UNITED STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549










FORM
10-Q





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





For the
Quarterly Period Ended September 30, 2009





OR





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





For the
transition period from ________ to ________





Commission
file number 0-22345





SHORE BANCSHARES,
INC.


(Exact
name of registrant as specified in its charter)





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





(410)
822-1400


Registrant’s
Telephone Number, Including Area Code





N/A


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





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





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





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





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





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





APPLICABLE
ONLY TO CORPORATE ISSUERS





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





INDEX





PagePart
      I.Financial Information
                        2Item
      1.  Financial Statements
                        2Consolidated
      Balance Sheets -September
      30, 2009 (unaudited) and December 31, 2008
                        2Consolidated
      Statements of Income -For
      the three and nine months ended September 30, 2009 and 2008
      (unaudited)
                        3Consolidated
      Statements of Changes in Stockholders’ Equity -For
      the nine months ended September 30, 2009 and 2008
    (unaudited)
                        4Consolidated
      Statements of Comprehensive Income -For
      the three and nine months ended September 30, 2009 and 2008
      (unaudited)
                        5Consolidated
      Statements of Cash Flows -For
      the nine months ended September 30, 2009 and 2008
    (unaudited)
                        6Notes
      to Consolidated Financial Statements (unaudited)
                        7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                        18Item
      3.  Quantitative and Qualitative Disclosures about Market
      Risk
                        26Item
      4.  Controls and Procedures
                        26Part
      II.  Other Information
                        27Item
      1A.  Risk Factors
                        27Item
      6.  Exhibits
                        27Signatures
                        27Exhibit
      Index
                        28


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
      31,2009
                    
                    
                    2008(Unaudited)ASSETSCash
      and due from banks
                    
                    $
                    13,699
                    
                    
                    $
                    16,803Interest
      bearing deposits with other banks
                    
                    
                    1,601
                    
                    
                    
                    481Federal
      funds sold
                    
                    
                    72,061
                    
                    
                    
                    10,010Investment
      securities:Available
      for sale, at fair value
                    
                    
                    94,917
                    
                    
                    
                    79,204Held
      to maturity, at amortized cost – fair value of $9,183 (2009) and $10,390
      (2008)
                    
                    
                    9,004
                    
                    
                    
                    10,252Loans
                    
                    
                    918,601
                    
                    
                    
                    888,528Less:  allowance
      for credit losses
                    
                    
                    (10,723
                    )
                    
                    
                    (9,320
                    )Loans,
      net
                    
                    
                    907,878
                    
                    
                    
                    879,208Insurance
      premiums receivable
                    
                    
                    1,193
                    
                    
                    
                    1,348Premises
      and equipment, net
                    
                    
                    14,012
                    
                    
                    
                    13,855Accrued
      interest receivable
                    
                    
                    4,769
                    
                    
                    
                    4,606Goodwill
                    
                    
                    15,954
                    
                    
                    
                    15,954Other
      intangible assets, net
                    
                    
                    5,535
                    
                    
                    
                    5,921Deferred
      income taxes
                    
                    
                    2,903
                    
                    
                    
                    1,579Other
      real estate owned
                    
                    
                    2,062
                    
                    
                    
                    148Interest
      rate caps
                    
                    
                    6,034
                    
                    
                    
                    -Other
      assets
                    
                    
                    6,063
                    
                    
                    
                    5,272TOTAL
      ASSETS
                    
                    $
                    1,157,685
                    
                    
                    $
                    1,044,641LIABILITIESDeposits:Noninterest
      bearing demand
                    
                    $
                    124,440
                    
                    
                    $
                    102,584Interest
      bearing demand
                    
                    
                    113,735
                    
                    
                    
                    125,370Money
      market and savings
                    
                    
                    243,576
                    
                    
                    
                    150,958Certificates
      of deposit $100,000 or more
                    
                    
                    275,351
                    
                    
                    
                    235,235Other
      time
                    
                    
                    235,094
                    
                    
                    
                    231,224Total
      deposits
                    
                    
                    992,196
                    
                    
                    
                    845,371Accrued
      interest payable
                    
                    
                    2,218
                    
                    
                    
                    2,350Short-term
      borrowings
                    
                    
                    17,673
                    
                    
                    
                    52,969Long-term
      debt
                    
                    
                    1,947
                    
                    
                    
                    7,947Other
      liabilities
                    
                    
                    15,432
                    
                    
                    
                    8,619TOTAL
      LIABILITIES
                    
                    
                    1,029,466
                    
                    
                    
                    917,256STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01 per share; shares authorized – 35,000,000; shares
      issued and outstanding – 8,418,963 (2009) and 8,404,684
    (2008)
                    
                    
                    84
                    
                    
                    
                    84Warrants
                    
                    
                    1,543
                    
                    
                    
                    -Additional
      paid in capital
                    
                    
                    29,844
                    
                    
                    
                    29,768Retained
      earnings
                    
                    
                    96,283
                    
                    
                    
                    96,140Accumulated
      other comprehensive income
                    
                    
                    465
                    
                    
                    
                    1,393TOTAL
      STOCKHOLDERS’ EQUITY
                    
                    
                    128,219
                    
                    
                    
                    127,385TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                    
                    $
                    1,157,685
                    
                    
                    $
                    1,044,641





See
accompanying notes to Consolidated Financial Statements.


2


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME (Unaudited)


(Dollars
in thousands, except per share amounts)





For
      the Three Months Ended
                
                
                For
      the Nine Months EndedSeptember
      30,
                
                
                September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008INTEREST
      INCOMEInterest
      and fees on loans
                
                $
                14,001
                
                
                $
                14,179
                
                
                $
                41,372
                
                
                $
                42,700Interest
      and dividends on investment securities:Taxable
                
                
                800
                
                
                
                924
                
                
                
                2,324
                
                
                
                2,949Tax-exempt
                
                
                77
                
                
                
                95
                
                
                
                241
                
                
                
                327Interest
      on federal funds sold
                
                
                31
                
                
                
                79
                
                
                
                61
                
                
                
                284Interest
      on deposits with other banks
                
                
                4
                
                
                
                21
                
                
                
                11
                
                
                
                88Total
      interest income
                
                
                14,913
                
                
                
                15,298
                
                
                
                44,009
                
                
                
                46,348INTEREST
      EXPENSEInterest
      on deposits
                
                
                4,368
                
                
                
                4,955
                
                
                
                13,094
                
                
                
                15,295Interest
      on short-term borrowings
                
                
                19
                
                
                
                344
                
                
                
                96
                
                
                
                1,026Interest
      on long-term debt
                
                
                98
                
                
                
                90
                
                
                
                247
                
                
                
                456Total
      interest expense
                
                
                4,485
                
                
                
                5,389
                
                
                
                13,437
                
                
                
                16,777NET
      INTEREST INCOME
                
                
                10,428
                
                
                
                9,909
                
                
                
                30,572
                
                
                
                29,571Provision
      for credit losses
                
                
                1,702
                
                
                
                875
                
                
                
                5,318
                
                
                
                1,952NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                
                
                8,726
                
                
                
                9,034
                
                
                
                25,254
                
                
                
                27,619NONINTEREST
      INCOMEService
      charges on deposit accounts
                
                
                861
                
                
                
                923
                
                
                
                2,558
                
                
                
                2,711Other
      service charges and fees
                
                
                763
                
                
                
                668
                
                
                
                2,275
                
                
                
                2,169Investment
      securities gains
                
                
                -
                
                
                
                -
                
                
                
                49
                
                
                
                -Other
      than temporary impairment of securities
                
                
                -
                
                
                
                (371
                )
                
                
                -
                
                
                
                (371
                )Insurance
      agency commissions income
                
                
                2,744
                
                
                
                2,845
                
                
                
                8,972
                
                
                
                9,595Gain
      on disposals of premises and equipment
                
                
                -
                
                
                
                1,264
                
                
                
                -
                
                
                
                1,255Loss
      on sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                (337
                )
                
                
                -
                
                
                
                (337
                )Other
      noninterest income
                
                
                351
                
                
                
                254
                
                
                
                1,562
                
                
                
                920Total
      noninterest income
                
                
                4,719
                
                
                
                5,246
                
                
                
                15,416
                
                
                
                15,942NONINTEREST
      EXPENSESalaries
      and wages
                
                
                4,765
                
                
                
                4,662
                
                
                
                14,064
                
                
                
                13,837Employee
      benefits
                
                
                1,211
                
                
                
                1,140
                
                
                
                3,791
                
                
                
                3,708Occupancy
      expense
                
                
                616
                
                
                
                558
                
                
                
                1,752
                
                
                
                1,594Furniture
      and equipment expense
                
                
                299
                
                
                
                310
                
                
                
                915
                
                
                
                894Data
      processing
                
                
                675
                
                
                
                610
                
                
                
                1,865
                
                
                
                1,728Directors’
      fees
                
                
                109
                
                
                
                131
                
                
                
                394
                
                
                
                426Amortization
      of intangible assets
                
                
                128
                
                
                
                128
                
                
                
                386
                
                
                
                386Insurance
      agency commissions expense
                
                
                428
                
                
                
                447
                
                
                
                1,515
                
                
                
                1,770FDIC
      insurance premium expense
                
                
                458
                
                
                
                135
                
                
                
                1,621
                
                
                
                209Other
      noninterest expenses
                
                
                1,608
                
                
                
                1,308
                
                
                
                4,570
                
                
                
                4,197Total
      noninterest expense
                
                
                10,297
                
                
                
                9,429
                
                
                
                30,873
                
                
                
                28,749INCOME
      BEFORE INCOME TAXES
                
                
                3,148
                
                
                
                4,851
                
                
                
                9,797
                
                
                
                14,812Income
      tax expense
                
                
                1,197
                
                
                
                1,780
                
                
                
                3,740
                
                
                
                5,603NET
      INCOME
                
                
                1,951
                
                
                
                3,071
                
                
                
                6,057
                
                
                
                9,209Preferred
      stock dividends and discount accretion
                
                
                -
                
                
                
                -
                
                
                
                1,876
                
                
                
                -Net
      income available to common shareholders
                
                $
                1,951
                
                
                $
                3,071
                
                
                $
                4,181
                
                
                $
                9,209Basic
      earnings per common share
                
                $
                0.23
                
                
                $
                0.37
                
                
                $
                0.50
                
                
                $
                1.10Diluted
      earnings per common share
                
                $
                0.23
                
                
                $
                0.37
                
                
                $
                0.50
                
                
                $
                1.10Cash
      dividends paid per common share
                
                $
                0.16
                
                
                $
                0.16
                
                
                $
                0.48
                
                
                $
                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, 2009 and 2008


(Dollars
in thousands, except per share amounts)




AccumulatedAdditional
                            
                            
                            
                            
                            
                            Other
                            
                            
                            TotalPreferred
                            
                            
                            Common
                            
                            
                            
                            
                            
                            Paid
      in
                            
                            
                            Retained
                            
                            
                            Comprehensive
                            
                            
                            Stockholders’Stock
                            
                            
                            Stock
                            
                            
                            Warrants
                            
                            
                            Capital
                            
                            
                            Earnings
                            
                            
                            Income
      (Loss)
                            
                            
                            EquityBalances,
      January 1, 2009
                            
                            $
                            -
                            
                            
                            $
                            84
                            
                            
                            $
                            -
                            
                            
                            $
                            29,768
                            
                            
                            $
                            96,140
                            
                            
                            $
                            1,393
                            
                            
                            $
                            127,385Comprehensive
      income:Net
      income
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            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
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            5,129Warrants
      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
                            
                            
                            $
                            128,219Balances,
      January 1, 2008
                            
                            $
                            -
                            
                            
                            $
                            84
                            
                            
                            $
                            -
                            
                            
                            $
                            29,539
                            
                            
                            $
                            90,365
                            
                            
                            $
                            247
                            
                            
                            $
                            120,235Adjustment
      to initially apply EITF Issue 06-4
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (318
                            )
                            
                            
                            -
                            
                            
                            
                            (318
                            )Comprehensive
      income:Net
      income
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            9,209
                            
                            
                            
                            -
                            
                            
                            
                            9,209Unrealized
      gains on available-for-sale securities, net of taxes
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            102
                            
                            
                            
                            102Total
      comprehensive income
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            9,311Shares
      issued for employee stock-based awards
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            136
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            136Stock-based
      compensation expense
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            69
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            69Cash
      dividends paid ($0.48 per share)
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (4,032
                            )
                            
                            
                            -
                            
                            
                            
                            (4,032
                            )Balances,
      September 30, 2008
                            
                            $
                            -
                            
                            
                            $
                            84
                            
                            
                            $
                            -
                            
                            
                            $
                            29,744
                            
                            
                            $
                            95,224
                            
                            
                            $
                            349
                            
                            
                            $
                            125,401




See
accompanying notes to Consolidated Financial Statements.


4


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)


(Dollars
in thousands)





For
      the Three Months Ended
                        September
      30,
                      
                      
                      For
      the Nine Months Ended
                        September
      30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Net
      income
                      
                      $
                      1,951
                      
                      
                      $
                      3,071
                      
                      
                      $
                      6,057
                      
                      
                      $
                      9,209Other
      comprehensive (loss) income:Securities
      available for sale:Unrealized
      holding gains (losses) on available-for-sale securities
                      
                      
                      604
                      
                      
                      
                      926
                      
                      
                      
                      (410
                      )
                      
                      
                      175Tax
      effect
                      
                      
                      (241
                      )
                      
                      
                      (370
                      )
                      
                      
                      163
                      
                      
                      
                      (73
                      )Reclassification
      of (gains) losses recognized in net income
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (49
                      )
                      
                      
                      -Tax
      effect
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      20
                      
                      
                      
                      -Net
      of tax amount
                      
                      
                      363
                      
                      
                      
                      556
                      
                      
                      
                      (276
                      )
                      
                      
                      102Cash
      flow hedging activities:Unrealized
      holding losses on cash flow hedging activities
                      
                      
                      (1,093
                      )
                      
                      
                      -
                      
                      
                      
                      (1,093
                      )
                      
                      
                      -Tax
      effect
                      
                      
                      441
                      
                      
                      
                      -
                      
                      
                      
                      441
                      
                      
                      
                      -Net
      of tax amount
                      
                      
                      (652
                      )
                      
                      
                      -
                      
                      
                      
                      (652
                      )
                      
                      
                      -Total
      other comprehensive (loss) income
                      
                      
                      (289
                      )
                      
                      
                      556
                      
                      
                      
                      (928
                      )
                      
                      
                      102Comprehensive
      income
                      
                      $
                      1,662
                      
                      
                      $
                      3,627
                      
                      
                      $
                      5,129
                      
                      
                      $
                      9,311





See
accompanying notes to Consolidated Financial Statements.


5


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited)


(Dollars
in thousands)





For the Nine Months Ended September
      30,2009
                
                
                2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                
                $
                6,057
                
                
                $
                9,209Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for credit losses
                
                
                5,318
                
                
                
                1,952Depreciation
      and amortization
                
                
                1,370
                
                
                
                1,330Discount
      accretion on debt securities
                
                
                (191
                )
                
                
                (164
                )Stock-based
      compensation expense
                
                
                74
                
                
                
                69Gain
      on sales of securities
                
                
                (49
                )
                
                
                -Other
      than temporary impairment of securities
                
                
                -
                
                
                
                371Gain
      on disposals of premises and equipment
                
                
                -
                
                
                
                (1,255
                )Loss
      on sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                337Loss
      on sales of other real estate owned
                
                
                -
                
                
                
                50Write-downs
      of other real estate owned
                
                
                159
                
                
                
                -Net
      changes in:Insurance
      premiums receivable
                
                
                155
                
                
                
                (81
                )Accrued
      interest receivable
                
                
                (163
                )
                
                
                (15
                )Other
      assets
                
                
                (2,124
                )
                
                
                (1,592
                )Accrued
      interest payable
                
                
                (132
                )
                
                
                (656
                )Other
      liabilities
                
                
                285
                
                
                
                579Net
      cash provided by operating activities
                
                
                10,759
                
                
                
                10,134CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                
                
                36,686
                
                
                
                71,189Proceeds
      from sales of investment securities available for sale
                
                
                2,048
                
                
                
                -Purchases
      of securities available for sale
                
                
                (54,851
                )
                
                
                (56,416
                )Proceeds
      from maturities and principal payments of securities held to
      maturity
                
                
                2,815
                
                
                
                2,991Purchases
      of securities held to maturity
                
                
                (1,563
                )
                
                
                (1,012
                )Net
      increase in loans
                
                
                (36,059
                )
                
                
                (90,109
                )Purchases
      of premises and equipment
                
                
                (982
                )
                
                
                (292
                )Proceeds
      from sales of premises and equipment
                
                
                -
                
                
                
                2,773Proceeds
      from sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                600Proceeds
      from sales of other real estate owned
                
                
                -
                
                
                
                264Purchases
      of interest rate caps
                
                
                (6,475
                )
                
                
                -Net
      cash used in investing activities
                
                
                (58,381
                )
                
                
                (70,012
                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      increase in demand, money market and savings deposits
                
                
                102,839
                
                
                
                29,990Net
      increase in certificates of deposit
                
                
                43,987
                
                
                
                43,332Net
      (decrease) increase in short-term borrowings
                
                
                (35,296
                )
                
                
                5,384Proceeds
      from issuance of long-term debt
                
                
                -
                
                
                
                3,000Repayment
      of long-term debt
                
                
                (6,000
                )
                
                
                (7,000
                )Net
      receipt of counterparty collateral – interest rate caps
                
                
                6,528Proceeds
      from issuance of preferred stock and warrants
                
                
                25,000
                
                
                
                -Repurchase
      of preferred stock
                
                
                (23,525
                )
                
                
                -Proceeds
      from issuance of common stock
                
                
                2
                
                
                
                136Preferred
      stock dividends paid
                
                
                (1,808
                )
                
                
                -Common
      stock dividends paid
                
                
                (4,038
                )
                
                
                (4,032
                )Net
      cash provided by financing activities
                
                
                107,689
                
                
                
                70,810Net
      increase in cash and cash equivalents
                
                
                60,067
                
                
                
                10,932Cash
      and cash equivalents at beginning of period
                
                
                27,294
                
                
                
                26,880Cash
      and cash equivalents at end of period
                
                $
                87,361
                
                
                $
                37,812Supplemental
      cash flows information:Interest
      paid
                
                $
                13,569
                
                
                $
                17,433Income
      taxes paid
                
                $
                3,678
                
                
                $
                7,437Transfers
      from loans to other real estate owned
                
                $
                2,072
                
                
                $
                138





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, 2009 and 2008


(Unaudited)





Note 1 - Basis of
Presentation





The
consolidated financial statements include the accounts of Shore Bancshares, Inc.
and its subsidiaries with all significant intercompany transactions
eliminated.The consolidated financial statements conform to accounting
principles generally accepted in the United States of America (“GAAP”) and to
prevailing practices within the banking industry.  The accompanying
interim financial statements are unaudited; however, in the opinion of
management all adjustments necessary to present fairly the consolidated
financial position at September 30, 2009, the consolidated results of operations
for the three and nine months ended September 30, 2009 and 2008, changes in
stockholders’ equity for the nine months ended September 30, 2009 and 2008, and
cash flows for the nine months ended September 30, 2009 and 2008, have been
included.  All such adjustments are of a normal recurring
nature.  The amounts as of December 31, 2008 were derived from the
2008 audited financial statements.  The results of operations for the
three and nine months ended September 30, 2009 are not necessarily indicative of
the results to be expected for any other interim period or for the full
year.  This Quarterly Report on Form 10-Q should be read in
conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for
the year ended December 31, 2008.





The
Financial Accounting Standards Board’s (FASB) Accounting Standards Codification
(ASC) became effective on July 1, 2009. At that date, the ASC became FASB’s
officially recognized source of authoritative U.S. generally accepted accounting
principles (GAAP) applicable to all public and non-public non-governmental
entities, superseding existing FASB, American Institute of Certified Public
Accountants (AICPA), Emerging Issues Task Force (EITF) and related literature.
Rules and interpretive releases of the SEC under the authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. All
other accounting literature is considered non-authoritative. The switch to the
ASC affects the way companies refer to U.S. GAAP in financial statements and
accounting policies. Citing particular content in the ASC involves specifying
the unique numeric path to the content through the Topic, Subtopic, Section and
Paragraph structure.





The
Company has evaluated events and transactions occurring subsequent to the
balance sheet date of September 30, 2009 for items that should potentially be
recognized or disclosed in these financial statements as prescribed by recently
issued FASB ASC Topic 855, “Subsequent Events”.  The evaluation was
conducted through November 9, 2009, the date these financial statements were
issued.





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





Note 2 – Earnings Per
Share





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





For
      the Three Months Ended
                
                
                For
      the Nine Months EndedSeptember 30,
                
                
                September 30,(In thousands, except per share
      data)
                
                2009
                
                
                2008
                
                
                2009
                
                
                2008Net
      income available to common shareholders
                
                $
                1,951
                
                
                $
                3,071
                
                
                $
                4,181
                
                
                $
                9,209Weighted
      average shares outstanding - Basic
                
                
                8,419
                
                
                
                8,405
                
                
                
                8,412
                
                
                
                8,398Dilutive
      effect of stock-based awards
                
                
                4
                
                
                
                6
                
                
                
                4
                
                
                
                7Weighted
      average shares outstanding - Diluted
                
                
                8,423
                
                
                
                8,411
                
                
                
                8,416
                
                
                
                8,405Earnings
      per common share - Basic
                
                $
                0.23
                
                
                $
                0.37
                
                
                $
                0.50
                
                
                $
                1.10Earnings
      per common share - Diluted
                
                $
                0.23
                
                
                $
                0.37
                
                
                $
                0.50
                
                
                $
                1.10


7


That
portion of a warrant to purchase 173 thousand weighted average shares of common
stock was excluded from the diluted earnings per share calculation for the three
months ended September 30, 2009 because its effect would have been
antidilutive.  That portion of a warrant to purchase 168 thousand
weighted average shares was excluded from the diluted earnings per share
calculation for the nine months ended September 30, 2009 because its effect
would have been antidilutive.  There were 3,000 and 16,000
antidilutive weighted average stock-based awards excluded from the diluted
earnings per share calculation for the three and nine months ended September 30,
2008, respectively.





Note 3 – 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.





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





September
      30,
                
                
                December
      31,
                
                
                September
      30,(Dollars
      in thousands)
                
                2009
                
                
                2008
                
                
                2008Impaired
      loans with a valuation allowance
                
                $
                548
                
                
                $
                2,550
                
                
                $
                2,290Impaired
      loans with no valuation allowance
                
                
                14,919
                
                
                
                5,565
                
                
                
                5,206Total
      impaired loans
                
                $
                15,467
                
                
                $
                8,115
                
                
                $
                7,496Allowance
      for credit losses applicable to impaired loans
                
                $
                226
                
                
                $
                341
                
                
                $
                318Allowance
      for credit losses applicable to other than impaired loans
                
                
                10,497
                
                
                
                8,979
                
                
                
                8,300Total
      allowance for credit losses
                
                $
                10,723
                
                
                $
                9,320
                
                
                $
                8,618Average
      recorded investment in impaired loans
                
                $
                11,733
                
                
                $
                5,477
                
                
                $
                4,817





Gross
interest income of $576 thousand for the first nine months of 2009, $476
thousand for fiscal year 2008 and $314 thousand for the first nine months of
2008 would have been recorded if nonaccrual loans had been current and
performing in accordance with their original terms.  Interest actually
recorded on such loans was $4 thousand for the first nine months of 2009, $193
thousand for fiscal year 2008 and $193 thousand for the first nine months of
2008.





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


8





Note 4 – Investment
Securities





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





Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                Fair(Dollars
      in thousands)
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueAvailable-for-sale
      securities:September
      30, 2009:Obligations
      of U.S. Treasury
                
                $
                5,996
                
                
                $
                3
                
                
                $
                -
                
                
                $
                5,999Obligations
      of U.S. Government agencies and corporations
                
                
                52,913
                
                
                
                1,043
                
                
                
                68
                
                
                
                53,888Mortgage-backed
      securities
                
                
                30,453
                
                
                
                898
                
                
                
                22
                
                
                
                31,329Federal
      Home Loan Bank stock
                
                
                2,822
                
                
                
                -
                
                
                
                -
                
                
                
                2,822Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                566
                
                
                
                11
                
                
                
                -
                
                
                
                577$
                93,052
                
                
                $
                1,955
                
                
                $
                90
                
                
                $
                94,917December
      31, 2008:Obligations
      of U.S. Treasury
                
                $
                1,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,000Obligations
      of U.S. Government agencies and corporations
                
                
                49,996
                
                
                
                1,451
                
                
                
                -
                
                
                
                51,447Mortgage-backed
      securities
                
                
                22,028
                
                
                
                879
                
                
                
                8
                
                
                
                22,899Federal
      Home Loan Bank stock
                
                
                3,003
                
                
                
                -
                
                
                
                -
                
                
                
                3,003Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                551
                
                
                
                2
                
                
                
                -
                
                
                
                553$
                76,880
                
                
                $
                2,332
                
                
                $
                8
                
                
                $
                79,204Held-to
      maturity securities:September
      30, 2009:Obligations
      of states and political subdivisions
                
                $
                9,004
                
                
                $
                192
                
                
                $
                13
                
                
                $
                9,183December
      31, 2008:Obligations
      of states and political subdivisions
                
                $
                10,252
                
                
                $
                159
                
                
                $
                21
                
                
                $
                10,390





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, 2009, are as follows:





Less
      than
                    12 Months
                  
                  
                  More
      than
                    12 Months
                  
                  
                  Total(Dollars
      in thousands)
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    LossesAvailable-for-sale
      securities:U.S.
      Gov’t. agencies and corporations
                  
                  $
                  13,152
                  
                  
                  $
                  68
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  13,152
                  
                  
                  $
                  68Mortgage-backed
      securities
                  
                  
                  2,314
                  
                  
                  
                  22
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,314
                  
                  
                  
                  22Total
                  
                  $
                  15,466
                  
                  
                  $
                  90
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  15,466
                  
                  
                  $
                  90





The
available-for-sale securities have a fair value of approximately $94.9
million.  Of these securities, approximately $15.5 million have
unrealized losses when compared to their purchase prices.  The
securities with the unrealized losses in the available-for-sale portfolio all
have modest duration risk, low credit risk, and minimal losses (approximately
0.10%) when compared to amortized cost.  The unrealized losses that
exist are the result of market changes in interest rates since 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 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, 2009, are as follows:





Less
      than
                    12 Months
                  
                  
                  More
      than
                    12 Months
                  
                  
                  Total(Dollars
      in thousands)
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair
                    Value
                  
                  
                  Unrealized
                    LossesHeld-to-maturity
      securities:Obligations
      of states and political subdivisions
                  
                  $
                  501
                  
                  
                  $
                  6
                  
                  
                  $
                  806
                  
                  
                  $
                  7
                  
                  
                  $
                  1,307
                  
                  
                  $
                  13





The
held-to-maturity securities have a fair value of approximately $9.2 million, of
which approximately $1.3 million of these securities have unrealized losses when
compared to their purchase price.  All of the securities with
unrealized losses are municipal securities with modest duration risk, low credit
risk, and minimal losses (approximately 0.14%) when compared to amortized
cost.  The unrealized losses that exist are the result of market
changes in interest rates since the original purchase.  Because the
Company does not intend to sell these securities and it is not more likely than
not that the Company will be required to sell these securities before recovery
of their amortized cost bases, which may be at maturity, the Company considers
that the unrealized losses in the held-to-maturity portfolio are
temporary.


9





Note 5 –
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, 2009, total
commitments to extend credit were approximately $158.4 million. The comparable
amount was $211.4 million at December 31, 2008.  Outstanding letters
of credit were approximately $20.1 million at September 30, 2009 and $12.5
million at December 31, 2008.





Note 6 - Stock-Based
Compensation





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





Stock-based
awards granted to date are generally time-based, vest 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.  ESPP awards are rights
granted to employees to purchase shares of Shore Bancshares, Inc. common stock
at 85% of the fair market value on the date of grant.  ESPP awards are
100% vested when granted and have 27-month terms.





During
the three and nine months ended September 30, 2009, the Company recognized
pre-tax stock-based compensation expense of $28 thousand and $74 thousand,
respectively, compared to $22 thousand and $69  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 $483 thousand as of September 30, 2009.  The
weighted-average period over which this unrecognized expense was expected to be
recognized was 2.8 years.





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





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





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





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


10


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





Weighted
                
                
                AggregateNumber
                
                
                Average
                
                
                Intrinsicof Shares
                
                
                Exercise Price
                
                
                ValueOutstanding
      at beginning of year
                
                
                18,550
                
                
                $
                15.52Granted
                
                
                -
                
                
                
                -Exercised
                
                
                (25
                )
                
                
                21.33Expired/Cancelled
                
                
                (4,975
                )
                
                
                21.33Outstanding
      at end of period
                
                
                13,550
                
                
                
                13.37
                
                
                $
                45,536Exercisable
      at end of period
                
                
                13,550
                
                
                $
                13.37
                
                
                $
                45,536





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





Options Outstanding and ExercisableOptions Outstanding
                      
                      
                      
                      
                      
                      Weighted AverageRemainingExercise Price
                      
                      Number
                      
                      
                      Number
                      
                      
                      Contract Life (in years)$ 14.00
                      
                      
                      3,255
                      
                      
                      
                      3,255
                      
                      
                      
                      0.413.17
                      
                      
                      10,295
                      
                      
                      
                      10,295
                      
                      
                      
                      2.613,550
                      
                      
                      
                      13,550





The total
intrinsic value of stock options exercised during the nine months ended
September 30, 2009 was less than $1 thousand. The comparable amount for the nine
months ended September 30, 2008 was approximately $80 thousand.  Cash
received upon exercise of options during the first nine months of 2009 and 2008
was approximately $1 thousand and $136 thousand, respectively.





Note 7 – Segment
Reporting





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





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


11


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





Community
                
                
                Insurance Products
                
                
                Parent
                
                
                Consolidated(Dollars in thousands)
                
                Banking
                
                
                and Services
                
                
                Company
                
                
                Total2009Interest
      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
                
                
                $
                1,157,6852008Interest
      income
                
                $
                46,299
                
                
                $
                49
                
                
                $
                -
                
                
                $
                46,348Interest
      expense
                
                
                (16,676
                )
                
                
                -
                
                
                
                (101
                )
                
                
                (16,777
                )Provision
      for credit losses
                
                
                (1,952
                )
                
                
                -
                
                
                
                -
                
                
                
                (1,952
                )Noninterest
      income
                
                
                5,865
                
                
                
                10,077
                
                
                
                -
                
                
                
                15,942Noninterest
      expense
                
                
                (15,486
                )
                
                
                (9,128
                )
                
                
                (4,135
                )
                
                
                (28,749
                )Net
      intersegment income (expense)
                
                
                (3,577
                )
                
                
                (312
                )
                
                
                3,889
                
                
                
                -Income
      (loss) before taxes
                
                
                14,473
                
                
                
                686
                
                
                
                (347
                )
                
                
                14,812Income
      tax (expense) benefit
                
                
                (5,475
                )
                
                
                (259
                )
                
                
                131
                
                
                
                (5,603
                )Net
      income
                
                $
                8,998
                
                
                $
                427
                
                
                $
                (216
                )
                
                $
                9,209Total
      assets
                
                $
                1,013,939
                
                
                $
                20,332
                
                
                $
                2,755
                
                
                $
                1,037,026





Note 8 – Disclosures about
Fair Value of Financial Instruments





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





Cash and Cash
Equivalents


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





Investment
Securities


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





Loan
Receivables


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





Financial
Liabilities


The fair
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.  The fair values of securities sold under agreements to
repurchase and long-term debt are estimated using the rates offered for similar
borrowings.


12


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, excluding
goodwill, as of September 30, 2009 and December 31, 2008 are as
follows:





September
      30, 2009
                
                
                December
      31, 2008Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars
      in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      assets:Cash
      and cash equivalents
                
                $
                87,361
                
                
                $
                87,361
                
                
                $
                27,294
                
                
                $
                27,294Investment
      securities
                
                
                103,921
                
                
                
                104,100
                
                
                
                89,456
                
                
                
                89,594Loans
                
                
                918,601
                
                
                
                936,054
                
                
                
                888,528
                
                
                
                914,695Less:  allowance
      for loan losses
                
                
                (10,723
                )
                
                -
                
                
                
                (9,320
                )
                
                _
      -$
                1,099,160
                
                
                $
                1,127,515
                
                
                $
                995,958
                
                
                $
                1,031,583Financial
      liabilities:Deposits
                
                $
                992,196
                
                
                $
                1,001,146
                
                
                $
                845,371
                
                
                $
                861,951Short-term
      borrowings
                
                
                17,673
                
                
                
                17,673
                
                
                
                52,969
                
                
                
                52,969Long-term
      debt
                
                
                1,947
                
                
                
                2,065
                
                
                
                7,947
                
                
                
                8,060$
                1,011,816
                
                
                $
                1,020,884
                
                
                $
                906,287
                
                
                $
                922,980








September
      30, 2009
                
                
                December
      31, 2008Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars
      in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueUnrecognized
      financial instruments:Commitments
      to extend credit
                
                $
                158,374
                
                
                $
                -
                
                
                $
                211,423
                
                
                $
                -Standby
      letters of credit
                
                
                20,127
                
                
                
                -
                
                
                
                12,508
                
                
                
                -$
                178,501
                
                
                $
                -
                
                
                $
                223,931
                
                
                $
                -





Note 9 – 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.




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.


13




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 principle will not be made in accordance with the contractual terms of the
loan are considered impaired.  The fair values of impaired loans are
estimated using one of several methods, including the collateral value, market
value of similar debt, enterprise value, liquidation value and discounted cash
flows. Those impaired loans not requiring a specific allowance represent loans
for which the fair values of expected repayments or collateral exceed the
recorded investment in such loans.  At September 30, 2009,
substantially all of the impaired loans were evaluated based upon the fair value
of the collateral.  In accordance with ASC 820, impaired loans that
have an allowance established based on the fair value of collateral require
classification in the fair value hierarchy.  When the fair value of
the collateral is based on an observable market price or a current appraised
value, the Company records the loan as nonrecurring Level 2.  When an
appraised value is not available or management determines the fair value of the
collateral is further impaired below the appraised value and there is no
observable market price, the Company records the loan as nonrecurring Level
3.





Foreclosed
Assets


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





Derivative Assets and
Liabilities


Derivative
instruments held or issued by the Company for risk management purposes are
traded in over-the-counter markets where quoted market prices are not readily
available.  For those derivatives, the Company measures fair value
using models that use primarily market observable inputs, such as yield curves
and option volatilities, and include the value associated with counterparty
credit risk.  The Company classifies derivative instruments held or
issued for risk management purposes as recurring Level 2.  As of
September 30, 2009, 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 sheet.


14


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, 2009.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Securities
      available for sale:U.S.
      Treasury
                  
                  $
                  5,999
                  
                  
                  $
                  5,999
                  
                  
                  $
                  -
                  
                  
                  $
                  -U.S.
      Government agencies
                  
                  
                  53,888
                  
                  
                  
                  -
                  
                  
                  
                  53,888
                  
                  
                  
                  -Mortgage-backed
      securities
                  
                  
                  31,329
                  
                  
                  
                  -
                  
                  
                  
                  31,329
                  
                  
                  
                  -Federal
      Home Loan Bank stock
                  
                  
                  2,822
                  
                  
                  
                  -
                  
                  
                  
                  2,822
                  
                  
                  
                  -Federal
      Reserve Bank stock
                  
                  
                  302
                  
                  
                  
                  -
                  
                  
                  
                  302
                  
                  
                  
                  -Other
      equity securities
                  
                  
                  577
                  
                  
                  
                  -
                  
                  
                  
                  577
                  
                  
                  
                  -$
                  94,917
                  
                  
                  $
                  5,999
                  
                  
                  $
                  88,918
                  
                  
                  $
                  -Interest
      rate caps
                  
                  $
                  6,034
                  
                  
                  $
                  -
                  
                  
                  $
                  6,034
                  
                  
                  $
                  -





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, 2009.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars
      in thousands)
                  
                  Fair
      Value
                  
                  
                  (Level
      1)
                  
                  
                  (Level
      2)
                  
                  
                  (Level
      3)Impaired
      loans
                  
                  $
                  15,241
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  15,241Other
      real estate owned
                  
                  
                  2,062
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,062





Impaired
loans had a carrying amount of $15.5 million with a valuation allowance of $226
thousand at September 30, 2009.





Note 10 – Restricted
Investment in Bank Stock





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





Management’s
determination of whether these investments are impaired is based on an
assessment of the ultimate recoverability of their costs rather than by
recognizing temporary declines in value.  The determination of whether
a decline affects the ultimate recoverability of the cost of an investment is
influenced by criteria such as (1) the significance of the decline in net assets
of the issuing bank as compared to the capital stock amount for that bank and
the length of time this situation has persisted, (2) commitments by the issuing
bank to make payments required by law or regulation and the level of such
payments in relation to the operating performance of that bank, and (3) the
impact of legislative and regulatory changes on institutions and, accordingly,
on the customer base of the issuing bank.





During
the third quarter, the FHLB of Atlanta paid its first dividend of
2009.  Prior to the dividend paid in the third quarter of 2009, the
FHLB of Atlanta last paid a dividend in the third quarter of
2008.  Also during the third quarter of 2009, the FHLB of Atlanta
announced that it would not repurchase excess activity-based stock outstanding
as of the end of the second quarter of 2009.  Since December 2008, the
FHLB of Pittsburgh voluntarily suspended the payment of dividends and the
repurchase of excess capital stock from member banks. The FHLB of Pittsburgh
last paid a dividend in the third quarter of 2008.





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





15




Note 11 – 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 Company uses derivative
instruments to hedge its exposure to changes in interest rates.  The
Company does not use derivatives for any trading or other speculative
purposes.





During
the second quarter of 2009, the Company entered into 5-year interest rate swap
agreements with notional amounts of $70 million to effectively fix the interest
rate on $70 million of the Company’s money market deposit accounts at 2.97%.
Because the interest rate swaps did not qualify for the hedge accounting, the
Company restructured the original transactions and purchased interest rate caps
for $6.5 million during the third quarter of 2009. The interest rate caps
qualify for hedge accounting.  At September 30, 2009, the aggregate
fair value of these derivatives was an asset of $6.0 million.  For the
nine months ended September 30, 2009, other noninterest income included a gain
relating to the swap  transactions of $420 thousand which was recorded
in the second quarter of 2009.





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





Note 12 – Repurchase of
Preferred Stock





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





Note 13 – New Accounting
Pronouncements





Pronouncements
adopted


As
discussed in Note 1 – Basis of Presentation, the FASB established the Accounting
Standards Codification as the source of authoritative accounting principles
recognized by the FASB to be applied by non-governmental entities in the
preparation of financial statements in conformity with generally accepted
accounting principles. Rules and interpretive releases of the SEC under
authority of federal securities laws are also sources of authoritative guidance
for SEC registrants. All guidance contained in the ASC carries an equal level of
authority. All non-grandfathered, non-SEC accounting literature not included in
the ASC is superseded and deemed non-authoritative.





FASB ASC Topic 260, “Earnings Per
Share”.New accounting guidance under ASC Topic 260 clarifies
that instruments granted in share-based payment transactions can be
participating securities prior to the requisite service having been rendered. A
basic principle of this guidance is that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities and are to be included in the
computation of EPS pursuant to the two-class method. The provisions of this
guidance are effective for financial statements issued for fiscal years
beginning after December 15, 2008, and interim periods within those years.
All prior-period EPS data presented are required to be adjusted retrospectively
to conform with the provisions of this guidance. The Company adopted this new
accounting guidance effective March 31, 2009, and adoption did not have a
material effect on the Company’s consolidated results of operations or earnings
per share.


16


FASB ASC Topic 805, “Business
Combinations”.  New accounting guidance under ASC Topic 805
recognizes and measures the goodwill acquired in a business combination and
defines a bargain purchase, and requires the acquirer to recognize that excess
as a gain attributable to the acquirer. In contrast, previous accounting
guidance required the “negative goodwill” amount to be allocated as a pro rata
reduction of the amounts assigned to assets acquired. ASC Topic 805 requires
that assets acquired and liabilities assumed in a business combination that
arise from contingencies be recognized at fair value if fair value can be
reasonably estimated. If fair value of such an asset or liability cannot be
reasonably estimated, the asset or liability would generally be recognized in
accordance with ASC Topic 450, “Contingencies.” Under ASC Topic 805, the
requirements of ASC Topic 420, “Exit or Disposal Cost Obligations,” would have
to be met in order to accrue for a restructuring plan in purchase accounting.
This new accounting guidance applies prospectively to business combinations for
which the acquisition date is on or after December 15, 2008. The Company adopted
this guidance effective January 1, 2009.  This new accounting guidance
will change the Company’s accounting treatment for business combinations on a
prospective basis.





FASB ASC Topic 810,
“Consolidation”. During December 2007, the
FASB issued new accounting guidance under ASC Topic 810 to establish accounting
and reporting standards for the noncontrolling interest in a subsidiary and for
the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest
in a subsidiary is an ownership interest in the consolidated entity that should
be reported as equity in the consolidated financial statement, but separate from
the parent’s equity.  This guidance is effective for fiscal years, and
interim periods within those fiscal years, beginning on or after December 15,
2008. Management adopted this new accounting guidance effective January 1, 2009,
and adoption did not have a material impact on the Company’s consolidated
financial condition or results of operations.





FASB ASC Topic 815, “Derivatives and
Hedging”.  New accounting guidance under ASC Topic 815 is
intended to enhance the disclosures required under previous accounting guidance
to include how and why an entity uses derivative instruments, how derivative
instruments and related hedge items are accounted for and their impact on an
entity’s financial positions, results of operations and cash
flows.  This guidance is effective for financial statements issued for
fiscal years and interim periods beginning after November 15,
2008.  Adoption of this new accounting guidance did not have a
material impact on the consolidated financial statements.





FASB ASC Topic 820, “Fair Value
Measurements and Disclosures”. New accounting guidance under ASC Topic
820 addresses concerns regarding (1) determining whether a market is not active
and a transaction is not orderly, (2) recognition and presentation of
other-than-temporary impairments and (3) interim disclosures of fair values of
financial instruments. The guidance is effective for interim and annual periods
ending after June 15, 2009, with early adoption permitted for periods ending
after March 15, 2009. The Company adopted the new accounting guidance effective
June


30, 2009
and adoption did not have a material effect on the Company’s consolidated
results of operations.





FASB ASC Topic 855, “Subsequent
Events”.New accounting guidance under ASC Topic 855
incorporates accounting guidance that originated as U.S. auditing standards into
the body of authoritative literature issued by the FASB.  This
guidance is based on the same principles as those that currently exist in the
auditing standards.  However, the new guidance does make a few changes
such as eliminating Type I and Type II subsequent events and requiring an entity
to disclose the date through which it evaluated subsequent
events.  This guidance is effective for interim or annual periods
ending after June 15, 2009.  The Company adopted this new accounting
guidance effective June 30, 2009 and adoption did not have a material effect on
the Company’s consolidated financial statements.





Pronouncements
issued but not yet effective


FASB ASC Topic 810,
“Consolidation.”  New accounting guidance under ASC Topic 810
amends 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 will be effective January 1, 2010
and is not expected to have a significant impact on the Company’s financial
statements.





FASB ASC Topic 860, “Transfers and
Servicing.” New accounting guidance under ASC Topic 860 amends 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 will be effective January 1, 2010 and is not expected
to have a significant impact on the Company’s financial
statements.


17





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





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





Forward-Looking
Information


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





Introduction


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





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





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





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





Critical
Accounting Policies


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





We
believe that our most critical accounting policy relates to the allowance for
credit losses.  The allowance for credit losses is an estimate of the
losses that may be sustained in the loan portfolio.  The allowance is
based on two basic principles of accounting: (i) ASC Topic 450, “Contingencies”,
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.




18


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.





OVERVIEW





Net
income for the third quarter of 2009 was $1.951 million, or diluted earnings per
common share of $0.23, compared to $3.1 million, or diluted earnings per common
share of $0.37, for the third quarter of 2008.  For the second quarter
of 2009, net income was $354 thousand or $0.04 diluted earnings per common
share.  Annualized return on average assets was 0.66% for the three
months ended September 30, 2009, compared to 1.19% for the same period in
2008.  Annualized return on average stockholders’ equity was 6.03% for
the third quarter of 2009, compared to 9.81% for the third quarter of
2008.  For the second quarter of 2009, annualized return on average
assets was 0.13% and return on average equity was 1.07%.





Net
income for the first nine months of 2009 was $4.2 million, or diluted earnings
per common share of $0.50, compared to $9.2 million, or diluted earnings per
common share of $1.10, for the first nine months of 2008.  Annualized
return on average assets was 0.50% for the nine months ended September 30, 2009,
compared to 1.23% for the same period in 2008. Annualized return on average
stockholders’ equity was 4.08% for the first nine months of 2009, compared to
9.95% for the first nine months of 2008.





During
the first nine months of 2009, net income available to common stockholders was
negatively impacted by $1.9 million in 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. These
dividends and discount accretion had no impact on net income available to common
stockholders for the third quarter of 2009.


19




RESULTS
OF OPERATIONS





Net
Interest Income


Net
interest income for the three months ended September 30, 2009 was $10.4 million,
an increase of 5.2% when compared to the same period last year.  An
increase in average earning assets and lower rates paid on interest bearing
liabilities were sufficient to offset the decline in yields on earning
assets.  The net interest margin was 3.79% for the third quarter of
2009, a decrease of 31 basis points when compared to the third quarter of
2008.  The 400 basis-point reduction in interest rates by the Federal
Reserve during 2008 had a significant impact on the overall yield on earning
assets.  Net interest income increased 3.4% from the second quarter of
2009, also due to a higher volume of average earning assets and lower rates paid
partially offset by lower yields earned.  The net interest margin
decreased six basis points from 3.85% for the second quarter of
2009.





Interest
income was $14.9 million for the third quarter of 2009, a decrease of 2.5% from
the third quarter of 2008.  Average earning assets increased 13.3%
during the third quarter of 2009 when compared to the same period in 2008, while
yields earned decreased 89 basis points to 5.41%.  Average loans
increased 7.7% while the yield earned on loans decreased 57 basis points. Loans
comprised 83.6% of total average earning assets for the third quarter of 2009, a
decrease from the 87.9% for the third quarter of 2008.  The mix of
earning assets shifted from loans and securities to Federal funds sold which
comprised 7.4% of total earning assets compared to 1.8% for the third quarter of
2008. Interest income increased 1.9% when compared to the second quarter of
2009.  Average earning assets increased 3.7% during the third quarter
of 2009 when compared to the second quarter of 2009, while yields earned
decreased 15 basis points.





Interest
expense decreased 16.8% for the three months ended September 30, 2009 when
compared to the same period last year. Average interest bearing liabilities
increased 15.8%, while rates paid decreased 78 basis points to
1.97%.  During the second quarter of 2009, the Company began to
participate in the Promontory Insured Network Deposits Program
(“IND”).  The $165.0 million increase in average interest bearing
deposits for the third quarter of 2009 over the same period of 2008 included
approximately $88.9 million from the IND program.  The Company incurs
the largest amount of interest expense from time deposits.  For the
three months ended September  30, 2009, the average balance of
certificates of deposit $100,000 or more increased 39.5% when compared to the
same period last year, while the average rate paid on these certificates of
deposit decreased 113 basis points to 2.82%.  Comparing the third
quarter of 2009 to the third quarter of 2008, average other time deposits
increased 5.2% while the rate paid on average other time deposits decreased 73
basis points.  Comparing the third quarter of 2009 to the second
quarter of 2009, interest expense decreased 1.3% and average interest bearing
liabilities increased 4.3%, while rates paid decreased 13 basis
points.  Average interest bearing deposits for the third quarter of
2009 included approximately $88.9 million from the IND program, compared to
approximately $60.6 million for the second quarter of 2009.





Net
interest income for the nine months ended September 30, 2009 was $30.6 million,
an increase of 3.4% when compared to the same period last year.  An
increase in the volume of average earning assets and a reduction in the cost of
funds were sufficient to offset the decline in yields on earning
assets.  The net interest margin was 3.90% for the first nine months
of 2009, a decrease of 31 basis points when compared to the first nine months of
2008.





Interest
income was $44.0 million for the first nine months of 2009, a decrease of 5.0%
from the first nine months of 2008.  Average earning assets increased
11.7% during the nine months ended September 30, 2009 when compared to the same
period in 2008, while yields earned decreased 99 basis points to
5.60%.  Comparing the nine months ended September 30, 2009 to the same
period of last year, average loans increased 10.4% while the yield earned on
loans decreased 85 basis points.  Loans comprised 86.2% and 87.2% of
total average earning assets for the first nine months of 2009 and 2008,
respectively.





Interest
expense decreased 19.9% for the nine months ended September 30, 2009 when
compared to the same period last year.  Average interest bearing
liabilities increased 12.3%, while rates paid decreased 84 basis points to
2.10%.  For the nine months ended September 30, 2009, the average
balance of certificates of deposit $100,000 or more increased 35.4% when
compared to the same period last year, while the average rate paid on these
certificates of deposit decreased 113 basis points to 3.13%.  Average
other time deposits increased 6.8%, while the rate paid on average other time
deposits decreased 79 basis points when compared to the first nine months of
2008.


20


Analysis
of Interest Rates and Interest Differentials


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





For the Three Months Ended
                
                
                For the Three Months EndedSeptember 30, 2009
                
                
                September 30, 2008Average
                
                
                Income(1)/
                
                
                Yield/
                
                
                Average
                
                
                Income(1)/
                
                
                Yield/(Dollars in thousands)
                
                Balance
                
                
                Expense
                
                
                Rate
                
                
                Balance
                
                
                Expense
                
                
                RateEarning
      assetsLoans
      (2), (3)
                
                $
                920,241
                
                
                $
                14,042
                
                
                
                6.05
                %
                
                $
                854,371
                
                
                $
                14,225
                
                
                
                6.62
                %Investment
      securitiesTaxable
                
                
                89,101
                
                
                
                800
                
                
                
                3.56
                
                
                
                84,713
                
                
                
                924
                
                
                
                4.34Tax-exempt
                
                
                8,125
                
                
                
                118
                
                
                
                5.76
                
                
                
                10,320
                
                
                
                145
                
                
                
                5.63Federal
      funds sold
                
                
                81,466
                
                
                
                31
                
                
                
                0.16
                
                
                
                17,921
                
                
                
                79
                
                
                
                1.74Interest
      bearing deposits
                
                
                1,605
                
                
                
                4
                
                
                
                0.77
                
                
                
                4,218
                
                
                
                21
                
                
                
                2.01Total
      earning assets
                
                
                1,100,538
                
                
                
                14,995
                
                
                
                5.41
                %
                
                
                971,543
                
                
                
                15,394
                
                
                
                6.30
                %Cash
      and due from banks
                
                
                20,042
                
                
                
                
                
                
                
                
                
                
                
                14,306Other
      assets
                
                
                57,049
                
                
                
                
                
                
                
                
                
                
                
                50,358Allowance
      for credit losses
                
                
                (11,042
                )
                
                
                
                
                
                
                
                
                
                
                (8,468
                )Total
      assets
                
                $
                1,166,587
                
                
                
                
                
                
                
                
                
                
                $
                1,027,739Interest
      bearing liabilitiesDemand
      deposits
                
                $
                125,233
                
                
                
                82
                
                
                
                0.26
                %
                
                $
                112,000
                
                
                
                97
                
                
                
                0.34
                %Money
      market and savings deposits
                
                
                245,801
                
                
                
                412
                
                
                
                0.67
                
                
                
                183,408
                
                
                
                673
                
                
                
                1.46Certificates
      of deposit $100,000 or more
                
                
                274,580
                
                
                
                1,954
                
                
                
                2.82
                
                
                
                196,810
                
                
                
                1,953
                
                
                
                3.95Other
      time deposits
                
                
                237,757
                
                
                
                1,920
                
                
                
                3.20
                
                
                
                226,110
                
                
                
                2,232
                
                
                
                3.93Interest
      bearing deposits
                
                
                883,371
                
                
                
                4,368
                
                
                
                1.96
                
                
                
                718,328
                
                
                
                4,955
                
                
                
                2.74Short-term
      borrowings
                
                
                18,373
                
                
                
                19
                
                
                
                0.42
                
                
                
                53,450
                
                
                
                344
                
                
                
                2.56Long-term
      debt
                
                
                1,947
                
                
                
                98
                
                
                
                19.90
                
                
                
                8,485
                
                
                
                90
                
                
                
                4.21Total
      interest bearing liabilities
                
                
                903,691
                
                
                
                4,485
                
                
                
                1.97
                %
                
                
                780,263
                
                
                
                5,389
                
                
                
                2.75
                %Noninterest
      bearing deposits
                
                
                117,933
                
                
                
                
                
                
                
                
                
                
                
                111,915Other
      liabilities
                
                
                16,554
                
                
                
                
                
                
                
                
                
                
                
                10,978Stockholders’
      equity
                
                
                128,409
                
                
                
                
                
                
                
                
                
                
                
                124,583Total
      liabilities and stockholders’ equity
                
                $
                1,166,587
                
                
                
                
                
                
                
                
                
                
                $
                1,027,739Net
      interest spread
                
                
                
                
                
                $
                10,510
                
                
                
                3.44
                %
                
                
                
                
                
                $
                10,005
                
                
                
                3.55
                %Net
      interest margin
                
                
                
                
                
                
                
                
                
                
                3.79
                %
                
                
                
                
                
                
                
                
                
                
                4.10
                %Tax-equivalent
      adjustmentInvestment
      securities
                
                
                
                
                
                $
                41
                
                
                
                
                
                
                
                
                
                
                $
                50Loans
                
                
                
                
                
                
                41
                
                
                
                
                
                
                
                
                
                
                
                46$
                82
                
                
                
                
                
                
                
                
                
                
                $
                96


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, 2009 and 2008.





For the Nine Months Ended
                
                
                For the Nine Months EndedSeptember 30, 2009
                
                
                September 30, 2008Average
                
                
                Income(1)/
                
                
                Yield/
                
                
                Average
                
                
                Income(1)/
                
                
                Yield/(Dollars in thousands)
                
                Balance
                
                
                Expense
                
                
                Rate
                
                
                Balance
                
                
                Expense
                
                
                RateEarning
      assetsLoans
      (2), (3)
                
                $
                910,842
                
                
                $
                41,497
                
                
                
                6.09
                %
                
                $
                824,775
                
                
                $
                42,829
                
                
                
                6.94
                %Investment
      securitiesTaxable
                
                
                79,797
                
                
                
                2,324
                
                
                
                3.89
                
                
                
                86,633
                
                
                
                2,949
                
                
                
                4.55Tax-exempt
                
                
                8,443
                
                
                
                371
                
                
                
                5.87
                
                
                
                11,395
                
                
                
                502
                
                
                
                5.89Federal
      funds sold
                
                
                53,227
                
                
                
                61
                
                
                
                0.15
                
                
                
                17,893
                
                
                
                284
                
                
                
                2.12Interest
      bearing deposits
                
                
                4,053
                
                
                
                11
                
                
                
                0.35
                
                
                
                4,746
                
                
                
                88
                
                
                
                2.49Total
      earning assets
                
                
                1,056,362
                
                
                
                44,264
                
                
                
                5.60
                %
                
                
                945,442
                
                
                
                46,652
                
                
                
                6.59
                %Cash
      and due from banks
                
                
                16,960
                
                
                
                
                
                
                
                
                
                
                
                14,408Other
      assets
                
                
                52,700
                
                
                
                
                
                
                
                
                
                
                
                50,690Allowance
      for credit losses
                
                
                (10,523
                )
                
                
                
                
                
                
                
                
                
                
                (8,097
                )Total
      assets
                
                $
                1,115,499
                
                
                
                
                
                
                
                
                
                
                $
                1,002,443Interest
      bearing liabilitiesDemand
      deposits
                
                $
                123,821
                
                
                
                230
                
                
                
                0.25
                %
                
                $
                112,309
                
                
                
                363
                
                
                
                0.43
                %Money
      market and savings deposits
                
                
                207,588
                
                
                
                937
                
                
                
                0.60
                
                
                
                180,087
                
                
                
                2,032
                
                
                
                1.51Certificates
      of deposit $100,000 or more
                
                
                252,978
                
                
                
                5,920
                
                
                
                3.13
                
                
                
                186,879
                
                
                
                5,963
                
                
                
                4.26Other
      time deposits
                
                
                236,643
                
                
                
                6,007
                
                
                
                3.39
                
                
                
                221,564
                
                
                
                6,937
                
                
                
                4.18Interest
      bearing deposits
                
                
                821,030
                
                
                
                13,094
                
                
                
                2.13
                
                
                
                700,839
                
                
                
                15,295
                
                
                
                2.92Short-term
      borrowings
                
                
                27,718
                
                
                
                96
                
                
                
                0.46
                
                
                
                47,409
                
                
                
                1,026
                
                
                
                2.89Long-term
      debt
                
                
                5,925
                
                
                
                247
                
                
                
                5.57
                
                
                
                12,821
                
                
                
                456
                
                
                
                4.75Total
      interest bearing liabilities
                
                
                854,673
                
                
                
                13,437
                
                
                
                2.10
                %
                
                
                761,069
                
                
                
                16,777
                
                
                
                2.94
                %Noninterest
      bearing deposits
                
                
                110,663
                
                
                
                
                
                
                
                
                
                
                
                106,328Other
      liabilities
                
                
                13,074
                
                
                
                
                
                
                
                
                
                
                
                11,419Stockholders’
      equity
                
                
                137,089
                
                
                
                
                
                
                
                
                
                
                
                123,627Total
      liabilities and stockholders’ equity
                
                $
                1,115,499
                
                
                
                
                
                
                
                
                
                
                $
                1,002,443Net
      interest spread
                
                
                
                
                
                $
                30,827
                
                
                
                3.50
                %
                
                
                
                
                
                $
                29,875
                
                
                
                3.65
                %Net
      interest margin
                
                
                
                
                
                
                
                
                
                
                3.90
                %
                
                
                
                
                
                
                
                
                
                
                4.22
                %Tax-equivalent
      adjustmentInvestment
      securities
                
                
                
                
                
                $
                130
                
                
                
                
                
                
                
                
                
                
                $
                175Loans
                
                
                
                
                
                
                125
                
                
                
                
                
                
                
                
                
                
                
                129$
                255
                
                
                
                
                
                
                
                
                
                
                $
                304





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


(2)
            Average
      loan balances include nonaccrual
loans.


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





Noninterest
Income


Noninterest
income for the third quarter of 2009 decreased $527 thousand, or 10.0%, when
compared to the third quarter of 2008. The decrease from the third quarter of
2008 was primarily due to a $1.3 million gain on the sale of a bank branch in
August 2008.  The gain on the branch sale was partially offset by a
$371 thousand other than temporary impairment of Freddie Mac Preferred Stock and
a $337 thousand loss on the sale of the Company’s investment in Delmarva Bank
Data Processing Center, Inc., an unconsolidated subsidiary.  A mark to
market gain on interest rate swaps of $420 thousand during the second quarter of
2009 and a decrease in insurance agency commissions of $149 thousand accounted
for most of the decrease from the second quarter of 2009.





Noninterest
income for the first nine months of 2009 decreased $526 thousand, or 3.3%, when
compared to the same period in 2008.  The mark to market gain on
interest rate swaps of $420 thousand during the second quarter of 2009, offset
by a decrease in insurance agency commissions of $623 thousand, accounted for
part of the decrease compared to the first nine months of 2008.  In
addition, noninterest income for the first nine months in 2008 included the
previously mentioned $1.3 million gain on the branch sale and the $708 thousand
combined loss relating to the other than temporary impairment and the sale of
the investment in the unconsolidated subsidiary.


22


Noninterest
Expense


Noninterest
expense for the third quarter of 2009 increased $868 thousand, or 9.2%, when
compared to the third quarter of 2008.  The increase was primarily
attributable to higher FDIC insurance premiums of $323 thousand and write-downs
of other real estate owned of $159 thousand.  Noninterest expense
decreased $396 thousand, or 3.7%, from the second quarter of 2009 primarily due
to lower FDIC insurance premiums of $462 thousand.  The second quarter
2009 FDIC insurance premium included a special one-time assessment of $513
thousand.





Noninterest
expense for the first nine months of 2009 increased $2.1 million, or 7.4%, when
compared to the first nine months of 2008.  The increase was primarily
attributable to higher FDIC insurance premiums of $1.4 million.  The
increase in FDIC insurance premiums was attributable to higher overall rates, a
one-time special assessment of $513 thousand and growth in the Company’s total
deposits.





Income
Taxes


The
Company’s effective tax rate was 38.0% for the three months ended September 30,
2009, compared to 36.7% for the same period last year.  For the nine
months ended September 30, 2009 and 2008, the effective tax rates were 38.2% and
37.8%, respectively.  Management is not aware of any development with
respect to tax law or our tax structure that is likely to have a material impact
on our future effective tax rate.





ANALYSIS
OF FINANCIAL CONDITION





Loans


Loans,
net of unearned income, totaled $918.6 million at September 30, 2009, an
increase of $30.1 million, or 3.4%, since December 31, 2008.  Average
loans, net of unearned income, were $920.2 million for the three months ended
September 30, 2009, an increase of $65.9 million, or 7.7%, when compared to the
same period last year.  Average loans, net of unearned income, were
$910.8 million for the nine months ended September 30, 2009, an increase of
$86.1 million, or 10.4%, when compared to the same period in 2008.





Allowance
for Credit Losses


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





The
provision for credit losses for the three months ended September 30, 2009 and
2008 was $1.7 million and $875 thousand, respectively. The provision for credit
losses for the second quarter of 2009 was $1.7 million.  The continued
increased level of provision expense was the result of sustained growth in the
loan portfolio, the overall increase in nonperforming assets and loan
charge-offs, and management’s assessment of general economic
conditions.  The provision for credit losses for the nine months ended
September 30, 2009 and 2008 was $5.3 million and $2.0 million,
respectively.  We continue to emphasize credit quality and believe
that our underwriting guidelines are strong.  However, the
continuation or worsening of the current economic recession will likely cause us
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 $1.8 million for the three months ended September 30, 2009,
compared to $539 thousand for the same period last year and $1.6 million for the
second quarter of 2009.  The allowance for credit losses as a
percentage of average loans was 1.17% for the third quarter of 2009, 1.01% for
the third quarter of 2008 and 1.18% for the second quarter of
2009.  Net charge-offs were $3.9 million for the first nine months of
2009, compared to $885 thousand for the same period in 2008. The allowance for
credit losses as a percentage of average loans increased to 1.18% for the first
nine months of 2009 from 1.04% for the same period last
year.  Nonperforming assets were $17.5 million at September 30, 2009,
compared to $8.3 million at December 31, 2008, with nonaccrual loans increasing
$7.4 million and other real estate owned increasing $1.9 million.  The
increase in nonaccrual loans was primarily in residential real
estate.  Loans past due 90 days and still accruing at September 30,
2009 increased to $9.1 million from $1.4 million at December 31,
2008.  The increase was primarily related to a $5 million secured
participation loan purchased from a regional bank.  The customer
continues to make interest payments, but the loan has matured and the lead bank
is negotiating a renewal with the customer.  Based on management’s
quarterly evaluation of the adequacy of the allowance for credit losses, it
believes that the allowance for credit losses and the related provision were
adequate at September 30, 2009 to provide for probable losses inherent in our
loan portfolio.


23


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)
                
                2009
                
                
                2008
                
                
                2009
                
                
                2008Allowance
      balance – beginning of period
                
                $
                10,784
                
                
                $
                8,282
                
                
                $
                9,320
                
                
                $
                7,551Charge-offs:Real
      estate – construction
                
                
                (148
                )
                
                
                (381
                )
                
                
                (363
                )
                
                
                (381
                )Real
      estate – residential
                
                
                (811
                )
                
                
                (74
                )
                
                
                (1,762
                )
                
                
                (145
                )Real
      estate – commercial
                
                
                (522
                )
                
                
                -
                
                
                
                (695
                )
                
                
                -Commercial
                
                
                (250
                )
                
                
                (185
                )
                
                
                (977
                )
                
                
                (381
                )Consumer
                
                
                (109
                )
                
                
                (63
                )
                
                
                (308
                )
                
                
                (198
                )Totals
                
                
                (1,840
                )
                
                
                (703
                )
                
                
                (4,105
                )
                
                
                (1,105
                )Recoveries:Real
      estate – construction
                
                
                -
                
                
                
                -
                
                
                
                2
                
                
                
                -Real
      estate – residential
                
                
                14
                
                
                
                10
                
                
                
                67
                
                
                
                18Real
      estate – commercial
                
                
                1
                
                
                
                -
                
                
                
                1
                
                
                
                -Commercial
                
                
                -
                
                
                
                120
                
                
                
                4
                
                
                
                127Consumer
                
                
                62
                
                
                
                34
                
                
                
                116
                
                
                
                75Totals
                
                
                77
                
                
                
                164
                
                
                
                190
                
                
                
                220Net
      charge-offs
                
                
                (1,763
                )
                
                
                (539
                )
                
                
                (3,915
                )
                
                
                (885
                )Provision
      for credit losses
                
                
                1,702
                
                
                
                875
                
                
                
                5,318
                
                
                
                1,952Allowance
      balance – end of period
                
                $
                10,723
                
                
                $
                8,618
                
                
                $
                10,723
                
                
                $
                8,618Average
      loans outstanding during the period
                
                $
                920,241
                
                
                $
                854,371
                
                
                $
                910,842
                
                
                $
                824,775Net
      charge-offs (annualized) as a percentage of average loans outstanding
      during the period
                
                
                0.76
                %
                
                
                0.25
                %
                
                
                0.57
                %
                
                
                0.14
                %Allowance
      for credit losses at period end as a percentage of average
      loans
                
                
                1.17
                %
                
                
                1.01
                %
                
                
                1.18
                %
                
                
                1.04
                %





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





We have a
concentration of commercial real estate loans.  Commercial real estate
loans, excluding construction and land development loans, were approximately
$307.7 million, or 33.5% of total loans, at September 30, 2009, compared to
$304.4 million, or 34.3% of total loans, at December 31,
2008.  Construction and land development loans were $168.8 million, or
18.4% of total loans, at September 30, 2009, compared to $179.8 million, or
20.2% of total loans, at December 31, 2008.  We do not engage in
foreign or subprime lending activities.


24


Nonperforming
Assets


The
following table summarizes our nonperforming and past due assets:





September 30,
                    
                    
                    December 31,(Dollars in thousands)
                    
                    2009
                    
                    
                    2008Nonperforming
      assetsNonaccrual
      loansReal
      estate – construction
                    
                    $
                    5,403
                    
                    
                    $
                    5,277Real
      estate – residential
                    
                    
                    7,082
                    
                    
                    
                    1,015Real
      estate – commercial
                    
                    
                    866
                    
                    
                    
                    1,682Commercial
                    
                    
                    2,070
                    
                    
                    
                    137Consumer
                    
                    
                    46
                    
                    
                    
                    4Total
      nonaccrual loans
                    
                    
                    15,467
                    
                    
                    
                    8,115Other
      real estate owned
                    
                    
                    2,062
                    
                    
                    
                    148Total
      nonperforming assets
                    
                    
                    17,529
                    
                    
                    
                    8,263Loans
      90 days past due and still accruing
                    
                    
                    9,118
                    
                    
                    
                    1,381Total
      nonperforming assets and past due loans
                    
                    $
                    26,647
                    
                    
                    $
                    9,644





Investment
Securities


Investment
securities totaled $103.9 million at September 30, 2009, compared to $89.5
million at December 31, 2008.  The average balance of investment
securities was $97.2 million for the three months ended September 30, 2009,
compared to $95.0 million for the same period in 2008.  The increases
in the period end and three-month average balances reflected the investment of
excess deposits. The tax equivalent yields on investment securities were 3.75%
and 4.48% for the three months ended September 30, 2009 and 2008,
respectively.  The average balance of investment securities was $88.2
million for the nine months ended September 30, 2009, compared to $98.0 million
for the same period in 2008.  The tax equivalent yields on investment
securities were 4.08% and 4.70% for the nine months ended September 30, 2009 and
2008, respectively. The decrease in average balances for the nine month period
compared to one year ago reflected the use of proceeds from maturing securities
to fund loan growth.





Deposits


Total
deposits at September 30, 2009 were $992.2 million, compared to $845.4 million
at December 31, 2008.  All categories of deposits grew from the
comparable amounts at the end of 2008 except for interest bearing demand
deposits, which decreased 9.3%.  The largest growth was in money
market and savings accounts, which increased $92.6 million, or 61.4%, of which
approximately $80 million is from our participation in the IND program which
began in the second quarter of 2009.





Short-Term
Borrowings


Short-term
borrowings at September 30, 2009 and December 31, 2008 were $17.7 million and
$53.0 million, respectively.  Short-term borrowings consisted of
securities sold under agreements to repurchase, overnight borrowings from
correspondent banks and short-term advances from the 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, 2008
was primarily due to the repayment of advances from the FHLB.





Long-Term
Debt


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





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





The FHLB
borrowings were repaid in July of 2009.  The Company incurred a $78
thousand early repayment penalty which was reflected in interest
expense.


25


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 Centreville National Bank 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 $56.3 million in the aggregate at
September 30, 2009. Management is not aware of any trends or demands,
commitments, events or uncertainties that are likely to materially affect our
future ability to maintain liquidity at satisfactory levels.





Total
stockholders’ equity was $128.2 million at September 30, 2009, compared to
$127.4 million at December 31, 2008. The slight increase in stockholders’ equity
since the end of 2008 included the $1.5 million increase in warrants and net
income exceeding dividends paid by $211 thousand. Also, net unrealized gains on
investment securities available for sale decreased $276 thousand and unrealized
losses on cash flow hedging activities increased $652 thousand since the end of
2008, resulting in accumulated other comprehensive income of $465 thousand at
September 30, 2009.





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





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





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





MinimumSeptember
      30,
                    
                    
                    December
      31,
                    
                    
                    Regulatory2009
                    
                    
                    2008
                    
                    
                    RequirementsTier
      1 risk-based capital ratio
                    
                    
                    11.44
                    %
                    
                    
                    11.65
                    %
                    
                    
                    4.00
                    %Total
      risk-based capital ratio
                    
                    
                    12.64
                    %
                    
                    
                    12.74
                    %
                    
                    
                    8.00
                    %Leverage
      ratio
                    
                    
                    9.28
                    %
                    
                    
                    10.27
                    %
                    
                    
                    4.00
                    %





Item
3.  Quantitative and Qualitative Disclosures about Market
Risk.





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





Item
4.  Controls and Procedures.





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


26


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





There was
no change in our internal control over financial reporting during the third
quarter of 2009 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.





PART
II – OTHER INFORMATION





Item
1A.  Risk Factors.





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





Item 6.  Exhibits.





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





SIGNATURES





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





SHORE
      BANCSHARES, INC.Date:
      November 9, 2009
                BY:
                /s/ W. Moorhead VermilyeW.
      Moorhead VermilyePresident/Chief
      Executive OfficerDate:
      November 9, 2009
                BY:
                /s/ Susan E. LeavertonSusan
      E. Leaverton, CPATreasurer/Principal
      Accounting Officer


27


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).


28