UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549








FORM
10-Q





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





For the
Quarterly Period Ended June 30, 2010





OR





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





For the
transition period from ________ to ________





Commission
file number 0-22345





SHORE BANCSHARES,
INC.


(Exact
name of registrant as specified in its charter)





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





(410)
822-1400


Registrant’s
Telephone Number, Including Area Code





N/A


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





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





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





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





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





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





APPLICABLE
ONLY TO CORPORATE ISSUERS





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date:  8,443,436 shares of common
stock outstanding as of July 31, 2010.





INDEX





PagePart
      I. Financial Information
                        2Item
      1.  Financial Statements
                        2Consolidated
      Balance Sheets -June
      30, 2010 (unaudited) and December 31, 2009
                        2Consolidated
      Statements of Income (Loss) -For
      the three and six months ended June 30, 2010 and 2009
      (unaudited)
                        3Consolidated
      Statements of Changes in Stockholders’ Equity -For
      the six months ended June 30, 2010 and 2009 (unaudited)
                        4Consolidated
      Statements of Comprehensive Income (Loss) -For
      the three and six months ended June 30, 2010 and 2009
      (unaudited)
                        5Consolidated
      Statements of Cash Flows -For
      the six months ended June 30, 2010 and 2009 (unaudited)
                        6Notes
      to Consolidated Financial Statements (unaudited)
                        7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                        17Item
      3.  Quantitative and Qualitative Disclosures about Market
      Risk
                        27Item
      4.  Controls and Procedures
                        27Part
      II.  Other Information
                        27Item
      1A.  Risk Factors
                        27Item
      6.  Exhibits
                        28Signatures
                        28Exhibit
      Index
                        29


1


PART
I – FINANCIAL INFORMATION


Item
1.  Financial Statements.


SHORE
BANCSHARES, INC.


CONSOLIDATED
BALANCE SHEETS


(Dollars
in thousands, except per share amounts)





June 30,
                      
                      
                      December 31,2010
                      
                      
                      2009(Unaudited)ASSETSCash
      and due from banks
                      
                      $
                      16,645
                      
                      
                      $
                      14,411Interest-bearing
      deposits with other banks
                      
                      
                      15,652
                      
                      
                      
                      598Federal
      funds sold
                      
                      
                      32,372
                      
                      
                      
                      60,637Investment
      securities:Available
      for sale, at fair value
                      
                      
                      98,211
                      
                      
                      
                      97,595Held
      to maturity, at amortized cost – fair value of $8,523 (2010) and $9,012
      (2009)
                      
                      
                      8,345
                      
                      
                      
                      8,940Loans
                      
                      
                      905,477
                      
                      
                      
                      916,557Less:  allowance
      for credit losses
                      
                      
                      (13,289
                      )
                      
                      
                      (10,876
                      )Loans,
      net
                      
                      
                      892,188
                      
                      
                      
                      905,681Premises
      and equipment, net
                      
                      
                      14,924
                      
                      
                      
                      14,307Goodwill
                      
                      
                      15,954
                      
                      
                      
                      15,954Other
      intangible assets, net
                      
                      
                      5,148
                      
                      
                      
                      5,406Other
      real estate and other assets owned, net
                      
                      
                      1,428
                      
                      
                      
                      2,572Other
      assets
                      
                      
                      28,329
                      
                      
                      
                      30,415TOTAL
      ASSETS
                      
                      $
                      1,129,196
                      
                      
                      $
                      1,156,516LIABILITIESDeposits:Noninterest-bearing
      demand
                      
                      $
                      121,410
                      
                      
                      $
                      122,492Interest-bearing
      demand
                      
                      
                      136,041
                      
                      
                      
                      133,946Money
      market and savings
                      
                      
                      256,975
                      
                      
                      
                      249,793Certificates
      of deposit $100,000 or more
                      
                      
                      244,048
                      
                      
                      
                      262,663Other
      time
                      
                      
                      213,134
                      
                      
                      
                      222,043Total
      deposits
                      
                      
                      971,608
                      
                      
                      
                      990,937Short-term
      borrowings
                      
                      
                      17,864
                      
                      
                      
                      20,404Accrued
      expenses and other liabilities
                      
                      
                      13,629
                      
                      
                      
                      15,936Long-term
      debt
                      
                      
                      1,429
                      
                      
                      
                      1,429TOTAL
      LIABILITIES
                      
                      
                      1,004,530
                      
                      
                      
                      1,028,706STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01 per share; shares authorized – 35,000,000; shares
      issued and outstanding – 8,443,436 (2010) and 8,418,963 (2009)
                      
                      
                      84
                      
                      
                      
                      84Warrant
                      
                      
                      1,543
                      
                      
                      
                      1,543Additional
      paid in capital
                      
                      
                      30,081
                      
                      
                      
                      29,872Retained
      earnings
                      
                      
                      94,021
                      
                      
                      
                      96,151Accumulated
      other comprehensive (loss) income
                      
                      
                      (1,063
                      )
                      
                      
                      160TOTAL
      STOCKHOLDERS’ EQUITY
                      
                      
                      124,666
                      
                      
                      
                      127,810TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                      
                      $
                      1,129,196
                      
                      
                      $
                      1,156,516





See
accompanying notes to Consolidated Financial Statements.


2


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME (LOSS) (Unaudited)


(Dollars
in thousands, except per share amounts)





For the Three Months Ended
                
                
                For the Six Months EndedJune 30,
                
                
                June 30,2010
                
                
                2009
                
                
                2010
                
                
                2009INTEREST
      INCOMEInterest
      and fees on loans
                
                $
                13,047
                
                
                $
                13,754
                
                
                $
                25,921
                
                
                $
                27,371Interest
      and dividends on investment securities:Taxable
                
                
                846
                
                
                
                768
                
                
                
                1,728
                
                
                
                1,524Tax-exempt
                
                
                56
                
                
                
                79
                
                
                
                115
                
                
                
                164Interest
      on federal funds sold
                
                
                14
                
                
                
                23
                
                
                
                26
                
                
                
                30Interest
      on deposits with other banks
                
                
                4
                
                
                
                6
                
                
                
                5
                
                
                
                7Total
      interest income
                
                
                13,967
                
                
                
                14,630
                
                
                
                27,795
                
                
                
                29,096INTEREST
      EXPENSEInterest
      on deposits
                
                
                3,242
                
                
                
                4,441
                
                
                
                6,627
                
                
                
                8,726Interest
      on short-term borrowings
                
                
                19
                
                
                
                28
                
                
                
                51
                
                
                
                77Interest
      on long-term debt
                
                
                15
                
                
                
                75
                
                
                
                31
                
                
                
                149Total
      interest expense
                
                
                3,276
                
                
                
                4,544
                
                
                
                6,709
                
                
                
                8,952NET
      INTEREST INCOME
                
                
                10,691
                
                
                
                10,086
                
                
                
                21,086
                
                
                
                20,144Provision
      for credit losses
                
                
                4,917
                
                
                
                1,681
                
                
                
                12,534
                
                
                
                3,616NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                
                
                5,774
                
                
                
                8,405
                
                
                
                8,552
                
                
                
                16,528NONINTEREST
      INCOMEService
      charges on deposit accounts
                
                
                831
                
                
                
                888
                
                
                
                1,617
                
                
                
                1,697Trust
      and investment fee income
                
                
                372
                
                
                
                258
                
                
                
                788
                
                
                
                476Investment
      securities gains
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                49Insurance
      agency commissions
                
                
                2,595
                
                
                
                2,893
                
                
                
                5,484
                
                
                
                6,228Other
      noninterest income
                
                
                770
                
                
                
                1,308
                
                
                
                1,561
                
                
                
                2,247Total
      noninterest income
                
                
                4,568
                
                
                
                5,347
                
                
                
                9,450
                
                
                
                10,697NONINTEREST
      EXPENSESalaries
      and wages
                
                
                4,363
                
                
                
                4,759
                
                
                
                8,853
                
                
                
                9,299Employee
      benefits
                
                
                758
                
                
                
                1,200
                
                
                
                2,039
                
                
                
                2,580Occupancy
      expense
                
                
                597
                
                
                
                587
                
                
                
                1,219
                
                
                
                1,136Furniture
      and equipment expense
                
                
                313
                
                
                
                302
                
                
                
                613
                
                
                
                616Data
      processing
                
                
                660
                
                
                
                580
                
                
                
                1,291
                
                
                
                1,190Directors’
      fees
                
                
                105
                
                
                
                117
                
                
                
                226
                
                
                
                285Amortization
      of other intangible assets
                
                
                129
                
                
                
                129
                
                
                
                258
                
                
                
                258Insurance
      agency commissions expense
                
                
                464
                
                
                
                537
                
                
                
                892
                
                
                
                1,087FDIC
      insurance premium expense
                
                
                460
                
                
                
                919
                
                
                
                941
                
                
                
                1,163Other
      noninterest expenses
                
                
                1,839
                
                
                
                1,563
                
                
                
                3,677
                
                
                
                2,962Total
      noninterest expense
                
                
                9,688
                
                
                
                10,693
                
                
                
                20,009
                
                
                
                20,576INCOME
      (LOSS) BEFORE INCOME TAXES
                
                
                654
                
                
                
                3,059
                
                
                
                (2,007
                )
                
                
                6,649Income
      tax expense (benefit)
                
                
                209
                
                
                
                1,166
                
                
                
                (890
                )
                
                
                2,543NET
      INCOME (LOSS)
                
                
                445
                
                
                
                1,893
                
                
                
                (1,117
                )
                
                
                4,106Preferred
      stock dividends and discount accretion
                
                
                -
                
                
                
                1,539
                
                
                
                -
                
                
                
                1,876Net
      income (loss) available to common shareholders
                
                $
                445
                
                
                $
                354
                
                
                $
                (1,117
                )
                
                $
                2,230Basic
      net earnings (loss) per common share
                
                $
                0.05
                
                
                $
                0.04
                
                
                $
                (0.13
                )
                
                $
                0.27Diluted
      net earnings (loss) per common share
                
                $
                0.05
                
                
                $
                0.04
                
                
                $
                (0.13
                )
                
                $
                0.27Dividends
      paid per common share
                
                $
                0.06
                
                
                $
                0.16
                
                
                $
                0.12
                
                
                $
                0.32





See
accompanying notes to Consolidated Financial Statements.


3


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)


For the
Six Months Ended June 30, 2010 and 2009


(Dollars
in thousands, except per share amounts)





AccumulatedAdditional
                                    
                                    
                                    
                                    
                                    
                                    Other
                                    
                                    
                                    TotalPreferred
                                    
                                    
                                    Common
                                    
                                    
                                    
                                    
                                    
                                    Paid
      in
                                    
                                    
                                    Retained
                                    
                                    
                                    Comprehensive
                                    
                                    
                                    Stockholders’Stock
                                    
                                    
                                    Stock
                                    
                                    
                                    Warrant
                                    
                                    
                                    Capital
                                    
                                    
                                    Earnings
                                    
                                    
                                    Income
      (Loss)
                                    
                                    
                                    EquityBalances,
      January 1, 2010
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    84
                                    
                                    
                                    $
                                    1,543
                                    
                                    
                                    $
                                    29,872
                                    
                                    
                                    $
                                    96,151
                                    
                                    
                                    $
                                    160
                                    
                                    
                                    $
                                    127,810Comprehensive
      income:Net
      loss
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,117
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,117
                                    )Unrealized
      gains on available-for-sale securities, net of taxes
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    844
                                    
                                    
                                    
                                    844Unrealized
      losses on cash flow hedging activities, net of taxes
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (2,067
                                    )
                                    
                                    
                                    (2,067
                                    )Total
      comprehensive income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (2,340
                                    )Stock-based
      compensation expense
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    209
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    209Cash
      dividends paid ($0.12 per share)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,013
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,013
                                    )Balances,
      June 30, 2010
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    84
                                    
                                    
                                    $
                                    1,543
                                    
                                    
                                    $
                                    30,081
                                    
                                    
                                    $
                                    94,021
                                    
                                    
                                    $
                                    (1,063
                                    )
                                    
                                    $
                                    124,666Balances,
      January 1, 2009
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    84
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    29,768
                                    
                                    
                                    $
                                    96,140
                                    
                                    
                                    $
                                    1,393
                                    
                                    
                                    $
                                    127,385Comprehensive
      income:Net
      income
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    4,106
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    4,106Unrealized
      losses on available-for-sale securities, net of taxes
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (639
                                    )
                                    
                                    
                                    (639
                                    )Total
      comprehensive income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    3,467Warrant
      issued
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,543
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,543Preferred
      shares issued pursuant to TARP
                                    
                                    
                                    25,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    25,000Discount
      from issuance of preferred stock
                                    
                                    
                                    (1,543
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,543
                                    )Discount
      accretion
                                    
                                    
                                    68
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (68
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Repurchase
      of preferred stock
                                    
                                    
                                    (23,525
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (23,525
                                    )Common
      shares issued for employee stock-based awards
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2Stock-based
      compensation expense
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    46
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    46Preferred
      stock dividends
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,808
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,808
                                    )Cash
      dividends paid ($0.32 per share)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (2,691
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (2,691
                                    )Balances,
      June 30, 2009
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    84
                                    
                                    
                                    $
                                    1,543
                                    
                                    
                                    $
                                    29,816
                                    
                                    
                                    $
                                    95,679
                                    
                                    
                                    $
                                    754
                                    
                                    
                                    $
                                    127,876





See
accompanying notes to Consolidated Financial Statements.


4


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)


(Dollars
in thousands)





For the Three Months Ended
                                    June 30,
                                  
                                  
                                  For the Six Months Ended
                                    June 30,2010
                                  
                                  
                                  2009
                                  
                                  
                                  2010
                                  
                                  
                                  2009Net
      income (loss)
                                  
                                  $
                                  445
                                  
                                  
                                  $
                                  1,893
                                  
                                  
                                  $
                                  (1,117
                                  )
                                  
                                  $
                                  4,106Other
      comprehensive (loss) income:Securities
      available for sale:Unrealized
      holding gains (losses) on available-for-sale securities
                                  
                                  
                                  1,338
                                  
                                  
                                  
                                  (447
                                  )
                                  
                                  
                                  1,412
                                  
                                  
                                  
                                  (1,014
                                  )Tax
      effect
                                  
                                  
                                  (538
                                  )
                                  
                                  
                                  178
                                  
                                  
                                  
                                  (568
                                  )
                                  
                                  
                                  404Reclassification
      of gains recognized in net income
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (49
                                  )Tax
      effect
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  20Net
      of tax amount
                                  
                                  
                                  800
                                  
                                  
                                  
                                  (269
                                  )
                                  
                                  
                                  844
                                  
                                  
                                  
                                  (639
                                  )Cash
      flow hedging activities:Unrealized
      holding losses on cash flow hedging activities
                                  
                                  
                                  (2,135
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (3,466
                                  )
                                  
                                  
                                  -Tax
      effect
                                  
                                  
                                  862
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,399
                                  
                                  
                                  
                                  -Net
      of tax amount
                                  
                                  
                                  (1,273
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,067
                                  )
                                  
                                  
                                  -Total
      other comprehensive loss
                                  
                                  
                                  (473
                                  )
                                  
                                  
                                  (269
                                  )
                                  
                                  
                                  (1,223
                                  )
                                  
                                  
                                  (639
                                  )Comprehensive
      (loss) income
                                  
                                  $
                                  (28
                                  )
                                  
                                  $
                                  1,624
                                  
                                  
                                  $
                                  (2,340
                                  )
                                  
                                  $
                                  3,467





See
accompanying notes to Consolidated Financial Statements.


5


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited)


(Dollars
in thousands)





For the Six Months EndedJune 30,2010
                          
                          
                          2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      (loss) income
                          
                          $
                          (1,117
                          )
                          
                          $
                          4,106Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for credit losses
                          
                          
                          12,534
                          
                          
                          
                          3,616Depreciation
      and amortization
                          
                          
                          1,147
                          
                          
                          
                          890Discount
      accretion on debt securities
                          
                          
                          (63
                          )
                          
                          
                          (131
                          )Stock-based
      compensation expense
                          
                          
                          209
                          
                          
                          
                          46Gains
      on sales of securities
                          
                          
                          -
                          
                          
                          
                          (49
                          )Losses
      on sales of other real estate owned
                          
                          
                          55
                          
                          
                          
                          -Write-downs
      of other real estate owned
                          
                          
                          522
                          
                          
                          
                          -Net
      changes in:Insurance
      premiums receivable
                          
                          
                          (42
                          )
                          
                          
                          (43
                          )Accrued
      interest receivable
                          
                          
                          199
                          
                          
                          
                          251Other
      assets
                          
                          
                          (681
                          )
                          
                          
                          (2,384
                          )Accrued
      interest payable
                          
                          
                          (384
                          )
                          
                          
                          18Other
      liabilities
                          
                          
                          (1,923
                          )
                          
                          
                          1,973Net
      cash provided by operating activities
                          
                          
                          10,456
                          
                          
                          
                          8,293CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                          
                          
                          26,343
                          
                          
                          
                          30,828Proceeds
      from sales of investment securities available for sale
                          
                          
                          -
                          
                          
                          
                          2,048Purchases
      of securities available for sale
                          
                          
                          (25,797
                          )
                          
                          
                          (34,933
                          )Proceeds
      from maturities and principal payments of securities held to
      maturity
                          
                          
                          585
                          
                          
                          
                          2,080Purchases
      of securities held to maturity
                          
                          
                          -
                          
                          
                          
                          (824
                          )Net
      decrease (increase) in loans
                          
                          
                          742
                          
                          
                          
                          (34,776
                          )Purchases
      of premises and equipment
                          
                          
                          (1,183
                          )
                          
                          
                          (715
                          )Proceeds
      from sales of other real estate owned
                          
                          
                          784
                          
                          
                          
                          -Investment
      in unconsolidated subsidiary
                          
                          
                          (25
                          )
                          
                          
                          -Net
      cash provided by (used in) investing activities
                          
                          
                          1,449
                          
                          
                          
                          (36,292
                          )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      increase in demand, money market and savings deposits
                          
                          
                          8,195
                          
                          
                          
                          105,291Net
      (decrease) increase in certificates of deposit
                          
                          
                          (27,524
                          )
                          
                          
                          30,672Net
      decrease in short-term borrowings
                          
                          
                          (2,540
                          )
                          
                          
                          (24,874
                          )Proceeds
      from issuance of preferred stock and warrant
                          
                          
                          -
                          
                          
                          
                          25,000Repurchase
      of preferred stock
                          
                          
                          -
                          
                          
                          
                          (23,525
                          )Proceeds
      from issuance of common stock
                          
                          
                          -
                          
                          
                          
                          2Preferred
      stock dividends paid
                          
                          
                          -
                          
                          
                          
                          (1,808
                          )Common
      stock dividends paid
                          
                          
                          (1,013
                          )
                          
                          
                          (2,691
                          )Net
      cash (used in) provided by financing activities
                          
                          
                          (22,882
                          )
                          
                          
                          108,067Net
      (decrease) increase in cash and cash equivalents
                          
                          
                          (10,977
                          )
                          
                          
                          80,068Cash
      and cash equivalents at beginning of period
                          
                          
                          75,646
                          
                          
                          
                          27,294Cash
      and cash equivalents at end of period
                          
                          $
                          64,669
                          
                          
                          $
                          107,362Supplemental
      cash flows information:Interest
      paid
                          
                          $
                          7,094
                          
                          
                          $
                          8,934Income
      taxes paid
                          
                          $
                          846
                          
                          
                          $
                          3,123Transfers
      from loans to other real estate owned
                          
                          $
                          216
                          
                          
                          $
                          2,064





See
accompanying notes to Consolidated Financial Statements.


6


Shore
Bancshares, Inc.


Notes to
Consolidated Financial Statements


For the
Three and Six Months Ended June 30, 2010 and 2009


(Unaudited)





Note 1 - Basis of
Presentation





The
consolidated financial statements include the accounts of Shore Bancshares, Inc.
and its subsidiaries with all significant intercompany transactions eliminated.
The consolidated financial statements conform to accounting principles generally
accepted in the United States of America (“GAAP”) and to prevailing practices
within the banking industry.  The accompanying interim financial
statements are unaudited; however, in the opinion of management all adjustments
necessary to present fairly the consolidated financial position at June 30,
2010, the consolidated results of operations for the three and six months ended
June 30, 2010 and 2009, changes in stockholders’ equity for the six months ended
June 30, 2010 and 2009, and cash flows for the six months ended June 30, 2010
and 2009, have been included.  All such adjustments are of a normal
recurring nature.  The amounts as of December 31, 2009 were derived
from the 2009 audited financial statements.  The results of operations
for the three and six months ended June 30, 2010 are not necessarily indicative
of the results to be expected for any other interim period or for the full
year.  This Quarterly Report on Form 10-Q should be read in
conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for
the year ended December 31, 2009.  For purposes of comparability,
certain reclassifications have been made to amounts previously reported to
conform with the current period presentation.





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





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





Note 2 – Earnings Per
Share





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





For the Three Months Ended
                
                
                For the Six Months EndedJune 30,
                
                
                June 30,(In thousands, except per share
      data)
                
                2010
                
                
                2009
                
                
                2010
                
                
                2009Net
      income (loss) available to common shareholders
                
                $
                445
                
                
                $
                354
                
                
                $
                (1,117
                )
                
                $
                2,230Weighted
      average shares outstanding - Basic
                
                
                8,443
                
                
                
                8,413
                
                
                
                8,440
                
                
                
                8,409Dilutive
      effect of stock-based awards
                
                
                -
                
                
                
                4
                
                
                
                -
                
                
                
                4Weighted
      average shares outstanding - Diluted
                
                
                8,443
                
                
                
                8,417
                
                
                
                8,440
                
                
                
                8,413Earnings
      (loss) per common share - Basic
                
                $
                0.05
                
                
                $
                0.04
                
                
                $
                (0.13
                )
                
                $
                0.27Earnings
      (loss) per common share - Diluted
                
                $
                0.05
                
                
                $
                0.04
                
                
                $
                (0.13
                )
                
                $
                0.27





The
calculations of diluted earnings/(loss) per share for the three and six months
ended June 30, 2010 each excluded ninethousand
weighted average stock-based awards and that portion of a warrant to purchase
173 thousand weighted average shares of common stock because the effect would
have been antidilutive.  There were no weighted average stock-based
awards excluded from the calculations of diluted earnings per share for the
three and six months ended June 30, 2009.  The calculations of diluted
earnings per share for the three and six months ended June 30, 2009 excluded
that portion of a warrant to purchase 173 thousand and 165 thousand weighted
average shares of common stock, respectively, because the effect would have been
antidilutive.


7


Note 3 – Investment
Securities





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





Gross
                                
                                
                                Gross
                                
                                
                                EstimatedAmortized
                                
                                
                                Unrealized
                                
                                
                                Unrealized
                                
                                
                                Fair(Dollars in thousands)
                                
                                Cost
                                
                                
                                Gains
                                
                                
                                Losses
                                
                                
                                ValueAvailable-for-sale
      securities:June
      30, 2010:Obligations
      of U.S. Treasury
                                
                                $
                                2,999
                                
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                2,999Obligations
      of U.S. Government agencies and corporations
                                
                                
                                58,760
                                
                                
                                
                                1,262
                                
                                
                                
                                39
                                
                                
                                
                                59,983Mortgage-backed
      securities
                                
                                
                                33,269
                                
                                
                                
                                1,391
                                
                                
                                
                                7
                                
                                
                                
                                34,653Other
      equity securities
                                
                                
                                556
                                
                                
                                
                                20
                                
                                
                                
                                -
                                
                                
                                
                                576Total
                                
                                $
                                95,584
                                
                                
                                $
                                2,673
                                
                                
                                $
                                46
                                
                                
                                $
                                98,211December
      31, 2009:Obligations
      of U.S. Treasury
                                
                                $
                                2,998
                                
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                2,998Obligations
      of U.S. Government agencies and corporations
                                
                                
                                57,258
                                
                                
                                
                                879
                                
                                
                                
                                397
                                
                                
                                
                                57,740Mortgage-backed
      securities
                                
                                
                                35,579
                                
                                
                                
                                818
                                
                                
                                
                                90
                                
                                
                                
                                36,307Other
      equity securities
                                
                                
                                546
                                
                                
                                
                                4
                                
                                
                                
                                -
                                
                                
                                
                                550Total
                                
                                $
                                96,381
                                
                                
                                $
                                1,701
                                
                                
                                $
                                487
                                
                                
                                $
                                97,595Held-to-maturity
      securities:June
      30, 2010:Obligations
      of states and political subdivisions
                                
                                $
                                8,345
                                
                                
                                $
                                186
                                
                                
                                $
                                8
                                
                                
                                $
                                8,523December
      31, 2009:Obligations
      of states and political subdivisions
                                
                                $
                                8,940
                                
                                
                                $
                                163
                                
                                
                                $
                                91
                                
                                
                                $
                                9,012





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





Available-for-sale
                
                
                Held-to-maturityAmortized
                
                
                Estimated
                
                
                Amortized
                
                
                Estimated(Dollars in thousands)
                
                Cost
                
                
                Fair Value
                
                
                Cost
                
                
                Fair ValueDue
      in one year or less
                
                $
                12,438
                
                
                $
                11,578
                
                
                $
                2,138
                
                
                $
                2,147Due
      after one year through five years
                
                
                39,342
                
                
                
                41,289
                
                
                
                4,252
                
                
                
                4,406Due
      after five years through ten years
                
                
                18,525
                
                
                
                19,182
                
                
                
                1,450
                
                
                
                1,467Due
      after ten years
                
                
                24,723
                
                
                
                25,586
                
                
                
                505
                
                
                
                50395,028
                
                
                
                97,635
                
                
                
                8,345
                
                
                
                8,523Equity
      securities
                
                
                556
                
                
                
                576
                
                
                
                -
                
                
                
                -Total
                
                $
                95,584
                
                
                $
                98,211
                
                
                $
                8,345
                
                
                $
                8,523





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


8


Gross
unrealized losses and fair value by length of time that the individual
available-for-sale securities have been in a continuous unrealized loss position
at June 30, 2010, are as follows:





Less than
                      12 Months
                    
                    
                    More than
                      12 Months
                    
                    
                    Total(Dollars in thousands)
                    
                    Fair
                      Value
                    
                    
                    Unrealized
                      Losses
                    
                    
                    Fair
                      Value
                    
                    
                    Unrealized
                      Losses
                    
                    
                    Fair
                      Value
                    
                    
                    Unrealized
                      LossesAvailable-for-sale
      securities:U.S.
      Gov’t. agencies and corporations
                    
                    $
                    6,060
                    
                    
                    $
                    39
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    6,060
                    
                    
                    $
                    39Mortgage-backed
      securities
                    
                    
                    1,153
                    
                    
                    
                    7
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,153
                    
                    
                    
                    7Total
                    
                    $
                    7,213
                    
                    
                    $
                    46
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    7,213
                    
                    
                    $
                    46





The
available-for-sale securities have a fair value of approximately $98.2
million.  Of these securities, approximately $7.2 million have
unrealized losses when compared to their amortized cost.  The
securities with the unrealized losses in the available-for-sale portfolio all
have modest duration risk, low credit risk, and minimal losses (approximately
0.05%) when compared to amortized cost.  The unrealized losses on debt
securities that exist are the result of market changes in interest rates since
original purchase.  Because the Company does not intend to sell these
debt securities and it is not more likely than not that the Company will be
required to sell these securities before recovery of their amortized cost bases,
which may be at maturity, the Company considers the unrealized losses in the
available-for-sale portfolio to be temporary.





Gross
unrealized losses and fair value by length of time that the individual
held-to-maturity securities have been in a continuous unrealized loss position
at June 30, 2010, are as follows:





Less than
                  12 Months
                
                
                More than
                  12 Months
                
                
                Total(Dollars in thousands)
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  LossesHeld-to-maturity
      securities:Obligations
      of states and political subdivisions
                
                $
                1,059
                
                
                $
                4
                
                
                $
                186
                
                
                $
                4
                
                
                $
                1,245
                
                
                $
                8





The
held-to-maturity securities have a fair value of approximately $8.5
million.  Approximately $1.2 million of these securities have
unrealized losses when compared to their amortized cost.  All of the
securities with unrealized losses are municipal securities with modest duration
risk, low credit risk, and minimal losses (approximately 0.10%) 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.





Note 4 – Impaired
Loans





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


9


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





June 30,
                
                
                December 31,
                
                
                June 30,(Dollars in thousands)
                
                2010
                
                
                2009
                
                
                2009Impaired
      loans with a valuation allowance
                
                $
                7,254
                
                
                $
                2,028
                
                
                $
                1,093Impaired
      loans with no valuation allowance
                
                
                30,234
                
                
                
                14,274
                
                
                
                12,602Total
      impaired loans
                
                $
                37,488
                
                
                $
                16,302
                
                
                $
                13,695Allowance
      for credit losses applicable to impaired loans
                
                $
                1,362
                
                
                $
                468
                
                
                $
                454Allowance
      for credit losses applicable to other than impaired loans
                
                
                11,927
                
                
                
                10,408
                
                
                
                10,330Total
      allowance for credit losses
                
                $
                13,289
                
                
                $
                10,876
                
                
                $
                10,784Average
      recorded investment in impaired loans
                
                $
                28,082
                
                
                $
                12,646
                
                
                $
                4,817





Gross
interest income of $1.0 million for the first six months of 2010, $859 thousand
for fiscal year 2009 and $327 thousand for the first six months of 2009 would
have been recorded if nonaccrual loans had been current and performing in
accordance with their original terms.  Interest actually recorded on
such loans was $0 for the first six months of 2010 and $4 thousand for both
fiscal year 2009 and the first six months of 2009.





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





Note 5 – Other Assets and
Liabilities





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





(Dollars in thousands)
                
                June 30, 2010
                
                
                December 31, 2009Nonmarketable investment securities
                
                $
                3,149
                
                
                $
                3,149Insurance
      premiums receivable
                
                
                1,025
                
                
                
                983Accrued
      interest receivable
                
                
                4,605
                
                
                
                4,804Deferred
      income taxes
                
                
                5,836
                
                
                
                3,337Interest
      rate caps (1)
                
                
                2,602
                
                
                
                6,168Prepaid
      FDIC premium expense
                
                
                4,760
                
                
                
                5,449Other
      assets
                
                
                6,352
                
                
                
                6,525Total
                
                $
                28,329
                
                
                $
                30,415





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





(Dollars
      in thousands)
                
                June
      30, 2010
                
                
                December
      31, 2009Accrued
      interest payable
                
                $
                1,397
                
                
                $
                1,781Counterparty
      collateral - interest rate caps (1)
                
                
                3,098
                
                
                
                4,847Other
      liabilities
                
                
                9,134
                
                
                
                9,308Total
                
                $
                13,629
                
                
                $
                15,936





(1)  See
Note 8 for further discussion.





Note 6 - Stock-Based
Compensation





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





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


10


During
the three and six months ended June 30, 2010, the Company recognized pre-tax
stock-based compensation expense of $93 thousand and $209 thousand,
respectively, compared to $25 thousand and $46 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 $607
thousand as of June 30, 2010.  The weighted-average period over which
this unrecognized expense was expected to be recognized was 2.0
years.





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





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





The
Company estimates the fair value of stock options using the Black-Scholes
valuation model with weighted average assumptions for dividend yield, expected
volatility, risk-free interest rate and expected lives (in
years).  The expected dividend yield is calculated by dividing the
total expected annual dividend payout by the average stock price.  The
expected volatility is based on historical volatility of the underlying
securities.  The risk-free interest rate is based on the Federal
Reserve Bank’s constant maturities daily interest rate in effect at grant
date.  The expected life of the options represents the period of time
that the Company expects the awards to be outstanding based on historical
experience with similar awards.  Stock-based compensation expense
recognized in the consolidated statements of income for the six months ended
June 30, 2010 and 2009 reflected forfeitures as they occurred.





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





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





At June
30, 2010, all 8,420 outstanding options were exercisable, had a weighted average
exercise price of $13.17, and had a remaining contract life of 1.8
years.





There was
no aggregate intrinsic value in options outstanding and exercisable based on the
$11.91 market value per share of the Company’s common stock at June 30,
2010.  The total intrinsic value of stock options exercised during the
six months ended June 30, 2010 and 2009 was $0 and less than $1 thousand,
respectively.  Cash received upon exercise of options during the first
six months of 2010 and 2009 was $0 and approximately $1 thousand,
respectively.





Note 7 – Fair Value
Measurements





ASC 820,
“Fair Value Measurements and
Disclosures”, provides a framework for measuring and disclosing fair
value under GAAP. This accounting guidance requires disclosures about the fair
values of assets and liabilities recognized in the balance sheet, whether the
measurements are made on a recurring basis or on a nonrecurring
basis.




ASC 820
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date.  ASC 820 also establishes
a fair value hierarchy, which requires an entity to maximize the use of
observable inputs and minimize the use of unobservable inputs when measuring
fair value.


11




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




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





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





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





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




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





Investment Securities
Available for Sale


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





Loans


The
Company does not record loans at fair value on a recurring basis; however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established.  Loans for which it is probable that payment of interest
and principle will not be made in accordance with the contractual terms of the
loan are considered impaired.  The fair value of impaired loans is
estimated using one of several methods, including the collateral value, market
value of similar debt, enterprise value, liquidation value and discounted cash
flows.  At June 30, 2010, substantially all impaired loans were
evaluated based on the fair value of the collateral.  Those impaired
loans not requiring a specific allowance represent loans for which the fair
value of expected repayments or collateral exceed the recorded investment in
such loans.   Impaired loans that have an allowance established
based on the fair value of collateral require classification in the fair value
hierarchy.  When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
loan as nonrecurring Level 2.  When an appraised value is not
available or management determines the fair value of the collateral is further
impaired below the appraised value and there is no observable market price, the
Company records the loan as nonrecurring Level 3.





Other Real Estate and Other
Assets Owned (Foreclosed Assets)


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


12


Derivative Assets and
Liabilities


Derivative
instruments held or issued by the Company for risk management purposes are
traded in over-the-counter markets where quoted market prices are not readily
available.  For those derivatives, the Company measures fair value
using models that use primarily market observable inputs, such as yield curves
and option volatilities, and include the value associated with counterparty
credit risk.  The Company classifies derivative instruments held or
issued for risk management purposes as recurring Level 2.  As of June
30, 2010, the Company’s derivative instruments consisted solely of interest rate
caps.  Derivative assets and liabilities are included in other assets
and liabilities, respectively, in the accompanying consolidated balance
sheet.





Assets Recorded at Fair
Value on a Recurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
recurring basis at June 30, 2010.


There
were no transfers between Levels 1 and 2 during the first half of
2010.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Securities
      available for sale:U.S.
      Treasury
                  
                  $
                  2,999
                  
                  
                  $
                  2,999
                  
                  
                  $
                  -
                  
                  
                  $
                  -U.S.
      Government agencies
                  
                  
                  59,983
                  
                  
                  
                  -
                  
                  
                  
                  59,983
                  
                  
                  
                  -Mortgage-backed
      securities
                  
                  
                  34,653
                  
                  
                  
                  -
                  
                  
                  
                  34,653
                  
                  
                  
                  -Other
      equity securities
                  
                  
                  576
                  
                  
                  
                  -
                  
                  
                  
                  576
                  
                  
                  
                  -Total
                  
                  $
                  98,211
                  
                  
                  $
                  2,999
                  
                  
                  $
                  95,212
                  
                  
                  $
                  -Interest
      rate caps
                  
                  $
                  2,602
                  
                  
                  $
                  -
                  
                  
                  $
                  2,602
                  
                  
                  $
                  -





Assets Recorded at Fair
Value on a Nonrecurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
nonrecurring basis at June 30, 2010.





SignificantOther
                  
                  
                  SignificantQuoted
                  
                  
                  Observable
                  
                  
                  UnobservablePrices
                  
                  
                  Inputs
                  
                  
                  Inputs(Dollars
      in thousands)
                  
                  Fair Value
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Impaired
      loansReal
      estate - construction
                  
                  $
                  19,287
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  19,287Real
      estate - residential
                  
                  
                  8,583
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  8,583Real
      estate - commercial
                  
                  
                  4,224
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  4,224Commercial
                  
                  
                  3,968
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,968Consumer
                  
                  
                  64
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  64Total
                  
                  $
                  36,126
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  36,126Other
      real estate and other assets owned
                  
                  $
                  1,428
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,428





Impaired
loans had a carrying amount of $37.5 million at June 30, 2010 with a valuation
allowance of $1.4 million.





The
following disclosures relate to the fair value of the Company’s financial
instruments and include the methods and assumptions used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value:





Cash and Cash
Equivalents


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





Investment
Securities


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


13


Loans


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





Financial
Liabilities


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





Commitments to Extend Credit
and Standby Letters of Credit


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





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





June 30, 2010
                
                
                December 31, 2009Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      assets:Cash
      and cash equivalents
                
                $
                64,669
                
                
                $
                64,669
                
                
                $
                75,646
                
                
                $
                75,646Investment
      securities
                
                
                106,556
                
                
                
                106,734
                
                
                
                106,535
                
                
                
                106,607Loans
                
                
                905,477
                
                
                
                919,109
                
                
                
                916,557
                
                
                
                934,362Less:  allowance
      for loan  losses
                
                
                (13,289
                )
                
                _
      -
                
                
                
                (10,876
                )
                
                
                -Total
                
                $
                1,063,413
                
                
                $
                1,090,512
                
                
                $
                1,087,862
                
                
                $
                1,116,615Financial
      liabilities:Deposits
                
                $
                971,608
                
                
                $
                976,291
                
                
                $
                990,937
                
                
                $
                999,016Short-term
      borrowings
                
                
                17,864
                
                
                
                17,864
                
                
                
                20,404
                
                
                
                20,404Long-term
      debt
                
                
                1,429
                
                
                
                1,502
                
                
                
                1,429
                
                
                
                1,530Total
                
                $
                990,901
                
                
                $
                995,657
                
                
                $
                1,012,770
                
                
                $
                1,020,950





Note 8 – Derivative
Instruments and Hedging Activities





ASC 815,
“Derivatives and
Hedging”, defines derivatives, requires that derivatives be carried at
fair value on the balance sheet and provides for hedge accounting when certain
conditions are met.  Changes in the fair values of derivative
instruments designated as “cash flow” hedges, to the extent the hedges are
highly effective, are recorded in other comprehensive income, net of
taxes.  Ineffective portions of cash flow hedges, if any, are
recognized in current period earnings.  The net interest settlement on
cash flow hedges is treated as an adjustment of the of the interest income or
interest expense of the hedged assets or liabilities.  The Company
uses derivative instruments to hedge its exposure to changes in interest
rates.  The Company does not use derivatives for any trading or other
speculative purposes.





During
the third quarter of 2009, as part of its overall interest rate risk management
strategy, the Company purchased interest rate caps to effectively fix the
interest rate on $70 million of the Company’s money market deposit accounts at
2.97% for five years. The interest rate caps qualified for hedge
accounting.  The aggregate fair value of these derivatives was an
asset of $2.6 million at June 30, 2010 and $6.2 million at December 31,
2009.   For the second quarter and first half of 2010, interest
expense included a net interest settlement of $70 thousand and $100 thousand,
respectively.




14


By
entering into derivative instrument contracts, the Company exposes itself, from
time to time, to counterparty credit risk.  Counterparty credit risk
is the risk that the counterparty will fail to perform under the terms of the
derivative contract.  When the fair value of a derivative contract is
in an asset position, the counterparty has a liability to the Company, which
creates credit risk for the Company.  The Company attempts to minimize
this risk by selecting counterparties with investment grade credit ratings,
limiting its exposure to any single counterparty and regularly monitoring its
market position with each counterparty.  Also to minimize risk, the
Company obtained counterparty collateral which was recorded in other
liabilities.  The counterparty collateral was $3.1 million at June 30,
2010 and $4.8 million at December 31, 2009.





Note 9 –
Commitments





In the
normal course of business, to meet the financial needs of its customers, the
Company’s bank subsidiaries enter into financial instruments with off-balance
sheet risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  At June 30, 2010, total
commitments to extend credit were approximately $158.9 million. The comparable
amount was $147.3 million at December 31, 2009.  Outstanding letters
of credit were approximately $15.7 million at June 30, 2010 and $19.0 million at
December 31, 2009.





Note 10 – Segment
Reporting





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





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.




15


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





Community
                
                
                Insurance Products
                
                
                Parent
                
                
                Consolidated(Dollars in thousands)
                
                Banking
                
                
                and Services
                
                
                Company
                
                
                Total2010Interest
      income
                
                $
                27,708
                
                
                $
                87
                
                
                $
                -
                
                
                $
                27,795Interest
      expense
                
                
                (6,665
                )
                
                
                -
                
                
                
                (44
                )
                
                
                (6,709
                )Provision
      for credit losses
                
                
                (12,534
                )
                
                
                -
                
                
                
                -
                
                
                
                (12,534
                )Noninterest
      income
                
                
                3,625
                
                
                
                5,825
                
                
                
                -
                
                
                
                9,450Noninterest
      expense
                
                
                (11,820
                )
                
                
                (4,983
                )
                
                
                (3,206
                )
                
                
                (20,009
                )Net
      intersegment income (expense)
                
                
                (2,828
                )
                
                
                (243
                )
                
                
                3,071
                
                
                
                -Income
      (loss) before taxes
                
                
                (2,514
                )
                
                
                686
                
                
                
                (179
                )
                
                
                (2,007
                )Income
      tax (expense) benefit
                
                
                1,115
                
                
                
                (304
                )
                
                
                79
                
                
                
                890Net
      income (loss)
                
                $
                (1,399
                )
                
                $
                382
                
                
                $
                (100
                )
                
                $
                (1,117
                )Total
      assets
                
                $
                1,105,944
                
                
                $
                20,153
                
                
                $
                3,099
                
                
                $
                1,129,1962009Interest
      income
                
                $
                29,063
                
                
                $
                33
                
                
                $
                -
                
                
                $
                29,096Interest
      expense
                
                
                (8,912
                )
                
                
                -
                
                
                
                (40
                )
                
                
                (8,952
                )Provision
      for credit losses
                
                
                (3,616
                )
                
                
                -
                
                
                
                -
                
                
                
                (3,616
                )Noninterest
      income
                
                
                4,134
                
                
                
                6,563
                
                
                
                -
                
                
                
                10,697Noninterest
      expense
                
                
                (11,837
                )
                
                
                (5,666
                )
                
                
                (3,073
                )
                
                
                (20,576
                )Net
      intersegment income (expense)
                
                
                (2,799
                )
                
                
                (238
                )
                
                
                3,037
                
                
                
                -Income
      (loss) before taxes
                
                
                6,033
                
                
                
                692
                
                
                
                (76
                )
                
                
                6,649Income
      tax (expense) benefit
                
                
                (2,308
                )
                
                
                (264
                )
                
                
                29
                
                
                
                (2,543
                )Net
      income
                
                $
                3,725
                
                
                $
                428
                
                
                $
                (47
                )
                
                $
                4,106Total
      assets
                
                $
                1,134,421
                
                
                $
                20,012
                
                
                $
                3,779
                
                
                $
                1,158,212





Note 11 – New Accounting
Pronouncements





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





ASU No. 2009-17, “Consolidations
(Topic 810) – Improvements to Financial Reporting by Enterprises Involved with
Variable Interest Entities”.New accounting guidance under ASU
2009-17 amended prior guidance to change how a company determines when an entity
that is insufficiently capitalized or is not controlled through voting (or
similar rights) should be consolidated. The determination of whether a company
is required to consolidate an entity is based on, among other things, an
entity’s purpose and design and a company’s ability to direct the activities of
the entity that most significantly impact the entity’s economic performance.
This guidance requires additional disclosures about the reporting entity’s
involvement with variable-interest entities and any significant changes in risk
exposure due to that involvement as well as its affect on the entity’s financial
statements. This new accounting guidance became effective January 1, 2010
and did not have a significant impact on the Company’s financial
statements.


16




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





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





Forward-Looking
Information


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





Introduction


The
following discussion and analysis is intended as a review of significant factors
affecting the Company’s financial condition and results of operations for the
periods indicated.  This discussion and analysis should be read in
conjunction with the unaudited consolidated financial statements and related
notes presented in this report, as well as the audited consolidated financial
statements and related notes included in the Annual Report of Shore Bancshares,
Inc. on Form 10-K for the year ended December 31, 2009.





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





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





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





Critical
Accounting Policies


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





Allowance for Credit
Losses


The
allowance for credit losses is an estimate of the losses that may be sustained
in the loan portfolio.  The allowance is based on two basic principles
of accounting: (i) Topic 450, “Contingencies”, of the
Financial Accounting Standards Board’s Accounting Standards Codification
(“ASC”), which requires that losses be accrued when they are probable of
occurring and estimable, and (ii) ASC Topic 310, “Receivables”, which requires
that losses be accrued based on the differences between the loan balance and the
value of collateral, present value of future cash flows or values that are
observable in the secondary market.  Management uses many factors,
including economic conditions and trends, the value and adequacy of collateral,
the volume and mix of the loan portfolio, and our internal loan processes in
determining the inherent loss that may be present in our loan
portfolio.  Actual losses could differ significantly from management’s
estimates.  In addition, GAAP itself may change from one previously
acceptable method to another.  Although the economics of transactions
would be the same, the timing of events that would impact the transactions could
change.


17





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





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





Goodwill and Other
Intangible Assets


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





Impairment
testing requires that the fair value of each of the Company’s reporting units be
compared to the carrying amount of its net assets, including
goodwill.  The Company’s reporting units were identified based on an
analysis of each of its individual operating segments. If the fair value of a
reporting unit is less than book value, an expense may be required to write down
the related goodwill or purchased intangibles to record an impairment loss. At
June 30, 2010, it was determined that there were no circumstances that dictated
interim testing for impairment of goodwill or intangible assets.





Fair
Value


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




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


18





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





OVERVIEW





Net
income for the second quarter of 2010 was $445 thousand, or diluted earnings per
common share of $0.05, compared to $354 thousand, or diluted earnings per common
share of $0.04, for the second quarter of 2009.  For the first quarter
of 2010, the Company reported a net loss of $1.6 million, or diluted loss per
common share of $(0.19).   The second quarter of 2010 included a
provision for credit losses of $4.9 million, which was $3.2 million higher than
the comparable amount for the second quarter of 2009 but $2.7 million lower than
the comparable amount for the first quarter of 2010.  Annualized
return on average assets was 0.16% for the three months ended June 30, 2010,
compared to 0.13% for the same period in 2009.  Annualized return on
average stockholders’ equity was 1.42% for the second quarter of 2010, compared
to 1.07% for the second quarter of 2009.  For the first quarter of
2010, annualized return on average assets was (0.55)% and return on average
equity was (4.95)%.





For the
first six months of 2010, the Company reported a net loss of $1.1 million, or
diluted loss per common share of $(0.13), compared to net income of $2.2
million, or diluted earnings per common share of $0.27, for the first six months
of 2009.  Annualized return on average assets was (0.20)% for the six
months ended June 30, 2010, compared to 0.41% for the same period in
2009.  Annualized return on average stockholders’ equity was (1.78)%
for the first six months of 2010, compared to 3.18% for the first six months of
2009.





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





RESULTS
OF OPERATIONS





Net
Interest Income


Net
interest income for the three months ended June 30, 2010 was $10.7 million, an
increase of 6.0% when compared to the same period last year.  Slightly
higher 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 4.03% for the second quarter of
2010, an increase of 18 basis points when compared to the second quarter of
2009.  The net interest margin has benefited from the Company’s effort
to reduce deposit pricing structures.  Net interest income increased
2.8% from the first quarter of 2010, primarily due to slightly higher rates on
average earning assets and a decrease in the balances and rates paid on
interest-bearing liabilities offsetting the small decline in average earning
assets.  The net interest margin increased 8 basis points from 3.95%
for the first quarter of 2010.





Interest
income was $14.0 million for the second quarter of 2010, a decrease of 4.5% from
the second quarter of 2009. Average earning assets increased 1.0% during the
second quarter of 2010 when compared to the same period in 2009, while yields
earned decreased 30 basis points to 5.26%.  Average loans decreased
slightly and the yield earned on loans decreased 29 basis
points.  Loans comprised 84.9% of total average earning assets for the
second quarter of 2010, a decrease from the 86.1% for the second quarter of
2009.  Interest income increased 1.0% when compared to the first
quarter of 2010.  Average earning assets declined slightly during the
second quarter of 2010 when compared to the first quarter of 2010, while yields
earned increased 2 basis points.





Interest
expense was $3.3 million for the three months ended June 30, 2010, a decrease of
27.9%when compared to the same period last year. Average interest-bearing
liabilities increased 1.2%, while rates paid decreased 60 basis points to
1.50%.  During the second quarter of 2009, the Company began to
participate in the Promontory Insured Network Deposits Program
(“IND”).  The $36.4 million increase in average money market and
savings deposits for the second quarter of 2010 over the same period of 2009
included approximately $27.6 million from the IND program.  The
Company incurs the largest amount of interest expense from time
deposits.  For the three months ended June 30, 2010, the average
balance of certificates of deposit $100,000 or more increased 2.5% when compared
to the same period last year, while the average rate paid on these certificates
of deposit decreased 111 basis points to 2.09%.  Average other time
deposits decreased 9.9% and the rate paid on average other time deposits
decreased 89 basis points, when comparing the second quarter of 2010 to the
second quarter of 2009.  Expanded levels of FDIC insurance coverage
contributed to the shift from other time deposits to certificates of deposit
$100,000 or more.  When comparing the second quarter of 2010 to the
first quarter of 2010, interest expense decreased 4.6% because average
interest-bearing liabilities decreased slightly and rates paid decreased 8 basis
points.


19





Net
interest income for the six months ended June 30, 2010 was $21.1 million, an
increase of 4.7% when compared to the same period last year.  An
increase in the volume of average earning assets and a reduction in the cost of
funds were sufficient to offset the decline in yields on earning
assets.  The net interest margin increased from 3.96% for the first
six months of 2009 to 3.99% for the first six months of 2010.





Interest
income was $27.8 million for the first six months of 2010, a decrease of 4.5%
when compared to the first six months of 2009. Average earning assets increased
3.8% during the six months ended June 30, 2010 when compared to the same period
in 2009, while yields earned decreased 46 basis points to
5.25%.  Average loans increased slightly during the first six months
of 2010, while the yield earned on loans decreased 35 basis points when compared
to the same period of 2009.  Loans comprised 84.8% and 87.6% of total
average earning assets for the first six months of 2010 and 2009,
respectively.





Interest
expense was $6.7 million for the six months ended June 30, 2010, a decrease of
25.1% when compared to the same period last year.  Average
interest-bearing liabilities increased 6.1%, while rates paid decreased 64 basis
points to 1.54%.  The $70.0 million increase in average money market
and savings deposits for the first half of 2010 over the same period of 2009
included approximately $57.2 million from the IND program.  For the
six months ended June 30, 2010, the average balance of certificates
of  deposit $100,000 or more increased 5.6% when compared to the same
period last year, while the average rate paid decreased 113 basis points to
2.17%.  Average other time deposits decreased 7.7% and the rate paid
on average other time deposits decreased 88 basis points when compared to the
first six months of 2009.


20


Analysis
of Interest Rates and Interest Differentials


The
following table presents the distribution of the average consolidated balance
sheets, interest income/expense, and annualized yields earned and rates paid for
the three months ended June 30, 2010 and 2009.





For the Three Months Ended
                  
                  
                  For the Three Months EndedJune 30, 2010
                  
                  
                  June 30, 2009Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/
                  
                  
                  Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/(Dollars in thousands)
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  RateEarning
      assetsLoans
      (2), (3)
                  
                  $
                  909,295
                  
                  
                  $
                  13,083
                  
                  
                  
                  5.77
                  %
                  
                  $
                  913,671
                  
                  
                  $
                  13,795
                  
                  
                  
                  6.06
                  %Investment
      securitiesTaxable
                  
                  
                  103,284
                  
                  
                  
                  846
                  
                  
                  
                  3.29
                  
                  
                  
                  75,277
                  
                  
                  
                  768
                  
                  
                  
                  4.09Tax-exempt
                  
                  
                  6,460
                  
                  
                  
                  85
                  
                  
                  
                  5.30
                  
                  
                  
                  8,110
                  
                  
                  
                  122
                  
                  
                  
                  6.02Federal
      funds sold
                  
                  
                  38,001
                  
                  
                  
                  14
                  
                  
                  
                  0.15
                  
                  
                  
                  55,699
                  
                  
                  
                  23
                  
                  
                  
                  0.16Interest-bearing
      deposits
                  
                  
                  14,075
                  
                  
                  
                  4
                  
                  
                  
                  0.12
                  
                  
                  
                  8,129
                  
                  
                  
                  6
                  
                  
                  
                  0.33Total
      earning assets
                  
                  
                  1,071,115
                  
                  
                  
                  14,032
                  
                  
                  
                  5.26
                  %
                  
                  
                  1,060,886
                  
                  
                  
                  14,714
                  
                  
                  
                  5.56
                  %Cash
      and due from banks
                  
                  
                  9,997
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  18,705Other
      assets
                  
                  
                  67,860
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  51,595Allowance
      for credit losses
                  
                  
                  (14,310
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,848
                  )Total
      assets
                  
                  $
                  1,134,662
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,120,338Interest-bearing
      liabilitiesDemand
      deposits
                  
                  $
                  132,563
                  
                  
                  
                  83
                  
                  
                  
                  0.25
                  %
                  
                  $
                  125,076
                  
                  
                  
                  76
                  
                  
                  
                  0.24
                  %Money
      market and savings deposits
                  
                  
                  259,273
                  
                  
                  
                  468
                  
                  
                  
                  0.72
                  
                  
                  
                  222,825
                  
                  
                  
                  351
                  
                  
                  
                  0.63Certificates
      of deposit $100,000 or more
                  
                  
                  251,340
                  
                  
                  
                  1,310
                  
                  
                  
                  2.09
                  
                  
                  
                  245,210
                  
                  
                  
                  1,954
                  
                  
                  
                  3.20Other
      time deposits
                  
                  
                  215,987
                  
                  
                  
                  1,381
                  
                  
                  
                  2.56
                  
                  
                  
                  239,668
                  
                  
                  
                  2,060
                  
                  
                  
                  3.45Interest-bearing
      deposits
                  
                  
                  859,163
                  
                  
                  
                  3,242
                  
                  
                  
                  1.51
                  
                  
                  
                  832,779
                  
                  
                  
                  4,441
                  
                  
                  
                  2.14Short-term
      borrowings
                  
                  
                  15,771
                  
                  
                  
                  19
                  
                  
                  
                  0.48
                  
                  
                  
                  25,435
                  
                  
                  
                  28
                  
                  
                  
                  0.45Long-term
      debt
                  
                  
                  1,429
                  
                  
                  
                  15
                  
                  
                  
                  4.40
                  
                  
                  
                  7,947
                  
                  
                  
                  75
                  
                  
                  
                  3.78Total
      interest-bearing liabilities
                  
                  
                  876,363
                  
                  
                  
                  3,276
                  
                  
                  
                  1.50
                  %
                  
                  
                  866,161
                  
                  
                  
                  4,544
                  
                  
                  
                  2.10
                  %Noninterest-bearing
      deposits
                  
                  
                  117,586
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  109,652Other
      liabilities
                  
                  
                  15,043
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  11,918Stockholders’
      equity
                  
                  
                  125,670
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  132,607Total
      liabilities and stockholders’ equity
                  
                  $
                  1,134,662
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,120,338Net
      interest spread
                  
                  
                  
                  
                  
                  $
                  10,756
                  
                  
                  
                  3.76
                  %
                  
                  
                  
                  
                  
                  $
                  10,170
                  
                  
                  
                  3.46
                  %Net
      interest margin
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4.03
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.85
                  %Tax-equivalent
      adjustmentLoans
                  
                  
                  
                  
                  
                  $
                  36
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  41Investment
      securities
                  
                  
                  
                  
                  
                  
                  29
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  43Total
                  
                  
                  
                  
                  
                  $
                  65
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  84


21


The
following table presents the distribution of the average consolidated balance
sheets, interest income/expense, and annualized yields earned and rates paid for
the six months ended June 30, 2010 and 2009.





For the Six Months Ended
                  
                  
                  For the Six Months EndedJune 30, 2010
                  
                  
                  June 30, 2009Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/
                  
                  
                  Average
                  
                  
                  Income(1)/
                  
                  
                  Yield/(Dollars in thousands)
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Expense
                  
                  
                  RateEarning
      assetsLoans
      (2), (3)
                  
                  $
                  909,831
                  
                  
                  $
                  25,993
                  
                  
                  
                  5.76
                  %
                  
                  $
                  906,066
                  
                  
                  $
                  27,455
                  
                  
                  
                  6.11
                  %Investment
      securitiesTaxable
                  
                  
                  103,385
                  
                  
                  
                  1,728
                  
                  
                  
                  3.37
                  
                  
                  
                  75,067
                  
                  
                  
                  1,524
                  
                  
                  
                  4.09Tax-exempt
                  
                  
                  6,611
                  
                  
                  
                  175
                  
                  
                  
                  5.35
                  
                  
                  
                  8,605
                  
                  
                  
                  253
                  
                  
                  
                  5.92Federal
      funds sold
                  
                  
                  42,253
                  
                  
                  
                  26
                  
                  
                  
                  0.13
                  
                  
                  
                  38,873
                  
                  
                  
                  30
                  
                  
                  
                  0.15Interest-bearing
      deposits
                  
                  
                  11,177
                  
                  
                  
                  5
                  
                  
                  
                  0.10
                  
                  
                  
                  5,298
                  
                  
                  
                  7
                  
                  
                  
                  0.28Total
      earning assets
                  
                  
                  1,073,257
                  
                  
                  
                  27,927
                  
                  
                  
                  5.25
                  %
                  
                  
                  1,033,909
                  
                  
                  
                  29,269
                  
                  
                  
                  5.71
                  %Cash
      and due from banks
                  
                  
                  12,197
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  15,395Other
      assets
                  
                  
                  67,889
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  50,487Allowance
      for credit losses
                  
                  
                  (13,238
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (10,259
                  )Total
      assets
                  
                  $
                  1,140,105
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,089,532Interest-bearing
      liabilitiesDemand
      deposits
                  
                  $
                  130,287
                  
                  
                  
                  163
                  
                  
                  
                  0.25
                  %
                  
                  $
                  123,104
                  
                  
                  
                  148
                  
                  
                  
                  0.24
                  %Money
      market and savings deposits
                  
                  
                  258,180
                  
                  
                  
                  895
                  
                  
                  
                  0.70
                  
                  
                  
                  188,165
                  
                  
                  
                  525
                  
                  
                  
                  0.56Certificates
      of deposit $100,000 or more
                  
                  
                  255,416
                  
                  
                  
                  2,744
                  
                  
                  
                  2.17
                  
                  
                  
                  241,997
                  
                  
                  
                  3,966
                  
                  
                  
                  3.30Other
      time deposits
                  
                  
                  217,849
                  
                  
                  
                  2,825
                  
                  
                  
                  2.62
                  
                  
                  
                  236,077
                  
                  
                  
                  4,087
                  
                  
                  
                  3.50Interest-bearing
      deposits
                  
                  
                  861,732
                  
                  
                  
                  6,627
                  
                  
                  
                  1.55
                  
                  
                  
                  789,343
                  
                  
                  
                  8,726
                  
                  
                  
                  2.23Short-term
      borrowings
                  
                  
                  16,896
                  
                  
                  
                  51
                  
                  
                  
                  0.60
                  
                  
                  
                  32,469
                  
                  
                  
                  77
                  
                  
                  
                  0.48Long-term
      debt
                  
                  
                  1,429
                  
                  
                  
                  31
                  
                  
                  
                  4.43
                  
                  
                  
                  7,947
                  
                  
                  
                  149
                  
                  
                  
                  3.78Total
      interest-bearing liabilities
                  
                  
                  880,057
                  
                  
                  
                  6,709
                  
                  
                  
                  1.54
                  %
                  
                  
                  829,759
                  
                  
                  
                  8,952
                  
                  
                  
                  2.18
                  %Noninterest-bearing
      deposits
                  
                  
                  117,759
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  106,968Other
      liabilities
                  
                  
                  15,420
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  11,304Stockholders’
      equity
                  
                  
                  126,869
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  141,501Total
      liabilities and stockholders’ equity
                  
                  $
                  1,140,105
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  1,089,532Net
      interest spread
                  
                  
                  
                  
                  
                  $
                  21,218
                  
                  
                  
                  3.71
                  %
                  
                  
                  
                  
                  
                  $
                  20,317
                  
                  
                  
                  3.53
                  %Net
      interest margin
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.99
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3.96
                  %Tax-equivalent
      adjustmentLoans
                  
                  
                  
                  
                  
                  $
                  72
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  84Investment
      securities
                  
                  
                  
                  
                  
                  
                  60
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  89Total
                  
                  
                  
                  
                  
                  $
                  132
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  173





(1)
            All
      amounts are reported on a tax equivalent basis computed using the
      statutory federal income tax rate of 34.5% for 2010 and 35.0% for 2009
      exclusive of the alternative minimum tax rate and nondeductible interest
      expense.


(2)
            Average
      loan balances include nonaccrual
loans.


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





Noninterest
Income


Noninterest
income for the second quarter of 2010 decreased $779 thousand, or 14.6%, when
compared to the second quarter of 2009.   The decline in
noninterest income during the second quarter of 2010 when compared to the second
quarter of 2009 was primarily due to a decline in insurance agency commissions
of $298 thousand and a $420 thousand mark-to-market gain on interest rate swaps
in 2009. The decrease of $314 thousand, or 6.4%, when compared to the first
quarter of 2010 was primarily a result of $744 thousand in insurance agency
contingency income which is typically received in the first quarter of each year
and based on the prior year’s performance.  The decrease in
contingency income was partially offset by an increase in commission
income.





Noninterest
income for the first six months of 2010 decreased $1.2 million, or 11.7%, when
compared to the first six months of 2009.  As with the second quarter
2010 results, the decrease was mainly due to a decline in insurance agency
commissions and the mark-to-market gain on interest rate swaps in
2009.


22





Noninterest
Expense


Noninterest
expense for the second quarter of 2010 decreased $1.0 million, or 9.4%, when
compared to the second quarter of 2009.  The decrease was primarily
attributable to lower expenses accrued for bonus and profit sharing plans and
lower FDIC insurance premium expense which were partially offset by higher
expenses related to collection and other real estate owned activities.Included in the FDIC
insurance premium expense for the second quarter of 2009 was a special one-time
assessment of $513 thousand.Noninterest expense
decreased $633 thousand, or 6.1%, from the first quarter of 2010 primarily due
to lower expenses accrued for bonus and profit sharing plans.





Noninterest
expense for the first six months of 2010 decreased $567 thousand, or 2.8%, when
compared to the first six months of 2009.  Similar to the second
quarter 2010 results, the decrease was primarily attributable to lower expenses
accrued for bonus and profit sharing plans and lower FDIC insurance premium
expense which were partially offset by higher expenses related to collection and
other real estate owned activities.





Income
Taxes


The
Company’s effective tax rate was 32.0% for the three months ended June 30, 2010,
compared to 38.1% for the same period last year.  For the six months
ended June 30, 2010, the effective tax rate was a 44.3% benefit compared to a
38.2% expense for the same period last year.  Management believes that
currently there are no additional changes in tax laws or to our tax structure
that are likely to have a material impact on our future effective tax
rate.





ANALYSIS
OF FINANCIAL CONDITION





Loans


Loans,
net of unearned income, totaled $905.5 million at June 30, 2010, a 1.2% decrease
since December 31, 2009.  Average loans were $909.3 million for the
three months ended June 30, 2010, which was slightly lower than the comparable
amount for the same period last year.  For the six months ended June
30, 2010, average loans were $909.8 million, which was slightly higher than the
comparable amount for the same period in 2009.  Loan growth slowed
when compared to the prior year as the weakened economy created fewer loan
opportunities to originate high-quality credits. At the
same time we are experiencing slowing loan growth, net loan charge-offs
increased $2.8 million and $8.0 million for the second quarter and first half of
2010, respectively, when compared to the same periods last year.





Our loan
portfolio has a concentration of commercial real estate
loans.  Commercial real estate loans, excluding construction and land
development loans, were approximately $316.4 million, or 34.9% of total loans,
at June 30, 2010, compared to $315.9 million, or 34.5% of total loans, at
December 31, 2009.  Construction and land development loans were
$155.2 million, or 17.1% of total loans, at June 30, 2010, compared to $161.4
million, or 17.6% of total loans, at December 31, 2009.  We do not
engage in foreign or subprime lending activities.





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





Allowance
for Credit Losses


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





The
provision for credit losses for the three months ended June 30, 2010 and 2009
was $4.9 million and $1.7 million, respectively. The provision for credit losses
for the first quarter of 2010 was $7.6 million.  The provision for
credit losses for the first six months of 2010 and 2009 was $12.5 million and
$3.6 million, respectively. The continued historically large level of provision
expense was the result of the overall increase in nonperforming assets and loan
charge-offs, and management’s assessment of the worsening in general economic
conditions.  We continue to emphasize credit quality and believe that
our underwriting guidelines are strong.  However, the prolonging or
deepening of the current economic recession will likely cause us to continue to
experience higher levels of provision expense, nonperforming assets and
charge-offs. As problem loans are identified, management takes prompt action to
quantify and minimize losses and also works with the borrowers in an effort to
reach mutually acceptable resolutions.


23





Net
charge-offs were $4.4 million for the three months ended June 30, 2010, compared
to $1.6 million for the same period last year and $5.7 million for the first
quarter of 2010.  Most of the charge offs in the second quarter of
2010 were residential real estate and commercial loans whereas most of the
charge-offs in the first quarter of 2010 were construction loans.  The
construction loan charge-offs during the first quarter of 2010 consisted
principally of one large real estate development loan of $3.4
million.  The allowance for credit losses as a percentage of average
loans increased to 1.46% for the second quarter of 2010, compared to 1.18% for
the second quarter of 2009 and 1.41% for the first quarter of
2010.  Net charge-offs were $10.1 million for the first six months of
2010, compared to $2.2 million for the same period in 2009. The allowance for
credit losses as a percentage of average loans increased to 1.46% for the first
six months of 2010 from 1.19% for the same period last year. Based on
management’s quarterly evaluation of the adequacy of the allowance for credit
losses, it believes that the allowance for credit losses and the related
provision were adequate at June 30, 2010 to provide for probable losses inherent
in our loan portfolio.





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





For the Three Months Ended
                  
                  
                  For the Six Months EndedJune 30,
                  
                  
                  June 30,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Allowance
      balance – beginning of period
                  
                  $
                  12,791
                  
                  
                  $
                  10,709
                  
                  
                  $
                  10,876
                  
                  
                  $
                  9,320Charge-offs:Real
      estate – construction
                  
                  
                  (681
                  )
                  
                  
                  (128
                  )
                  
                  
                  (4,190
                  )
                  
                  
                  (215
                  )Real
      estate – residential
                  
                  
                  (2,525
                  )
                  
                  
                  (611
                  )
                  
                  
                  (3,516
                  )
                  
                  
                  (951
                  )Real
      estate – commercial
                  
                  
                  (46
                  )
                  
                  
                  (173
                  )
                  
                  
                  (46
                  )
                  
                  
                  (173
                  )Commercial
                  
                  
                  (1,164
                  )
                  
                  
                  (629
                  )
                  
                  
                  (2,388
                  )
                  
                  
                  (727
                  )Consumer
                  
                  
                  (145
                  )
                  
                  
                  (88
                  )
                  
                  
                  (311
                  )
                  
                  
                  (199
                  )Totals
                  
                  
                  (4,561
                  )
                  
                  
                  (1,629
                  )
                  
                  
                  (10,451
                  )
                  
                  
                  (2,265
                  )Recoveries:Real
      estate – construction
                  
                  
                  13
                  
                  
                  
                  2
                  
                  
                  
                  13
                  
                  
                  
                  2Real
      estate – residential
                  
                  
                  36
                  
                  
                  
                  1
                  
                  
                  
                  74
                  
                  
                  
                  53Real
      estate – commercial
                  
                  
                  1
                  
                  
                  
                  -
                  
                  
                  
                  102
                  
                  
                  
                  -Commercial
                  
                  
                  53
                  
                  
                  
                  -
                  
                  
                  
                  56
                  
                  
                  
                  4Consumer
                  
                  
                  39
                  
                  
                  
                  20
                  
                  
                  
                  85
                  
                  
                  
                  54Totals
                  
                  
                  142
                  
                  
                  
                  23
                  
                  
                  
                  330
                  
                  
                  
                  113Net
      charge-offs
                  
                  
                  (4,419
                  )
                  
                  
                  (1,606
                  )
                  
                  
                  (10,121
                  )
                  
                  
                  (2,152
                  )Provision
      for credit losses
                  
                  
                  4,917
                  
                  
                  
                  1,681
                  
                  
                  
                  12,534
                  
                  
                  
                  3,616Allowance
      balance – end of period
                  
                  $
                  13,289
                  
                  
                  $
                  10,784
                  
                  
                  $
                  13,289
                  
                  
                  $
                  10,784Average
      loans outstanding during the period
                  
                  $
                  909,295
                  
                  
                  $
                  913,671
                  
                  
                  $
                  909,831
                  
                  
                  $
                  906,066Net
      charge-offs (annualized) as a percentage of average loans outstanding
      during the period
                  
                  
                  1.95
                  %
                  
                  
                  0.71
                  %
                  
                  
                  2.24
                  %
                  
                  
                  0.95
                  %Allowance
      for credit losses at period end as a percentage of average
      loans
                  
                  
                  1.46
                  %
                  
                  
                  1.18
                  %
                  
                  
                  1.46
                  %
                  
                  
                  1.19
                  %


24


Nonperforming
Assets


Nonperforming
assets were $38.9 million at June 30, 2010, compared to $18.9 million at
December 31, 2009.  The increase in nonaccrual loans during the first
half of 2010 was primarily in construction loans and related largely to two
borrowing relationships. The Company has a $5.0 million participation with a
regional bank that is matured.  Through December 31, 2009, the
customer made all interest payments.  This loan migrated from 90 days
past due to nonaccrual in the first quarter of 2010.  Also during the
first quarter of 2010, a second significant construction loan relationship
totaling approximately $14.0 million was put on nonaccrual and subsequently $3.4
million was charged off.  Total nonperforming assets to total loans
and other real estate and other assets owned increased to 4.29% at June 30,
2010, compared to 2.05% at December 31, 2009.  Loans past due 90 days
and still accruing at June 30, 2010 decreased to $4.7 million from $7.4 million
at December 31, 2009 mainly due to the previously-mentioned migration of the
$5.0 million participation from 90 days past due to nonaccrual.  The
increase in the residential real estate category was due to delinquencies and
foreclosures occurring in the second quarter of 2010.





The
following table summarizes our nonperforming and past due assets:





June 30,
                  
                  
                  December 31,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009Nonperforming assetsNonaccrual
      loansReal
      estate – construction
                  
                  $
                  20,449
                  
                  
                  $
                  7,163Real
      estate – residential
                  
                  
                  8,783
                  
                  
                  
                  4,246Real
      estate – commercial
                  
                  
                  4,224
                  
                  
                  
                  2,828Commercial
                  
                  
                  3,968
                  
                  
                  
                  2,028Consumer
                  
                  
                  64
                  
                  
                  
                  37Total
      nonaccrual loans
                  
                  
                  37,488
                  
                  
                  
                  16,302Other
      real estate and other assets owned
                  
                  
                  1,428
                  
                  
                  
                  2,572Total
      nonperforming assets
                  
                  
                  38,916
                  
                  
                  
                  18,874Loans
      90 days past due and still accruingReal
      estate – construction
                  
                  
                  48
                  
                  
                  
                  5,096Real
      estate – residential
                  
                  
                  4,365
                  
                  
                  
                  2,274Real
      estate – commercial
                  
                  
                  107
                  
                  
                  
                  -Commercial
                  
                  
                  49
                  
                  
                  
                  -Consumer
                  
                  
                  150
                  
                  
                  
                  55Total
      loans 90 days past due
                  
                  
                  4,719
                  
                  
                  
                  7,425Total
      nonperforming assets and past due loans
                  
                  $
                  43,635
                  
                  
                  $
                  26,299Nonperforming
      assets to total loans and other real estate and other assets
      owned
                  
                  
                  4.29
                  %
                  
                  
                  2.05
                  %Nonperforming
      assets to total assets
                  
                  
                  3.45
                  %
                  
                  
                  1.63
                  %Nonperforming
      assets and past due loans, to total loans and other real estate and other
      assets owned
                  
                  
                  4.81
                  %
                  
                  
                  2.86
                  %Nonperforming
      assets and past due loans to total assets
                  
                  
                  3.86
                  %
                  
                  
                  2.27
                  %


25


Investment
Securities


Investment
securities totaled $106.6 million at June 30, 2010, relatively unchanged since
December 31, 2009.  The average balance of investment securities was
$109.7 million for the three months ended June 30, 2010, compared to $83.4
million for the same period in 2009.  The tax equivalent yields on
investment securities were 3.40% and 4.28% for the three months ended June 30,
2010 and 2009, respectively.  The average balance of investment
securities was $110.0 million for the six months ended June 30, 2010, compared
to $83.7 million for the same period in 2009.  The tax equivalent
yields on investment securities were 3.49% and 4.28% for the first six months of
2010 and 2009, respectively. The increases in the 2010 investment securities
average balances compared to the 2009 average balances reflected the investment
of excess deposits.





Deposits


Total
deposits at June 30, 2010 were $971.6 million, a $19.3 million, or 2.0%,
decrease when compared to the $990.9 million at December 31,
2009.  The decrease was primarily in certificates of deposit $100,000
or more mainly due to municipal deposits which historically decline at this time
of the year.  The decrease in other time deposits was attributable to
management’s effort to reduce deposit pricing structures.





Short-Term
Borrowings


Short-term
borrowings at June 30, 2010 and December 31, 2009 were $17.9 million and $20.4
million, respectively.  Short-term borrowings generally consist of
securities sold under agreements to repurchase, overnight borrowings from
correspondent banks and short-term advances from the FHLB.  Short-term
advances are defined as those with original maturities of one year or
less.  The decline in short-term borrowings since December 31, 2009
was primarily due to the repayment of $3.4 million drawn on a $10.0 million line
of credit with a commercial bank.





Long-Term
Debt


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





Liquidity
and Capital Resources


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





To the
extent that deposits are not adequate to fund customer loan demand, liquidity
needs can be met in the short-term funds markets through arrangements with
correspondent banks.  Talbot Bank and CNB are also members of the FHLB
of Atlanta and Felton Bank is a member of the FHLB of Pittsburgh, and these
banks have pledged collateral sufficient to permit additional borrowings of up
to approximately $24.3 million in the aggregate at June 30, 2010. Management is
not aware of any trends or demands, commitments, events or uncertainties that
are likely to materially affect our future ability to maintain liquidity at
satisfactory levels.





Total
stockholders’ equity was $124.7 million at June 30, 2010, compared to $127.8
million at December 31, 2009. The net loss, unrealized losses on cash flow
hedging activities and dividends paid all contributed to the decrease in
stockholders’ equity since the end of 2009.  To increase capital,
support the Company’s growth, and enhance capital ratios, management has reduced
dividends in 2010.  The Company reduced the quarterly common stock
dividend to $0.06 from $0.16 per share beginning with the
dividend that was payable on February 26, 2010.





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





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


26


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





MinimumJune 30,
                  
                  
                  December 31,
                  
                  
                  Regulatory2010
                  
                  
                  2009
                  
                  
                  RequirementsTier
      1 risk-based capital ratio
                  
                  
                  11.63
                  %
                  
                  
                  11.45
                  %
                  
                  
                  4.00
                  %Total
      risk-based capital ratio
                  
                  
                  12.86
                  %
                  
                  
                  12.59
                  %
                  
                  
                  8.00
                  %Leverage
      ratio
                  
                  
                  9.40
                  %
                  
                  
                  9.27
                  %
                  
                  
                  4.00
                  %





Item
3.  Quantitative and Qualitative Disclosures about Market
Risk.





Our
primary market risk is to interest rate fluctuation and management has
procedures in place to evaluate and mitigate this risk.  This risk and
these procedures are discussed in Item 7 of Part II of the Annual Report of
Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2009 under
the caption “Market Risk Management”.  Management believes that there
have been no material changes in our market risks, the procedures used to
evaluate and mitigate these risks, or our actual and simulated sensitivity
positions since December 31, 2009.





Item
4.  Controls and Procedures.





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





An
evaluation of the effectiveness of these disclosure controls as of June 30, 2010
was carried out under the supervision and with the participation of management,
including the CEO and the PAO.  Based on that evaluation, the
Company’s management, including the CEO and the PAO, has concluded that our
disclosure controls and procedures are, in fact, effective at the reasonable
assurance level.





There was
no change in our internal control over financial reporting during the second
quarter of 2010 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.





PART
II – OTHER INFORMATION





Item
1A.  Risk Factors.





The risks
and uncertainties to which our financial condition and operations are subject
are discussed in detail in Item 1A of Part I of the Annual Report of Shore
Bancshares, Inc. on Form 10-K for the year ended December 31,
2009.  Management does not believe that any material changes in our
risk factors have occurred since they were last disclosed other than the
following:





The Dodd-Frank Wall
Street Reform and Consumer Protection Act may affect our business activities,
financial position and profitability by increasing our regulatory compliance
burden and associated costs, placing restrictions on certain products and
services, and limiting our future capital raising strategies.


27


On
July 21, 2010, the President signed into law the Dodd-Frank Wall
Street Reform and Consumer Protection Act (the “Act”), which implements
significant changes in the financial regulatory landscape and will impact all
financial institutions, including Talbot Bank, CNB and Felton Bank. The Act is
likely to increase our regulatory compliance burden. However, it is too early
for us to fully assess the full impact of the Act on our business, financial
condition or results of operations in part because many of the Act’s provisions
require subsequent regulatory rulemaking.





Among the
Act’s significant regulatory changes, it creates a new financial consumer
protection agency, known as the Bureau of Consumer Financial Protection (the
“Bureau”), that is empowered to promulgate new consumer protection regulations
and revise existing regulations in many areas of consumer compliance, which will
increase our regulatory compliance burden and costs and may restrict the
financial products and services we offer to our customers.


Moreover,
the Act permits states to adopt stricter consumer protection laws and states
attorney general may enforce consumer protection rules issued by the Bureau. The
Act also imposes more stringent capital requirements on bank holding companies
by, among other things, imposing leverage ratios on bank holding companies and
prohibiting new trust preferred issuances from counting as Tier 1 capital. These
restrictions will limit our future capital strategies.


The Act
also increases regulation of derivatives and hedging transactions, which could
limit our ability to enter into, or increase the costs associated with, interest
rate and other hedging transactions.





Although
certain provisions of the Act, such as direct supervision by the Bureau, will
not apply to banking organizations with less than $10 billion of assets, such as
Talbot Bank, CNB and Felton Bank, the changes resulting from the legislation
will impact our business. These changes will require us to invest significant
management attention and resources to evaluate and make necessary
changes.





Recent
amendments to the Federal Reserve Board's Regulation E may negatively
impact our noninterest income.





On
November 12, 2009, the Board of Governors of the Federal Reserve System
announced the final rules amending Regulation E that prohibit financial
institutions from charging fees to consumers for paying overdrafts on
automated teller machine and one-time debit card transactions, unless a
consumer consents, or opts-in,  to the overdraft service for those
types of transactions.  Compliance with this regulation is effective July
1, 2010 for new consumer accounts and August 15, 2010for existing consumer
accounts.  The impact that these new rules will have on us is
unknown at this time, but they do have the potential to reduce our
noninterest income and this reduction could be material.





Item 6.  Exhibits.





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





SIGNATURES





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




SHORE
      BANCSHARES, INC.Date:
      August 6, 2010
                              By:
                              /s/ W. Moorhead VermilyeW.
      Moorhead VermilyePresident/Chief
      Executive
Officer





Date:
      August 6, 2010
                    By:
                    /s/ Susan E. LeavertonSusan
      E. Leaverton, CPATreasurer/Principal
      Accounting
Officer


28


EXHIBIT
INDEX


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


29