $9,012
      (2009)
                    
                    
                    7,856
                    
                    
                    
                    8,940Loans
                    
                    
                    906,490
                    
                    
                    
                    916,557Less:  allowance
      for credit losses
                    
                    
                    (13,153
                    )
                    
                    
                    (10,876
                    )Loans,
      net
                    
                    
                    893,337
                    
                    
                    
                    905,681Premises
      and equipment, net
                    
                    
                    14,714
                    
                    
                    
                    14,307Goodwill
                    
                    
                    12,954
                    
                    
                    
                    15,954Other
      intangible assets, net
                    
                    
                    4,969
                    
                    
                    
                    5,406Other
      real estate and other assets owned, net
                    
                    
                    1,517
                    
                    
                    
                    2,572Other
      assets
                    
                    
                    27,998
                    
                    
                    
                    30,415TOTAL
      ASSETS
                    
                    $
                    1,134,503
                    
                    
                    $
                    1,156,516LIABILITIESDeposits:Noninterest-bearing
      demand
                    
                    $
                    121,480
                    
                    
                    $
                    122,492Interest-bearing
      demand
                    
                    
                    122,774
                    
                    
                    
                    133,946Money
      market and savings
                    
                    
                    261,500
                    
                    
                    
                    249,793Certificates
      of deposit $100,000 or more
                    
                    
                    266,082
                    
                    
                    
                    262,663Other
      time
                    
                    
                    210,592
                    
                    
                    
                    222,043Total
      deposits
                    
                    
                    982,428
                    
                    
                    
                    990,937Short-term
      borrowings
                    
                    
                    17,782
                    
                    
                    
                    20,404Accrued
      expenses and other liabilities
                    
                    
                    10,509
                    
                    
                    
                    15,936Long-term
      debt
                    
                    
                    1,429
                    
                    
                    
                    1,429TOTAL
      LIABILITIES
                    
                    
                    1,012,148
                    
                    
                    
                    1,028,706STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01 per share; shares authorized – 35,000,000; shares
      issued and outstanding – 8,443,436 (2010) and 8,418,963
    (2009)
                    
                    
                    84
                    
                    
                    
                    84Warrant
                    
                    
                    1,543
                    
                    
                    
                    1,543Additional
      paid in capital
                    
                    
                    30,173
                    
                    
                    
                    29,872Retained
      earnings
                    
                    
                    92,115
                    
                    
                    
                    96,151Accumulated
      other comprehensive (loss) income
                    
                    
                    (1,560
                    )
                    
                    
                    160TOTAL
      STOCKHOLDERS’ EQUITY
                    
                    
                    122,355
                    
                    
                    
                    127,810TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                    
                    $
                    1,134,503
                    
                    
                    $
                    1,156,516





See
accompanying notes to Consolidated Financial Statements.


2


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME (LOSS) (Unaudited)


(Dollars
in thousands, except per share amounts)





For the Three Months Ended
                
                
                For the Nine Months EndedSeptember 30,
                
                
                September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009INTEREST
      INCOMEInterest
      and fees on loans
                
                $
                13,083
                
                
                $
                14,001
                
                
                $
                39,004
                
                
                $
                41,372Interest
      and dividends on investment securities:Taxable
                
                
                677
                
                
                
                800
                
                
                
                2,405
                
                
                
                2,324Tax-exempt
                
                
                50
                
                
                
                77
                
                
                
                165
                
                
                
                241Interest
      on federal funds sold
                
                
                21
                
                
                
                31
                
                
                
                47
                
                
                
                61Interest
      on deposits with other banks
                
                
                6
                
                
                
                4
                
                
                
                11
                
                
                
                11Total
      interest income
                
                
                13,837
                
                
                
                14,913
                
                
                
                41,632
                
                
                
                44,009INTEREST
      EXPENSEInterest
      on deposits
                
                
                3,117
                
                
                
                4,368
                
                
                
                9,744
                
                
                
                13,094Interest
      on short-term borrowings
                
                
                17
                
                
                
                19
                
                
                
                68
                
                
                
                96Interest
      on long-term debt
                
                
                16
                
                
                
                98
                
                
                
                47
                
                
                
                247Total
      interest expense
                
                
                3,150
                
                
                
                4,485
                
                
                
                9,859
                
                
                
                13,437NET
      INTEREST INCOME
                
                
                10,687
                
                
                
                10,428
                
                
                
                31,773
                
                
                
                30,572Provision
      for credit losses
                
                
                4,193
                
                
                
                1,702
                
                
                
                16,727
                
                
                
                5,318NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                
                
                6,494
                
                
                
                8,726
                
                
                
                15,046
                
                
                
                25,254NONINTEREST
      INCOMEService
      charges on deposit accounts
                
                
                841
                
                
                
                861
                
                
                
                2,458
                
                
                
                2,558Trust
      and investment fee income
                
                
                357
                
                
                
                274
                
                
                
                1,145
                
                
                
                750Investment
      securities gains
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                49Insurance
      agency commissions
                
                
                2,513
                
                
                
                2,744
                
                
                
                7,997
                
                
                
                8,972Other
      noninterest income
                
                
                932
                
                
                
                840
                
                
                
                2,493
                
                
                
                3,087Total
      noninterest income
                
                
                4,643
                
                
                
                4,719
                
                
                
                14,093
                
                
                
                15,416NONINTEREST
      EXPENSESalaries
      and wages
                
                
                4,404
                
                
                
                4,765
                
                
                
                13,257
                
                
                
                14,064Employee
      benefits
                
                
                897
                
                
                
                1,211
                
                
                
                2,936
                
                
                
                3,791Occupancy
      expense
                
                
                547
                
                
                
                616
                
                
                
                1,766
                
                
                
                1,752Furniture
      and equipment expense
                
                
                325
                
                
                
                299
                
                
                
                938
                
                
                
                915Data
      processing
                
                
                696
                
                
                
                675
                
                
                
                1,987
                
                
                
                1,865Directors’
      fees
                
                
                118
                
                
                
                109
                
                
                
                344
                
                
                
                394Goodwill
      and other intangible assets impairment
                
                
                3,051
                
                
                
                -
                
                
                
                3,051
                
                
                
                -Amortization
      of other intangible assets
                
                
                128
                
                
                
                128
                
                
                
                386
                
                
                
                386Insurance
      agency commissions expense
                
                
                338
                
                
                
                428
                
                
                
                1,230
                
                
                
                1,515FDIC
      insurance premium expense
                
                
                448
                
                
                
                458
                
                
                
                1,389
                
                
                
                1,621Other
      noninterest expenses
                
                
                1,677
                
                
                
                1,608
                
                
                
                5,354
                
                
                
                4,570Total
      noninterest expense
                
                
                12,629
                
                
                
                10,297
                
                
                
                32,638
                
                
                
                30,873(LOSS)
      INCOME BEFORE INCOME TAXES
                
                
                (1,492
                )
                
                
                3,148
                
                
                
                (3,499
                )
                
                
                9,797Income
      tax (benefit) expense
                
                
                (92
                )
                
                
                1,197
                
                
                
                (982
                )
                
                
                3,740NET
      (LOSS) INCOME
                
                
                (1,400
                )
                
                
                1,951
                
                
                
                (2,517
                )
                
                
                6,057Preferred
      stock dividends and discount accretion
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                1,876Net
      (loss) income available to common shareholders
                
                $
                (1,400
                )
                
                $
                1,951
                
                
                $
                (2,517
                )
                
                $
                4,181Basic
      net (loss) earnings per common share
                
                $
                (0.17
                )
                
                $
                0.23
                
                
                $
                (0.30
                )
                
                $
                0.50Diluted
      net (loss) earnings per common share
                
                $
                (0.17
                )
                
                $
                0.23
                
                
                $
                (0.30
                )
                
                $
                0.50Dividends
      paid per common share
                
                $
                0.06
                
                
                $
                0.16
                
                
                $
                0.18
                
                
                $
                0.48





See
accompanying notes to Consolidated Financial Statements.


3


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)


For the
Nine Months Ended September 30, 2010 and 2009


(Dollars
in thousands, except per share amounts)





AccumulatedAdditional
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalPreferred
                  
                  
                  Common
                  
                  
                  
                  
                  
                  Paid in
                  
                  
                  Retained
                  
                  
                  Comprehensive
                  
                  
                  Stockholders’Stock
                  
                  
                  Stock
                  
                  
                  Warrant
                  
                  
                  Capital
                  
                  
                  Earnings
                  
                  
                  Income (Loss)
                  
                  
                  EquityBalances,
      January 1, 2010
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  1,543
                  
                  
                  $
                  29,872
                  
                  
                  $
                  96,151
                  
                  
                  $
                  160
                  
                  
                  $
                  127,810Comprehensive
      income:Net
      loss
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,517
                  )
                  
                  
                  -
                  
                  
                  
                  (2,517
                  )Unrealized
      gains on available-for-sale securities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  989
                  
                  
                  
                  989Unrealized
      losses on cash flow hedging activities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,709
                  )
                  
                  
                  (2,709
                  )Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,237
                  )Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  301
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  301Cash
      dividends paid ($0.18 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,519
                  )
                  
                  
                  -
                  
                  
                  
                  (1,519
                  )Balances,
      September 30, 2010
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  1,543
                  
                  
                  $
                  30,173
                  
                  
                  $
                  92,115
                  
                  
                  $
                  (1,560
                  )
                  
                  $
                  122,355Balances,
      January 1, 2009
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  -
                  
                  
                  $
                  29,768
                  
                  
                  $
                  96,140
                  
                  
                  $
                  1,393
                  
                  
                  $
                  127,385Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  6,057
                  
                  
                  
                  -
                  
                  
                  
                  6,057Unrealized
      losses on available-for-sale securities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (276
                  )
                  
                  
                  (276
                  )Unrealized
      losses on cash flow hedging activities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (652
                  )
                  
                  
                  (652
                  )Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,129Warrant
      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
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  74
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  74Preferred
      stock dividends
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )Cash
      dividends paid ($0.48 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (4,038
                  )
                  
                  
                  -
                  
                  
                  
                  (4,038
                  )Balances,
      September 30, 2009
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  1,543
                  
                  
                  $
                  29,844
                  
                  
                  $
                  96,283
                  
                  
                  $
                  465
                  
                  
                  $
                  128,219





See
accompanying notes to Consolidated Financial Statements.


4


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)


(Dollars
in thousands)





For the Three Months Ended
                  September 30,
                
                
                For the Nine Months Ended
                  September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Net
      (loss) income
                
                $
                (1,400
                )
                
                $
                1,951
                
                
                $
                (2,517
                )
                
                $
                6,057Other
      comprehensive (loss) income:Securities
      available for sale:Unrealized
      holding gains (losses) on available-for-sale securities
                
                
                242
                
                
                
                604
                
                
                
                1,654
                
                
                
                (410
                )Tax
      effect
                
                
                (97
                )
                
                
                (241
                )
                
                
                (665
                )
                
                
                163Reclassification
      of gains recognized in net income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (49
                )Tax
      effect
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                20Net
      of tax amount
                
                
                145
                
                
                
                363
                
                
                
                989
                
                
                
                (276
                )Cash
      flow hedging activities:Unrealized
      holding losses on cash flow hedging activities
                
                
                (1,077
                )
                
                
                (1,093
                )
                
                
                (4,543
                )
                
                
                (1,093
                )Tax
      effect
                
                
                435
                
                
                
                441
                
                
                
                1,834
                
                
                
                441Net
      of tax amount
                
                
                (642
                )
                
                
                (652
                )
                
                
                (2,709
                )
                
                
                (652
                )Total
      other comprehensive loss
                
                
                (497
                )
                
                
                (289
                )
                
                
                (1,720
                )
                
                
                (928
                )Comprehensive
      (loss) income
                
                $
                (1,897
                )
                
                $
                1,662
                
                
                $
                (4,237
                )
                
                $
                5,129





See
accompanying notes to Consolidated Financial Statements.


5


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited)


(Dollars
in thousands)





For the Nine Months EndedSeptember 30,2010
                          
                          
                          2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      (loss) income
                          
                          $
                          (2,517
                          )
                          
                          $
                          6,057Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for credit losses
                          
                          
                          16,727
                          
                          
                          
                          5,318Goodwill
      and other intangible assets impairment
                          
                          
                          3,051
                          
                          
                          
                          -Depreciation
      and amortization
                          
                          
                          1,835
                          
                          
                          
                          1,370Discount
      accretion on debt securities
                          
                          
                          (91
                          )
                          
                          
                          (191
                          )Stock-based
      compensation expense
                          
                          
                          301
                          
                          
                          
                          74Gains
      on sales of securities
                          
                          
                          -
                          
                          
                          
                          (49
                          )Losses
      on sales of other real estate owned
                          
                          
                          56
                          
                          
                          
                          -Write-downs
      of other real estate owned
                          
                          
                          657
                          
                          
                          
                          159Gains
      on interest rate swaps
                          
                          
                          -
                          
                          
                          
                          (420
                          )Net
      changes in:Insurance
      premiums receivable
                          
                          
                          565
                          
                          
                          
                          155Accrued
      interest receivable
                          
                          
                          90
                          
                          
                          
                          (163
                          )Other
      assets
                          
                          
                          (1,589
                          )
                          
                          
                          (1,704
                          )Accrued
      interest payable
                          
                          
                          (855
                          )
                          
                          
                          (132
                          )Other
      liabilities
                          
                          
                          (4,572
                          )
                          
                          
                          285Net
      cash provided by operating activities
                          
                          
                          13,658
                          
                          
                          
                          10,759CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                          
                          
                          44,113
                          
                          
                          
                          36,686Proceeds
      from sales of securities available for sale
                          
                          
                          -
                          
                          
                          
                          2,048Purchases
      of securities available for sale
                          
                          
                          (41,580
                          )
                          
                          
                          (54,851
                          )Proceeds
      from maturities and principal payments of securities held to
      maturity
                          
                          
                          1,070
                          
                          
                          
                          2,815Purchases
      of securities held to maturity
                          
                          
                          -
                          
                          
                          
                          (1,563
                          )Net
      increase in loans
                          
                          
                          (5,030
                          )
                          
                          
                          (36,059
                          )Purchases
      of premises and equipment
                          
                          
                          (1,253
                          )
                          
                          
                          (982
                          )Proceeds
      from sales of other real estate owned
                          
                          
                          990
                          
                          
                          
                          -Purchases
      of interest rate caps
                          
                          
                          -
                          
                          
                          
                          (6,475
                          )Investment
      in unconsolidated subsidiary
                          
                          
                          (25
                          )
                          
                          
                          -Net
      cash used in investing activities
                          
                          
                          (1,715
                          )
                          
                          
                          (58,381
                          )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      (decrease) increase in demand, money market and savings
      deposits
                          
                          
                          (477
                          )
                          
                          
                          102,839Net
      (decrease) increase in certificates of deposit
                          
                          
                          (8,032
                          )
                          
                          
                          43,987Net
      decrease in short-term borrowings
                          
                          
                          (2,622
                          )
                          
                          
                          (35,296
                          )Repayment
      of long-term debt
                          
                          
                          -
                          
                          
                          
                          (6,000
                          )Net
      receipt of counterparty collateral – interest rate caps
                          
                          
                          -
                          
                          
                          
                          6,528Proceeds
      from issuance of preferred stock and warrant
                          
                          
                          -
                          
                          
                          
                          25,000Repurchase
      of preferred stock
                          
                          
                          -
                          
                          
                          
                          (23,525
                          )Proceeds
      from issuance of common stock
                          
                          
                          -
                          
                          
                          
                          2Preferred
      stock dividends paid
                          
                          
                          -
                          
                          
                          
                          (1,808
                          )Common
      stock dividends paid
                          
                          
                          (1,519
                          )
                          
                          
                          (4,038
                          )Net
      cash (used in) provided by financing activities
                          
                          
                          (12,650
                          )
                          
                          
                          107,689Net
      (decrease) increase in cash and cash equivalents
                          
                          
                          (707
                          )
                          
                          
                          60,067Cash
      and cash equivalents at beginning of period
                          
                          
                          75,646
                          
                          
                          
                          27,294Cash
      and cash equivalents at end of period
                          
                          $
                          74,939
                          
                          
                          $
                          87,361Supplemental
      cash flows information:Interest
      paid
                          
                          $
                          10,715
                          
                          
                          $
                          13,569Income
      taxes paid
                          
                          $
                          988
                          
                          
                          $
                          3,678Transfers
      from loans to other real estate owned
                          
                          $
                          668
                          
                          
                          $
                          2,072





See
accompanying notes to Consolidated Financial Statements.


6


Shore
Bancshares, Inc.


Notes to
Consolidated Financial Statements


For the
Three and Nine Months Ended September 30, 2010 and 2009


(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 September 30, 2010, the consolidated results of operations
and comprehensive income for the three and nine months ended September 30, 2010
and 2009, and changes in stockholders’ equity and cash flows for the nine months
ended September 30, 2010 and 2009, have been included.  All such
adjustments are of a normal recurring nature.  The amounts as of
December 31, 2009 were derived from the 2009 audited financial
statements.  The results of operations for the three and nine months
ended September 30, 2010 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,
2009.  For purposes of comparability, certain reclassifications have
been made to amounts previously reported to conform with the current period
presentation.





Shore
Bancshares, Inc. has evaluated events and transactions occurring subsequent to
the balance sheet date of September 30, 2010 for items that should potentially
be recognized or disclosed in these financial statements as prescribed by Topic
855, “Subsequent
Events”, of the Financial Accounting Standards Board’s Accounting
Standards Codification (“ASC”).





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/(loss) per common share are calculated by dividing net income/(loss)
available to common stockholders by the weighted average number of common shares
outstanding during the period.  Diluted earnings/(loss) per common
share are calculated by dividing net income/(loss) 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.  There is no dilutive effect on the loss per share during loss
periods.  The following table provides information relating to the
calculation of earnings/(loss) per common share:





For the Three Months Ended
                  
                  
                  For the Nine Months EndedSeptember 30,
                  
                  
                  September 30,(In thousands, except per share data)
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Net
      (loss) income available to common shareholders
                  
                  $
                  (1,400
                  )
                  
                  $
                  1,951
                  
                  
                  $
                  (2,517
                  )
                  
                  $
                  4,181Weighted
      average shares outstanding - Basic
                  
                  
                  8,443
                  
                  
                  
                  8,419
                  
                  
                  
                  8,441
                  
                  
                  
                  8,412Dilutive
      effect of stock-based awards
                  
                  
                  -
                  
                  
                  
                  4
                  
                  
                  
                  -
                  
                  
                  
                  4Weighted
      average shares outstanding - Diluted
                  
                  
                  8,443
                  
                  
                  
                  8,423
                  
                  
                  
                  8,441
                  
                  
                  
                  8,416(Loss)
      earnings per common share - Basic
                  
                  $
                  (0.17
                  )
                  
                  $
                  0.23
                  
                  
                  $
                  (0.30
                  )
                  
                  $
                  0.50(Loss)
      earnings per common share - Diluted
                  
                  $
                  (0.17
                  )
                  
                  $
                  0.23
                  
                  
                  $
                  (0.30
                  )
                  
                  $
                  0.50





The
calculations of diluted earnings/(loss) per share for the three and nine months
ended September 30, 2010 each excluded eight thousand weighted average
stock-based awards and that portion of a warrant to purchase 173 thousand
weighted average shares of common stock because the effect would have been
antidilutive.  There were no weighted average stock-based awards
excluded from the calculations of diluted earnings per share for the three and
nine months ended September 30, 2009.  The calculations of diluted
earnings per share for the three and nine months ended September 30, 2009
excluded that portion of a warrant to purchase 173 thousand and 168 thousand
weighted average shares of common stock, respectively, because the effect would
have been antidilutive.


7


Note 3 – 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:September
      30, 2010:Obligations
      of U.S. Government agencies and corporations
                  
                  $
                  55,902
                  
                  
                  $
                  1,648
                  
                  
                  $
                  32
                  
                  
                  $
                  57,518Mortgage-backed
      securities
                  
                  
                  36,888
                  
                  
                  
                  1,320
                  
                  
                  
                  91
                  
                  
                  
                  38,117Other
      equity securities
                  
                  
                  561
                  
                  
                  
                  23
                  
                  
                  
                  -
                  
                  
                  
                  584Total
                  
                  $
                  93,351
                  
                  
                  $
                  2,991
                  
                  
                  $
                  123
                  
                  
                  $
                  96,219December
      31, 2009:Obligations
      of U.S. Treasury
                  
                  $
                  2,998
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  2,998Obligations
      of U.S. Government agencies and corporations
                  
                  
                  57,258
                  
                  
                  
                  879
                  
                  
                  
                  397
                  
                  
                  
                  57,740Mortgage-backed
      securities
                  
                  
                  35,579
                  
                  
                  
                  818
                  
                  
                  
                  90
                  
                  
                  
                  36,307Other
      equity securities
                  
                  
                  546
                  
                  
                  
                  4
                  
                  
                  
                  -
                  
                  
                  
                  550Total
                  
                  $
                  96,381
                  
                  
                  $
                  1,701
                  
                  
                  $
                  487
                  
                  
                  $
                  97,595Held-to-maturity
      securities:September
      30, 2010:Obligations
      of states and political subdivisions
                  
                  $
                  7,856
                  
                  
                  $
                  273
                  
                  
                  $
                  4
                  
                  
                  $
                  8,125December
      31, 2009:Obligations
      of states and political subdivisions
                  
                  $
                  8,940
                  
                  
                  $
                  163
                  
                  
                  $
                  91
                  
                  
                  $
                  9,012





The
amortized cost and estimated fair values of investment securities by maturity
date at September 30, 2010 are as follows:





Available for sale
                
                
                Held to maturityAmortized
                
                
                Estimated
                
                
                Amortized
                
                
                Estimated(Dollars in thousands)
                
                Cost
                
                
                Fair Value
                
                
                Cost
                
                
                Fair ValueDue
      in one year or less
                
                $
                6,263
                
                
                $
                6,390
                
                
                $
                1,653
                
                
                $
                1,658Due
      after one year through five years
                
                
                38,508
                
                
                
                39,374
                
                
                
                4,479
                
                
                
                4,659Due
      after five years through ten years
                
                
                23,595
                
                
                
                24,661
                
                
                
                1,724
                
                
                
                1,808Due
      after ten years
                
                
                24,424
                
                
                
                25,210
                
                
                
                -
                
                
                
                -92,790
                
                
                
                95,635
                
                
                
                7,856
                
                
                
                8,125Equity
      securities
                
                
                561
                
                
                
                584
                
                
                
                -
                
                
                
                -Total
                
                $
                93,351
                
                
                $
                96,219
                
                
                $
                7,856
                
                
                $
                8,125





The
maturity dates for mortgage-backed securities are determined by expected
maturity dates.  The maturity dates for the remaining debt securities
are determined using contractual maturity dates.


8


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 September 30, 2010, 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-salesecurities:U.S.
      Gov’t. agencies and corporations
                
                $
                7,055
                
                
                $
                32
                
                
                $
                -
                
                
                $
                -
                
                
                $
                7,055
                
                
                $
                32Mortgage-backed
      securities
                
                
                7,258
                
                
                
                91
                
                
                
                -
                
                
                
                -
                
                
                
                7,258
                
                
                
                91Total
                
                $
                14,313
                
                
                $
                123
                
                
                $
                -
                
                
                $
                -
                
                
                $
                14,313
                
                
                $
                123





The
available-for-sale securities have a fair value of approximately $96.2
million.  Of these securities, approximately $14.3 million have
unrealized losses when compared to their amortized cost.  The
securities with the unrealized losses in the available-for-sale portfolio all
have modest duration risk, low credit risk, and minimal losses (approximately
0.13%) when compared to amortized cost.  The unrealized losses on debt
securities that exist are the result of market changes in interest rates since
original purchase.  Because the Company does not intend to sell these
debt 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 the unrealized losses in the
available-for-sale portfolio to be 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 September 30, 2010, 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
                
                $
                51
                
                
                $
                1
                
                
                $
                186
                
                
                $
                3
                
                
                $
                237
                
                
                $
                4





The
held-to-maturity securities have a fair value of approximately $8.1
million.  Approximately $237 thousand of these securities have
unrealized losses when compared to their amortized cost.  All of the
securities with unrealized losses are municipal securities with modest duration
risk, low credit risk, and minimal losses (approximately 0.05%) 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 to be
temporary.





Note 4 – Impaired
Loans





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.


9


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





September 30,
                
                
                December 31,
                
                
                September 30,(Dollars in thousands)
                
                2010
                
                
                2009
                
                
                2009Impaired
      loans with a valuation allowance
                
                $
                904
                
                
                $
                2,028
                
                
                $
                548Impaired
      loans with no valuation allowance
                
                
                35,881
                
                
                
                14,274
                
                
                
                14,919Total
      impaired loans
                
                $
                36,785
                
                
                $
                16,302
                
                
                $
                15,467Allowance
      for credit losses applicable to impaired loans
                
                $
                223
                
                
                $
                468
                
                
                $
                226Allowance
      for credit losses applicable to other than impaired loans
                
                
                12,930
                
                
                
                10,408
                
                
                
                10,497Total
      allowance for credit losses
                
                $
                13,153
                
                
                $
                10,876
                
                
                $
                10,723Average
      recorded investment in impaired loans
                
                $
                30,258
                
                
                $
                12,646
                
                
                $
                11,733





Gross
interest income of $1.6 million for the first nine months of 2010, $859 thousand
for fiscal year 2009 and $576 thousand for the first nine months of 2009 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 $0 for the first nine months of 2010 and $4 thousand for both
fiscal year 2009 and the first nine months of 2009.





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 5 – Other Assets and
Liabilities





The
Company had the following other assets at September 30, 2010 and December 31,
2009.





(Dollars in thousands)
                
                September 30, 2010
                
                
                December 31, 2009Nonmarketable
      investment securities
                
                $
                3,038
                
                
                $
                3,149Insurance
      premiums receivable
                
                
                418
                
                
                
                983Accrued
      interest receivable
                
                
                4,714
                
                
                
                4,804Deferred
      income taxes
                
                
                6,719
                
                
                
                3,337Interest
      rate caps (1)
                
                
                1,389
                
                
                
                6,168Prepaid
      FDIC premium expense
                
                
                4,419
                
                
                
                5,449Other
      assets
                
                
                7,301
                
                
                
                6,525Total
                
                $
                27,998
                
                
                $
                30,415





The
Company had the following other liabilities at September 30, 2010 and December
31, 2009.





(Dollars in thousands)
                
                September 30, 2010
                
                
                December 31, 2009Accrued
      interest payable
                
                $
                926
                
                
                $
                1,781Counterparty
      collateral - interest rate caps (1)
                
                
                1,656
                
                
                
                4,847Other
      liabilities
                
                
                7,927
                
                
                
                9,308Total
                
                $
                10,509
                
                
                $
                15,936





(1)  See
Note 8 for further discussion.





Note 6 - Stock-Based
Compensation





At
September 30, 2010, the Company maintained two equity compensation plans under
which it may issue shares of common stock or grant other equity-based
awards:  (i) the Shore Bancshares, Inc. 2006 Stock and Incentive
Compensation Plan (“2006 Equity Plan”); and (ii) the Shore Bancshares, Inc. 1998
Stock Option Plan (the “1998 Option Plan”).  The Company's ability to
grant options under the 1998 Option Plan expired on March 3, 2008 pursuant to
the terms of that plan, but stock options granted thereunder were outstanding as
of September 30, 2010.





Stock-based
awards granted to date generally are time-based, vest in equal installments on
each anniversary of the grant date over a three- to five-year period of time,
and, in the case of stock options, expire 10 years from the grant
date.


10


During
the three and nine months ended September 30, 2010, the Company recognized
pre-tax stock-based compensation expense of $92 thousand and $301 thousand,
respectively, compared to $28 thousand and $74 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 $515
thousand as of September 30, 2010.  The weighted-average period over
which this unrecognized expense was expected to be recognized was 1.8
years.





The
following table summarizes restricted stock award activity for the Company under
the 2006 Equity Plan for the nine months ended September 30, 2010:





Number
                  
                  
                  Weighted Average Grantof Shares
                  
                  
                  Date Fair ValueNonvested
      at beginning of period
                  
                  
                  27,405
                  
                  
                  $
                  20.23Granted
                  
                  
                  24,473
                  
                  
                  
                  13.41Vested
                  
                  
                  (7,751
                  )
                  
                  
                  18.47Cancelled
                  
                  
                  -
                  
                  
                  
                  -Nonvested
      at end of period
                  
                  
                  44,127
                  
                  
                  $
                  16.76





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 nine months ended
September 30, 2010 and 2009 reflected forfeitures as they occurred.





The
following table summarizes stock option activity for the Company for the nine
months ended September 30, 2010:





Weighted
                  
                  
                  AggregateNumber
                  
                  
                  Average
                  
                  
                  Intrinsicof
      Shares
                  
                  
                  Exercise
      Price
                  
                  
                  ValueOutstanding
      at beginning of year
                  
                  
                  10,850
                  
                  
                  $
                  13.36Granted
                  
                  
                  -
                  
                  
                  
                  -Exercised
                  
                  
                  -
                  
                  
                  
                  -Expired/Cancelled
                  
                  
                  (2,430
                  )
                  
                  
                  14.00Outstanding
      at end of period
                  
                  
                  8,420
                  
                  
                  
                  13.17
                  
                  
                  $
                  -Exercisable
      at end of period
                  
                  
                  8,420
                  
                  
                  $
                  13.17
                  
                  
                  $
                  -





At
September 30, 2010, all 8,420 outstanding options were exercisable, had a
weighted average exercise price of $13.17 per share, and had a remaining
contract life of 1.6 years.





There was
no aggregate intrinsic value in options outstanding and exercisable based on the
$9.48 market value per share of the Company’s common stock at September 30,
2010.  The total intrinsic value of stock options exercised during the
nine months ended September 30, 2010 and 2009 was $0 and less than $1 thousand,
respectively.  Cash received upon exercise of options during the first
nine months of 2010 and 2009 was $0 and approximately $1 thousand,
respectively.





Note 7 – Fair Value
Measurements







ASC 820,
“Fair Value Measurements and
Disclosures”, provides a framework for measuring and disclosing fair
value under GAAP. This accounting guidance 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.




ASC 820
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.  ASC 820 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.


11




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 ASC
820, 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.





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 principal will not be made in accordance with the contractual terms of the
loan are considered impaired.  The fair value of impaired loans is
estimated using one of several methods, including the collateral value, market
value of similar debt, enterprise value, liquidation value and discounted cash
flows.  At September 30, 2010, substantially all impaired loans were
evaluated based on the fair value of the collateral.  Those impaired
loans not requiring a specific allowance represent loans for which the fair
value of expected repayments or collateral exceed the recorded investment in
such loans.   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.





Other Real Estate and Other
Assets Owned (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 on 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.


12


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
September 30, 2010, the Company’s derivative instruments consisted solely of
interest rate caps.  Derivative assets and liabilities are included in
other assets and liabilities, respectively, in the accompanying consolidated
balance sheets.





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 September 30, 2010.  There were no transfers
between Levels 1 and 2 during the first nine months of 2010.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Securities
      available for sale:U.S.
      Government agencies
                  
                  $
                  57,518
                  
                  
                  $
                  -
                  
                  
                  $
                  57,518
                  
                  
                  $
                  -Mortgage-backed
      securities
                  
                  
                  38,117
                  
                  
                  
                  -
                  
                  
                  
                  38,117
                  
                  
                  
                  -Other
      equity securities
                  
                  
                  584
                  
                  
                  
                  -
                  
                  
                  
                  584
                  
                  
                  
                  -Total
                  
                  $
                  96,219
                  
                  
                  $
                  -
                  
                  
                  $
                  96,219
                  
                  
                  $
                  -Interest
      rate caps
                  
                  $
                  1,389
                  
                  
                  $
                  -
                  
                  
                  $
                  1,389
                  
                  
                  $
                  -





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 September 30, 2010.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Impaired
      loansReal
      estate - construction
                  
                  $
                  18,424
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  18,424Real
      estate - residential
                  
                  
                  11,238
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  11,238Real
      estate - commercial
                  
                  
                  2,955
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,955Commercial
                  
                  
                  3,851
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,851Consumer
                  
                  
                  94
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  94Total
                  
                  $
                  36,562
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  36,562Other
      real estate and other assets owned
                  
                  $
                  1,517
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,517





Impaired
loans had a carrying amount of $36.8 million at September 30, 2010 with a
valuation allowance of $223 thousand.





The
following disclosures relate to the fair value of the Company’s financial
instruments and include the methods and assumptions 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.


13


Loans


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





The
estimated fair values of the Company’s financial instruments as of September 30,
2010 and December 31, 2009 are as follows:





September 30, 2010
                
                
                December 31, 2009Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial assets:Cash
      and cash equivalents
                
                $
                74,939
                
                
                $
                74,939
                
                
                $
                75,646
                
                
                $
                75,646Investment
      securities
                
                
                104,075
                
                
                
                104,344
                
                
                
                106,535
                
                
                
                106,607Loans
                
                
                906,490
                
                
                
                922,523
                
                
                
                916,557
                
                
                
                934,362Less:  allowance
      for loan  losses
                
                
                (13,153
                )
                
                _
      -
                
                
                
                (10,876
                )
                
                
                -Total
                
                $
                1,072,351
                
                
                $
                1,101,806
                
                
                $
                1,087,862
                
                
                $
                1,116,615Financial
      liabilities:Deposits
                
                $
                982,428
                
                
                $
                987,903
                
                
                $
                990,937
                
                
                $
                999,016Short-term
      borrowings
                
                
                17,782
                
                
                
                17,782
                
                
                
                20,404
                
                
                
                20,404Long-term
      debt
                
                
                1,429
                
                
                
                1,488
                
                
                
                1,429
                
                
                
                1,530Total
                
                $
                1,001,639
                
                
                $
                1,007,173
                
                
                $
                1,012,770
                
                
                $
                1,020,950





Note 8 – Derivative
Instruments and Hedging Activities





ASC 815,
“Derivatives and
Hedging”, 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 net interest settlement on
cash flow hedges is treated as an adjustment of the of the interest income or
interest expense of the hedged assets or liabilities.  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 third quarter of 2009, as part of its overall interest rate risk management
strategy, the Company purchased interest rate caps to effectively fix the
interest rate on $70 million of the Company’s money market deposit accounts at
2.97% for five years. The interest rate caps qualified for hedge
accounting.  The aggregate fair value of these derivatives was an
asset of $1.4 million at September 30, 2010 and $6.2 million at December 31,
2009.   For the third quarter and first nine months of 2010,
interest expense included a net interest settlement of $136 thousand and $236
thousand, respectively.


14


By
entering into derivative instrument contracts, the Company exposes itself, from
time to time, to counterparty credit risk.  Counterparty credit risk
is the risk that the counterparty will fail 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.  Also to minimize risk, the
Company obtained counterparty collateral which was recorded in other
liabilities.  The counterparty collateral was $1.7 million at
September 30, 2010 and $4.8 million at December 31, 2009.





Note 9 –
Commitments





In the
normal course of business, to meet the financial needs of its customers, the
Company’s bank subsidiaries enter into financial instruments with off-balance
sheet risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  At September 30, 2010, total
commitments to extend credit were approximately $155.0 million. The comparable
amount was $147.3 million at December 31, 2009.  Outstanding letters
of credit were approximately $15.9 million at September 30, 2010 and $19.0
million at December 31, 2009.





Note 10 – 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.





During
the third quarter of 2010, goodwill and other intangible assets were tested for
impairment.  It was determined that goodwill at The Felton Bank, one
of the banks in our Community Banking segment, was impaired and the Company
recorded goodwill impairment charges of $1.5 million.  As of September
30, 2010, goodwill remaining at The Felton Bank after the $1.5 million
impairment charge was $1.1 million.





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.





During
the testing for goodwill and other intangible assets impairment in the third
quarter of 2010, it was determined that goodwill and other intangible assets at
TSGIA, Inc., a wholesale insurance agency in our Insurance Products and Services
segment, was impaired.  The Company recorded goodwill impairment
charges of $1.5 million and other intangible assets impairment charges of $51
thousand.  As of September 30, 2010, goodwill remaining at TSGIA, Inc.
after the $1.5 million goodwill impairment charge was $653
thousand.


15


Selected
financial information by business segments for the first nine months of 2010 and
2009 is included in the following table:





Community
                    
                    
                    Insurance Products
                    
                    
                    Parent
                    
                    
                    Consolidated(Dollars in thousands)
                    
                    Banking
                    
                    
                    and Services
                    
                    
                    Company
                    
                    
                    Total2010Interest
      income
                    
                    $
                    41,503
                    
                    
                    $
                    129
                    
                    
                    $
                    -
                    
                    
                    $
                    41,632Interest
      expense
                    
                    
                    (9,798
                    )
                    
                    
                    -
                    
                    
                    
                    (61
                    )
                    
                    
                    (9,859
                    )Provision
      for credit losses
                    
                    
                    (16,727
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (16,727
                    )Noninterest
      income
                    
                    
                    5,608
                    
                    
                    
                    8,485
                    
                    
                    
                    -
                    
                    
                    
                    14,093Noninterest
      expense
                    
                    
                    (18,959
                    )
                    
                    
                    (9,046
                    )
                    
                    
                    (4,633
                    )
                    
                    
                    (32,638
                    )Net
      intersegment income (expense)
                    
                    
                    (4,128
                    )
                    
                    
                    (385
                    )
                    
                    
                    4,513
                    
                    
                    
                    -(Loss)
      income before taxes
                    
                    
                    (2,501
                    )
                    
                    
                    (817
                    )
                    
                    
                    (181
                    )
                    
                    
                    (3,499
                    )Income
      tax benefit (expense)
                    
                    
                    701
                    
                    
                    
                    230
                    
                    
                    
                    51
                    
                    
                    
                    982Net
      (loss) income
                    
                    $
                    (1,800
                    )
                    
                    $
                    (587
                    )
                    
                    $
                    (130
                    )
                    
                    $
                    (2,517
                    )Total
      assets
                    
                    $
                    1,112,841
                    
                    
                    $
                    18,509
                    
                    
                    $
                    3,153
                    
                    
                    $
                    1,134,5032009Interest
      income
                    
                    $
                    43,957
                    
                    
                    $
                    52
                    
                    
                    $
                    -
                    
                    
                    $
                    44,009Interest
      expense
                    
                    
                    (13,378
                    )
                    
                    
                    -
                    
                    
                    
                    (59
                    )
                    
                    
                    (13,437
                    )Provision
      for credit losses
                    
                    
                    (5,318
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (5,318
                    )Noninterest
      income
                    
                    
                    5,952
                    
                    
                    
                    9,464
                    
                    
                    
                    -
                    
                    
                    
                    15,416Noninterest
      expense
                    
                    
                    (17,806
                    )
                    
                    
                    (8,456
                    )
                    
                    
                    (4,611
                    )
                    
                    
                    (30,873
                    )Net
      intersegment income (expense)
                    
                    
                    (4,118
                    )
                    
                    
                    (362
                    )
                    
                    
                    4,480
                    
                    
                    
                    -Income
      (loss) before taxes
                    
                    
                    9,289
                    
                    
                    
                    698
                    
                    
                    
                    (190
                    )
                    
                    
                    9,797Income
      tax (expense) benefit
                    
                    
                    (3,546
                    )
                    
                    
                    (267
                    )
                    
                    
                    73
                    
                    
                    
                    (3,740
                    )Net
      income
                    
                    $
                    5,743
                    
                    
                    $
                    431
                    
                    
                    $
                    (117
                    )
                    
                    $
                    6,057Total
      assets
                    
                    $
                    1,133,949
                    
                    
                    $
                    19,805
                    
                    
                    $
                    3,931
                    
                    
                    $
                    1,157,685





Note 11 – New Accounting
Pronouncements





Accounting Standards Update (“ASU”)
No. 2009-16, “Transfers and Servicing (Topic 860) – Accounting for Transfers of
Financial Assets”. New accounting guidance under ASU 2009-16 amended
prior accounting guidance to enhance reporting about transfers of financial
assets, including securitizations, and where companies have continuing exposure
to the risks related to transferred financial assets. This guidance eliminates
the concept of a “qualifying special-purpose entity” and changes the
requirements for derecognizing financial assets. This guidance also requires
additional disclosures about all continuing involvements with transferred
financial assets including information about gains and losses resulting from
transfers during the period. This new accounting guidance became effective
January 1, 2010 and did not have a significant impact on the Company’s
financial statements.





ASU No. 2009-17, “Consolidations
(Topic 810) – Improvements to Financial Reporting by Enterprises Involved with
Variable Interest Entities”.New accounting guidance under ASU
2009-17 amended prior guidance 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.
This guidance 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. This new accounting guidance became effective January 1, 2010
and did not have a significant impact on the Company’s financial
statements.





ASU No. 2010-18, “Effect of a Loan
Modification When the Loan is Part of a Pool that is Accounted for as a Single
Asset”.This Update clarifies that modifications of acquired
loans that are accounted for within a pool that have evidence of credit
deterioration upon acquisition, do not result in the removal of those loans from
the pool even if the modification would otherwise be considered a troubled debt
restructuring.  An entity will continue to be required to consider
whether the pool of assets in which the loan is included is impaired if expected
cash flows for the pool change.  The amendments do not affect the
accounting for loans that are not accounted for within pools.  Loans
accounted for individually continue to be subject to the troubled debt
restructuring accounting provisions.  The Company adopted ASU 2010-18,
and it did not have a significant impact on the Company’s financial
statements.


16


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 Company’s financial condition and results of operations 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, 2009.





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”), CNB
located in Centreville, Maryland (“CNB”), and The Felton Bank located in Felton,
Delaware (“Felton Bank” and, together with Talbot Bank and CNB, 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”).  Each of
these entities is a wholly-owned subsidiary of Shore Bancshares,
Inc.  The Company engages in the mortgage brokerage business under the
name “Wye Mortgage Group” through a minority series investment in an unrelated
Delaware limited liability company.





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.





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.





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) Topic 450, “Contingencies”, of the
Financial Accounting Standards Board’s Accounting Standards Codification
(“ASC”), which requires that losses be accrued when they are probable of
occurring and estimable, and (ii) ASC Topic 310, “Receivables”, 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.


17


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.





Goodwill and Other
Intangible Assets


Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired.  Other intangible assets represent purchased
assets that also lack physical substance but can be distinguished from goodwill
because of contractual or other legal rights or because the asset is capable of
being sold or exchanged either on its own or in combination with a related
contract, asset or liability.  Goodwill and other intangible assets
with indefinite lives are tested at least annually for impairment, usually
during the third quarter,  or on an interim basis if circumstances
dictate.  Intangible assets that have finite lives are amortized over
their estimated useful lives and also are subject to impairment
testing.





Impairment
testing requires that the fair value of each of the Company’s reporting units be
compared to the carrying amount of its net assets, including
goodwill.  The Company’s reporting units were identified based on an
analysis of each of its individual operating segments. If the fair value of a
reporting unit is less than book value, an expense may be required to write down
the related goodwill or purchased intangibles to record an impairment
loss.





During
the third quarter of 2010, as part of the Company’s annual impairment testing
process, goodwill and other intangible assets were tested for impairment and it
was determined that there was an impairment.  The Company recorded
goodwill impairment charges of $3.0 million and other intangible assets
impairment charges of $51 thousand.  Half of the goodwill impairment
charges related to the 2004 acquisition of The Felton Bank and the other half of
the goodwill charges and all of the other intangible assets impairment charges
related to the 2007 acquisition of TSGIA, Inc.


18


Fair
Value


The
Company measures certain financial assets and liabilities at fair
value.  Significant financial instruments measured at fair value on a
recurring basis are investment securities and interest rate
caps.  Impaired loans and other real estate and other assets owned are
significant financial instruments measured at fair value on a nonrecurring
basis.





The
Company conducts a review each quarter for all investment securities which
reflect possible impairment to determine whether unrealized losses are
temporary.  Valuations for the investment portfolio are determined
using quoted market prices, if available.  If quoted prices are not
available, fair values are measured using methods such as independent pricing
models or quotes for similar investment securities.





See Note
7, “Fair Value Measurements”, in the Notes to Consolidated Financial Statements
for a further discussion of fair value.





OVERVIEW





The
Company reported a net loss for the third quarter of 2010 of $1.4 million, or
diluted loss per common share of $(0.17), compared to net income of $2.0
million, or diluted earnings per common share of $0.23, for the third quarter of
2009.  For the second quarter of 2010, the Company reported net income
of $445 thousand, or diluted earnings per common share of
$0.05.   The net loss for the third quarter of 2010 included the
previously-mentioned goodwill and other intangible assets impairment charges of
$3.1 million.  The provision for credit losses for the third quarter
of 2010 was $4.2 million, which was $2.5 million higher than the provision for
the third quarter of 2009 and $724 thousand lower than the provision for the
second quarter of 2010.  Annualized return on average assets was
(0.49)% for the three months ended September 30, 2010, compared to 0.66% for the
same period in 2009.  Annualized return on average stockholders’
equity was (4.43)% for the third quarter of 2010, compared to 6.03% for the
third quarter of 2009.  For the second quarter of 2010, annualized
return on average assets was 0.16% and return on average equity was
1.42%.





For the
first nine months of 2010, the Company reported a net loss of $2.5 million, or
diluted loss per common share of $(0.30), compared to net income available to
common shareholders of $4.2 million, or diluted earnings per common share of
$0.50, for the first nine months of 2009.  The year-to-date 2010 net
loss included the $3.1 million impairment charges and $11.4 million more in the
provision for credit losses when compared to year-to-date September 30,
2009.  Annualized return on average assets was (0.30)% for the
nine  months ended September 30, 2010, compared to 0.50% for the same
period in 2009.  Annualized return on average stockholders’ equity was
(2.66)% for the first nine months of 2010, compared to 4.08% for the first nine
months of 2009.





During
the first nine months of 2009, net income available to common shareholders 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.  There were no dividends and accretion during the third
quarter of 2009 but $1.9 million in dividends and accretion during the first
nine months of 2009.





RESULTS
OF OPERATIONS





Net
Interest Income


Net
interest income for the three months ended September 30, 2010 was $10.7 million,
an increase of 2.5% when compared to the same period last year.  The
increase in net interest income when compared to the third quarter of 2009 was
primarily due to a decrease in the balances and rates paid on interest-bearing
liabilities that more than offset the decline in the balances and yields on
earning assets.  The net interest margin was 4.00% for the third
quarter of 2010, an increase of 21 basis points when compared to the third
quarter of 2009.  The net interest margin has benefited from the
Company’s effort to reduce deposit pricing structures.  Net interest
income was relatively unchanged from the second quarter of 2010.  The
net interest margin for the third quarter of 2010 was slightly lower than the
4.03% for the second quarter of 2010.





Interest
income was $13.8 million for the third quarter of 2010, a decrease of 7.2% from
the third quarter of 2009. Average earning assets decreased 3.1% during the
third quarter of 2010 when compared to the same period in 2009, while yields
earned decreased 23 basis points to 5.18%.  Average loans decreased
1.7% and the yield earned on loans decreased 29 basis points.  Loans
comprised 84.8% of total average earning assets for the third quarter of 2010,
slightly higher than the 83.6% for the third quarter of 2009.  Other
earning assets reflected a shift from federal funds sold to investment
securities and interest-bearing deposits when comparing quarter-to-date
September 30, 2010 and 2009 average balances.  Interest income
decreased less than 1.0% when compared to the second quarter of
2010.  Average earning assets declined slightly during the third
quarter of 2010 when compared to the second quarter of 2010, while yields earned
decreased 8 basis points.


19


Interest
expense was $3.2 million for the three months ended September 30, 2010, a
decrease of 29.8% when compared to the same period last year. Average
interest-bearing liabilities decreased 2.7%, while rates paid decreased 55 basis
points to 1.42%.  More than half of the Company’s interest-bearing
deposits are time deposits.  For the three months ended September 30,
2010, the average balance of certificates of deposit $100,000 or more decreased
5.8% when compared to the same period last year, while the average rate paid on
these certificates of deposit decreased  91 basis points to 1.91%.
Average other time deposits decreased 10.8% and the rate paid on average other
time deposits decreased 83 basis points, when comparing the third quarter of
2010 to the third quarter of 2009.  When comparing the third quarter
of 2010 to the second quarter of 2010, interest expense decreased 3.8% primarily
due to rates paid decreasing 8 basis points.





Net
interest income for the nine months ended September 30, 2010 was $31.8 million,
an increase of 3.9% 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 increased from 3.90% for the first
nine months of 2009 to 3.99% for the first nine months of 2010.





Interest
income was $41.6 million for the first nine months of 2010, a decrease of 5.4%
when compared to the first nine months of 2009. Average earning assets increased
1.4% during the nine months ended September 30, 2010 when compared to the same
period in 2009, while yields earned decreased 38 basis points to
5.22%.  Average loans decreased slightly during the first nine months
of 2010, while the yield earned on loans decreased 33 basis points when compared
to the same period of 2009.  Loans comprised 84.8% and 86.2% of total
average earning assets for the first nine months of 2010 and 2009,
respectively.  As with the quarter-to-date average balances, other
earning assets reflected a shift from federal funds sold to investment
securities and interest-bearing deposits when comparing year-to-date September
30, 2010 and 2009 average balances.





Interest
expense was $9.9 million for the nine months ended September 30, 2010, a
decrease of 26.6% when compared to the same period last year.  Average
interest-bearing liabilities increased 3.0%, while rates paid decreased 60 basis
points to 1.50%.  During the second quarter of 2009, the Company began
to participate in the Promontory Insured Network Deposits Program
(“IND”).  The $51.0 million increase in average money market and
savings deposits for the first three quarters of 2010 over the same period of
2009 included approximately $37.5 million from the IND program.  For
the nine months ended September 30, 2010, the average balance of certificates
of  deposit $100,000 or more increased 1.4% when compared to the same
period last year, while the average rate paid decreased 105 basis points to
2.08%.  Average other time deposits decreased 8.8% and the rate paid
on average other time deposits decreased 86 basis points when compared to the
first nine months of 2009.  Expanded levels of FDIC insurance coverage
contributed to the shift from other time deposits to certificates of deposit
$100,000 or more.


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 September 30, 2010 and 2009.





For the Three Months Ended
                  
                  
                  For the Three Months EndedSeptember 30, 2010
                  
                  
                  September 30, 2009Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/
                  
                  
                  Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/(Dollars in thousands)
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  RateEarning
      assetsLoans
      (2), (3)
                  
                  $
                  904,293
                  
                  
                  $
                  13,125
                  
                  
                  
                  5.76
                  %
                  
                  $
                  920,241
                  
                  
                  $
                  14,042
                  
                  
                  
                  6.05
                  %Investment
      securitiesTaxable
                  
                  
                  99,572
                  
                  
                  
                  677
                  
                  
                  
                  2.70
                  
                  
                  
                  89,101
                  
                  
                  
                  800
                  
                  
                  
                  3.56Tax-exempt
                  
                  
                  5,894
                  
                  
                  
                  75
                  
                  
                  
                  5.16
                  
                  
                  
                  8,125
                  
                  
                  
                  118
                  
                  
                  
                  5.76Federal
      funds sold
                  
                  
                  40,638
                  
                  
                  
                  21
                  
                  
                  
                  0.20
                  
                  
                  
                  81,466
                  
                  
                  
                  31
                  
                  
                  
                  0.16Interest-bearing
      deposits
                  
                  
                  15,666
                  
                  
                  
                  6
                  
                  
                  
                  0.15
                  
                  
                  
                  1,605
                  
                  
                  
                  4
                  
                  
                  
                  0.77Total
      earning assets
                  
                  
                  1,066,063
                  
                  
                  
                  13,904
                  
                  
                  
                  5.18
                  %
                  
                  
                  1,100,538
                  
                  
                  
                  14,995
                  
                  
                  
                  5.41
                  %Cash
      and due from banks
                  
                  
                  21,865
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  20,042Other
      assets
                  
                  
                  65,081
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  57,049Allowance
      for credit losses
                  
                  
                  (13,966
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (11,042
                  )Total
      assets
                  
                  $
                  1,139,043
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,166,587Interest-bearing
      liabilitiesDemand
      deposits
                  
                  $
                  132,023
                  
                  
                  
                  80
                  
                  
                  
                  0.24
                  %
                  
                  $
                  125,233
                  
                  
                  
                  82
                  
                  
                  
                  0.26
                  %Money
      market and savings deposits
                  
                  
                  259,511
                  
                  
                  
                  526
                  
                  
                  
                  0.81
                  
                  
                  
                  245,801
                  
                  
                  
                  412
                  
                  
                  
                  0.67Certificates
      of deposit $100,000 or more
                  
                  
                  258,542
                  
                  
                  
                  1,242
                  
                  
                  
                  1.91
                  
                  
                  
                  274,580
                  
                  
                  
                  1,954
                  
                  
                  
                  2.82Other
      time deposits
                  
                  
                  212,098
                  
                  
                  
                  1,269
                  
                  
                  
                  2.37
                  
                  
                  
                  237,757
                  
                  
                  
                  1,920
                  
                  
                  
                  3.20Interest-bearing
      deposits
                  
                  
                  862,174
                  
                  
                  
                  3,117
                  
                  
                  
                  1.44
                  
                  
                  
                  883,371
                  
                  
                  
                  4,368
                  
                  
                  
                  1.96Short-term
      borrowings
                  
                  
                  16,092
                  
                  
                  
                  17
                  
                  
                  
                  0.38
                  
                  
                  
                  18,373
                  
                  
                  
                  19
                  
                  
                  
                  0.42Long-term
      debt
                  
                  
                  1,429
                  
                  
                  
                  16
                  
                  
                  
                  4.36
                  
                  
                  
                  1,947
                  
                  
                  
                  98
                  
                  
                  
                  19.90Total
      interest-bearing liabilities
                  
                  
                  879,695
                  
                  
                  
                  3,150
                  
                  
                  
                  1.42
                  %
                  
                  
                  903,691
                  
                  
                  
                  4,485
                  
                  
                  
                  1.97
                  %Noninterest-bearing
      deposits
                  
                  
                  121,844
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  117,933Other
      liabilities
                  
                  
                  12,196
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  16,554Stockholders’
      equity
                  
                  
                  125,308
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  128,409Total
      liabilities and stockholders’ equity
                  
                  $
                  1,139,043
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,166,587Net
      interest spread
                  
                  
                  
                  
                  
                  $
                  10,754
                  
                  
                  
                  3.76
                  %
                  
                  
                  
                  
                  
                  $
                  10,510
                  
                  
                  
                  3.44
                  %Net
      interest margin
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4.00
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.79
                  %Tax-equivalent
      adjustmentLoans
                  
                  
                  
                  
                  
                  $
                  42
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  41Investment
      securities
                  
                  
                  
                  
                  
                  
                  25
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  41Total
                  
                  
                  
                  
                  
                  $
                  67
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  82


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 nine months ended September 30, 2010 and 2009.





For the Nine Months Ended
                  
                  
                  For the Nine Months EndedSeptember 30, 2010
                  
                  
                  September 30, 2009Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/
                  
                  
                  Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/(Dollars in thousands)
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  RateEarning
      assetsLoans
      (2), (3)
                  
                  $
                  907,965
                  
                  
                  $
                  39,118
                  
                  
                  
                  5.76
                  %
                  
                  $
                  910,842
                  
                  
                  $
                  41,497
                  
                  
                  
                  6.09
                  %Investment
      securitiesTaxable
                  
                  
                  102,100
                  
                  
                  
                  2,405
                  
                  
                  
                  3.15
                  
                  
                  
                  79,797
                  
                  
                  
                  2,324
                  
                  
                  
                  3.89Tax-exempt
                  
                  
                  6,369
                  
                  
                  
                  250
                  
                  
                  
                  5.26
                  
                  
                  
                  8,443
                  
                  
                  
                  371
                  
                  
                  
                  5.87Federal
      funds sold
                  
                  
                  41,709
                  
                  
                  
                  47
                  
                  
                  
                  0.15
                  
                  
                  
                  53,227
                  
                  
                  
                  61
                  
                  
                  
                  0.15Interest-bearing
      deposits
                  
                  
                  12,690
                  
                  
                  
                  11
                  
                  
                  
                  0.12
                  
                  
                  
                  4,053
                  
                  
                  
                  11
                  
                  
                  
                  0.35Total
      earning assets
                  
                  
                  1,070,833
                  
                  
                  
                  41,831
                  
                  
                  
                  5.22
                  %
                  
                  
                  1,056,362
                  
                  
                  
                  44,264
                  
                  
                  
                  5.60
                  %Cash
      and due from banks
                  
                  
                  15,455
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  16,960Other
      assets
                  
                  
                  66,942
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  52,700Allowance
      for credit losses
                  
                  
                  (13,483
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,523
                  )Total
      assets
                  
                  $
                  1,139,747
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,115,499Interest-bearing
      liabilitiesDemand
      deposits
                  
                  $
                  130,872
                  
                  
                  
                  243
                  
                  
                  
                  0.25
                  %
                  
                  $
                  123,821
                  
                  
                  
                  230
                  
                  
                  
                  0.25
                  %Money
      market and savings deposits
                  
                  
                  258,628
                  
                  
                  
                  1,421
                  
                  
                  
                  0.73
                  
                  
                  
                  207,588
                  
                  
                  
                  937
                  
                  
                  
                  0.60Certificates
      of deposit $100,000 or more
                  
                  
                  256,470
                  
                  
                  
                  3,986
                  
                  
                  
                  2.08
                  
                  
                  
                  252,978
                  
                  
                  
                  5,920
                  
                  
                  
                  3.13Other
      time deposits
                  
                  
                  215,911
                  
                  
                  
                  4,094
                  
                  
                  
                  2.53
                  
                  
                  
                  236,643
                  
                  
                  
                  6,007
                  
                  
                  
                  3.39Interest-bearing
      deposits
                  
                  
                  861,881
                  
                  
                  
                  9,744
                  
                  
                  
                  1.51
                  
                  
                  
                  821,030
                  
                  
                  
                  13,094
                  
                  
                  
                  2.13Short-term
      borrowings
                  
                  
                  16,673
                  
                  
                  
                  68
                  
                  
                  
                  0.55
                  
                  
                  
                  27,718
                  
                  
                  
                  96
                  
                  
                  
                  0.46Long-term
      debt
                  
                  
                  1,429
                  
                  
                  
                  47
                  
                  
                  
                  4.40
                  
                  
                  
                  5,925
                  
                  
                  
                  247
                  
                  
                  
                  5.57Total
      interest-bearing liabilities
                  
                  
                  879,983
                  
                  
                  
                  9,859
                  
                  
                  
                  1.50
                  %
                  
                  
                  854,673
                  
                  
                  
                  13,437
                  
                  
                  
                  2.10
                  %Noninterest-bearing
      deposits
                  
                  
                  119,087
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  110,663Other
      liabilities
                  
                  
                  14,334
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  13,074Stockholders’
      equity
                  
                  
                  126,343
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  137,089Total
      liabilities and stockholders’ equity
                  
                  $
                  1,139,747
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,115,499Net
      interest spread
                  
                  
                  
                  
                  
                  $
                  31,972
                  
                  
                  
                  3.72
                  %
                  
                  
                  
                  
                  
                  $
                  30,827
                  
                  
                  
                  3.50
                  %Net
      interest margin
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.99
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.90
                  %Tax-equivalent
      adjustmentLoans
                  
                  
                  
                  
                  
                  $
                  114
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  125Investment
      securities
                  
                  
                  
                  
                  
                  
                  85
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  130Total
                  
                  
                  
                  
                  
                  $
                  199
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  255





(1)
            All
      amounts are reported on a tax equivalent basis computed using the
      statutory federal income tax rate of 34.0% for 2010 and 35.0% for 2009
      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 third quarter of 2010 decreased $76 thousand, or 1.6%, when
compared to the third quarter of 2009.   The decline in
noninterest income during the third quarter of 2010 when compared to the third
quarter of 2009 was primarily due to decreases in mortgage broker fees and
insurance agency commissions which were partially offset by a $224 thousand gain
relating to the surrender of directors’ life insurance policies. The increase of
$75 thousand, or 1.6%, when compared to the second quarter of 2010 was primarily
due to the $224 thousand gain from the life insurance policies which was
partially offset by decreases in mortgage broker fees and insurance agency
commissions.





Noninterest
income for the first nine months of 2010 decreased $1.3 million, or 8.6%, when
compared to the first nine months of 2009.  The decrease in
noninterest income was mainly due to a decline in mortgage broker fees and
insurance agency commissions.


22


Noninterest
Expense





Noninterest
expense for the third quarter of 2010 increased $2.3 million, or 22.6%, when
compared to the third quarter of 2009 mainly due to goodwill impairment charges
of $3.0 million and other intangible assets impairment charges of $51
thousand.  The increase in noninterest expense was somewhat offset by
lower expenses accrued for bonus and profit sharing
plans.  Noninterest expense increased $2.9 million, or 30.4%, from the
second quarter of 2010 primarily due to the goodwill and other intangible assets
impairment charges.  The increase in noninterest expense was slightly
offset by lower expenses related to other real estate owned
activities.  Excluding the goodwill and other intangible assets
impairment charges, total noninterest expense would have decreased 7.0% and 1.1%
when compared to the third quarter of 2009 and the second quarter of 2010,
respectively.





Noninterest
expense for the first nine months of 2010 increased $1.8 million, or 5.7%, when
compared to the first nine months of 2009.  The increase in
noninterest expense was primarily due to the goodwill and other intangible
assets impairment charges and higher expenses related to collection and other
real estate owned activities.  The increase was partially offset by
lower expenses accrued for bonus and profit sharing plans, lower insurance
agency commissions expense and lower FDIC insurance premium
expense.  Excluding the goodwill and other intangible assets
impairment charges, total noninterest expense would have decreased 4.2% when
compared to the first nine months of 2009.





Income
Taxes


The
Company’s effective tax rate was a 6.2% benefit for the three months ended
September 30, 2010, compared to a 38.0% expense for the same period last
year.  For the nine months ended September 30, 2010, the effective tax
rate was a 28.1% benefit compared to a 38.2% expense for the same period last
year.  The tax benefit rate for quarter-to-date and year-to-date
September 30, 2010 reflected that $1.5 million of the goodwill impairment was
not tax deductible.  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 $906.5 million at September 30, 2010, a 1.1%
decrease since December 31, 2009. Average loans were $904.3 million for the
three months ended September 30, 2010, which was 1.7% lower than the comparable
amount for the same period last year.  For the nine months ended
September 30, 2010, average loans were $908.0 million, which was slightly lower
than the comparable amount for the same period in 2009.  Loan growth
slowed when compared to the prior year as the weakened economy created fewer
loan opportunities to originate high-quality credits.  At the same
time, we are experiencing slowing loan growth. Net loan charge-offs increased
$2.6 million and $10.5 million for the third quarter and first nine months of
2010, respectively, when compared to the same periods last year.





Our loan
portfolio has a concentration of commercial real estate
loans.  Commercial real estate loans, excluding construction and land
development loans, were approximately $323.4 million, or 35.7% of total loans,
at September 30, 2010, compared to $315.9 million, or 34.5% of total loans, at
December 31, 2009.  Construction and land development loans were
$149.1 million, or 16.5% of total loans, at September 30, 2010, compared to
$161.4 million, or 17.6% of total loans, at December 31, 2009.  We do
not engage in foreign or subprime lending activities.





Because
most of our loans are secured by real estate, weaknesses in the current local
real estate market and construction industry, and deterioration in overall
economic conditions have had a material adverse effect on the performance of our
loan portfolio and the value of the collateral securing that portfolio. Thus, we
have experienced higher provisions for credit losses, loan charge-offs and
nonperforming assets because of these weaknesses in the local economy.





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 and 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.


23


The
provision for credit losses for the three months ended September 30, 2010 and
2009 was $4.2 million and $1.7 million, respectively. The provision for credit
losses for the second quarter of 2010 was $4.9 million.  The provision
for credit losses for the first nine months of 2010 and 2009 was $16.7 million
and $5.3 million, respectively. The continued historically large level of
provision expense was the result of the overall increase in nonperforming assets
and loan charge-offs, and management’s assessment of the worsening in general
economic conditions.  We continue to emphasize credit quality and
believe that our underwriting guidelines are strong.  However, the
prolonging or deepening of the current economic recession will likely cause us
to continue to 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 $4.3 million for the three months ended September 30, 2010,
compared to $1.8 million for the same period last year and $4.4 million for the
second quarter of 2010.  While the overall level of charge-offs for
the third quarter of 2010 was consistent with the second quarter of 2010, there
was a reduction in losses from residential real estate loans and an increase in
losses related to construction loans.  The majority of losses on
construction loans that occurred in the third quarter related to the two
significant construction loan relationships discussed below in the nonperforming
assets section.  The allowance for credit losses as a percentage of
average loans increased to 1.45% for the third quarter of 2010, compared to
1.17% for the third quarter of 2009. The comparable ratio was 1.46% for the
second quarter of 2010.





Net
charge-offs were $14.5 million for the first nine months of 2010, compared to
$3.9 million for the same period in 2009.  The allowance for credit
losses as a percentage of average loans increased to 1.45% for the first nine
months of 2010 from 1.18% for the same period last year. 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 September 30, 2010 to provide for probable losses inherent in our
loan portfolio.





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





For the Three Months Ended
                
                
                For the Nine Months EndedSeptember 30,
                
                
                September 30,(Dollars in thousands)
                
                2010
                
                
                2009
                
                
                2010
                
                
                2009Allowance
      balance – beginning of period
                
                $
                13,289
                
                
                $
                10,784
                
                
                $
                10,876
                
                
                $
                9,320Charge-offs:Real
      estate – construction
                
                
                (1,931
                )
                
                
                (148
                )
                
                
                (6,121
                )
                
                
                (363
                )Real
      estate – residential
                
                
                (1,305
                )
                
                
                (811
                )
                
                
                (4,821
                )
                
                
                (1,762
                )Real
      estate – commercial
                
                
                (242
                )
                
                
                (522
                )
                
                
                (288
                )
                
                
                (695
                )Commercial
                
                
                (1,060
                )
                
                
                (250
                )
                
                
                (3,448
                )
                
                
                (977
                )Consumer
                
                
                (102
                )
                
                
                (109
                )
                
                
                (413
                )
                
                
                (308
                )Totals
                
                
                (4,640
                )
                
                
                (1,840
                )
                
                
                (15,091
                )
                
                
                (4,105
                )Recoveries:Real
      estate – construction
                
                
                -
                
                
                
                -
                
                
                
                13
                
                
                
                2Real
      estate – residential
                
                
                138
                
                
                
                14
                
                
                
                212
                
                
                
                67Real
      estate – commercial
                
                
                6
                
                
                
                1
                
                
                
                108
                
                
                
                1Commercial
                
                
                116
                
                
                
                -
                
                
                
                172
                
                
                
                4Consumer
                
                
                51
                
                
                
                62
                
                
                
                136
                
                
                
                116Totals
                
                
                311
                
                
                
                77
                
                
                
                641
                
                
                
                190Net
      charge-offs
                
                
                (4,329
                )
                
                
                (1,763
                )
                
                
                (14,450
                )
                
                
                (3,915
                )Provision
      for credit losses
                
                
                4,193
                
                
                
                1,702
                
                
                
                16,727
                
                
                
                5,318Allowance
      balance – end of period
                
                $
                13,153
                
                
                $
                10,723
                
                
                $
                13,153
                
                
                $
                10,723Average
      loans outstanding during the period
                
                $
                904,293
                
                
                $
                920,241
                
                
                $
                907,965
                
                
                $
                910,842Net
      charge-offs (annualized) as a percentage of average loans outstanding
      during the period
                
                
                1.90
                %
                
                
                0.76
                %
                
                
                2.13
                %
                
                
                0.57
                %Allowance
      for credit losses at period end as a percentage of average
      loans
                
                
                1.45
                %
                
                
                1.17
                %
                
                
                1.45
                %
                
                
                1.18
                %


24


Nonperforming
Assets


Nonperforming
assets were $38.3 million at September 30, 2010, compared to $18.9 million at
December 31, 2009.  Nonperforming assets declined $614 thousand since
June 30, 2010.  The increase in nonaccrual loans during the first nine
months of 2010 was primarily in construction loans and related largely to two
borrowing relationships. The Company has a $5.0 million participation with a
regional bank that is matured.  Through December 31, 2009, the
customer made all interest payments.  This loan migrated from 90 days
past due to nonaccrual in the first quarter of 2010 and $745 thousand was
subsequently charged off in the third quarter.  Also during the first
quarter of 2010, a second significant construction loan relationship totaling
approximately $14.0 million was put on nonaccrual and $3.4 million was charged
off in the first quarter with an additional $717 thousand charged off in the
third quarter.  Total nonperforming assets to total loans and other
real estate and other assets owned increased to 4.22% at September 30, 2010,
compared to 2.05% at December 31, 2009.  Loans past due 90 days and
still accruing at September 30, 2010 decreased to $3.3 million from $7.4 million
at December 31, 2009 mainly due to the previously-mentioned migration of the
$5.0 million participation from 90 days past due to nonaccrual.





The
following table summarizes our nonperforming and past due assets:





September 30,
                  
                  
                  December 31,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009Nonperforming
      assetsNonaccrual
      loansReal
      estate – construction
                  
                  $
                  18,424
                  
                  
                  $
                  7,163Real
      estate – residential
                  
                  
                  11,318
                  
                  
                  
                  4,246Real
      estate – commercial
                  
                  
                  3,098
                  
                  
                  
                  2,828Commercial
                  
                  
                  3,851
                  
                  
                  
                  2,028Consumer
                  
                  
                  94
                  
                  
                  
                  37Total
      nonaccrual loans
                  
                  
                  36,785
                  
                  
                  
                  16,302Other
      real estate and other assets owned
                  
                  
                  1,517
                  
                  
                  
                  2,572Total
      nonperforming assets
                  
                  
                  38,302
                  
                  
                  
                  18,874Loans
      90 days past due and still accruingReal
      estate – construction
                  
                  
                  -
                  
                  
                  
                  5,096Real
      estate – residential
                  
                  
                  2,771
                  
                  
                  
                  2,274Real
      estate – commercial
                  
                  
                  312
                  
                  
                  
                  -Commercial
                  
                  
                  154
                  
                  
                  
                  -Consumer
                  
                  
                  76
                  
                  
                  
                  55Total
      loans 90 days past due and still accruing
                  
                  
                  3,313
                  
                  
                  
                  7,425Total
      nonperforming assets and past due loans
                  
                  $
                  41,615
                  
                  
                  $
                  26,299Nonperforming
      assets to total loans and other real estate and other assets
      owned
                  
                  
                  4.22
                  %
                  
                  
                  2.05
                  %Nonperforming
      assets to total assets
                  
                  
                  3.38
                  %
                  
                  
                  1.63
                  %Nonperforming
      assets and past due loans, to total loans and other real estate and other
      assets owned
                  
                  
                  4.58
                  %
                  
                  
                  2.86
                  %Nonperforming
      assets and past due loans to total assets
                  
                  
                  3.67
                  %
                  
                  
                  2.27
                  %


25


Investment
Securities


Investment
securities totaled $104.1 million at September 30, 2010, a $2.5 million, or 2.3%
decrease since December 31, 2009. The average balance of investment securities
was $105.5 million for the three months ended September 30, 2010, compared to
$97.2 million for the same period in 2009.  The tax equivalent yields
on investment securities were 2.83% and 3.75% for the three months ended
September 30, 2010 and 2009, respectively.  The average balance of
investment securities was $108.5 million for the nine months ended September 30,
2010, compared to $88.2 million for the same period in 2009.  The tax
equivalent yields on investment securities were 3.27% and 4.08% for the first
nine months of 2010 and 2009, respectively. The increases in the 2010 investment
securities average balances when compared to the 2009 average balances reflected
the investment of excess deposits.





Deposits


Total
deposits at September 30, 2010 were $982.4 million, an $8.5 million, or less
than one percent, decrease when compared to the $990.9 million at December 31,
2009.  The decrease was primarily in other time deposits and
interest-bearing demand deposits which was attributable to management’s effort
to reduce deposit pricing structures.  Some of these deposits moved to
money market and savings deposits which had the largest increase when compared
to balances at the end of last year.





Short-Term
Borrowings


Short-term
borrowings at September 30, 2010 and December 31, 2009 were $17.8 million and
$20.4 million, respectively.  Short-term borrowings generally consist
of securities sold under agreements to repurchase, overnight borrowings from
correspondent banks and short-term advances from the FHLB.  Short-term
advances are defined as those with original maturities of one year or
less.  The decline in short-term borrowings since December 31, 2009
was primarily due to the repayment of $3.4 million drawn on a $10.0 million line
of credit with a commercial bank.





Long-Term
Debt


At
September 30, 2010 and December 31, 2009, the Company had $1.4 million in
long-term debt.  This debt was acquisition-related, incurred as part
of the purchase price of TSGIA, Inc. and is payable to the seller thereof, who
remains the President of that subsidiary.  The interest rate on the
debt is 4.08% and principal and interest are payable in annual installments for
five years.





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 has a five year term
and has a guaranteed minimum funding level of $70 million.





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 CNB are also members of the FHLB
of Atlanta and Felton Bank is a member of the FHLB of Pittsburgh, and these
banks have pledged collateral sufficient to permit additional borrowings of up
to approximately $29.2 million in the aggregate at September 30, 2010.
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 $122.4 million at September 30, 2010, compared to
$127.8 million at December 31, 2009. The net loss, unrealized losses on cash
flow hedging activities and dividends paid all contributed to the decrease in
stockholders’ equity since the end of 2009.  To increase capital,
support the Company’s growth, and enhance capital ratios, management has reduced
dividends in 2010.  The Company reduced the quarterly common stock
dividend to $0.06 from $0.16 per share beginning with the
dividend that was payable on February 26, 2010.





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.


26


A
comparison of the capital ratios of Shore Bancshares, Inc. (on a consolidated
basis) as of September 30, 2010 and December 31, 2009 to the minimum regulatory
requirements is presented below:





MinimumSeptember 30,
                  
                  
                  December 31,
                  
                  
                  Regulatory2010
                  
                  
                  2009
                  
                  
                  RequirementsTier
      1 risk-based capital ratio
                  
                  
                  11.73
                  %
                  
                  
                  11.45
                  %
                  
                  
                  4.00
                  %Total
      risk-based capital ratio
                  
                  
                  12.99
                  %
                  
                  
                  12.59
                  %
                  
                  
                  8.00
                  %Leverage
      ratio
                  
                  
                  9.46
                  %
                  
                  
                  9.27
                  %
                  
                  
                  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, 2009 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, 2009.





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 September 30,
2010 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.





There was
no change in our internal control over financial reporting during the third
quarter of 2010 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, 2009 and in Item
1A of Part II of Shore Bancshares, Inc.’s Quarterly Report on Form 10-Q for the
quarter ended June 30, 2010.  Management does not believe that any
material changes in our risk factors have occurred since they were last
disclosed .





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.


27


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:
      November 5, 2010
            By:
            /s/ W. Moorhead VermilyeW.
      Moorhead VermilyePresident/Chief
      Executive OfficerDate:
      November 5, 2010
            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