UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549










FORM
10-K





ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934





For the
Year Ended December 31, 2008





Commission
File No. 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





Securities
Registered pursuant to Section 12(b) of the Act:





Title of Each Class:
              
              Name of Each Exchange on Which
      Registered:Common
      stock, par value $.01 per share
              
              Nasdaq
      Global Select Market





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.   ̈





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 16(d) of the Act.  ̈





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 period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days Yes x No  ̈





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K  ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (check one):


Large
accelerated filer  ̈   Accelerated
filer x  
Non-accelerated filer  ̈Smaller Reporting Company  ̈





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act):


Yes  ̈ No x





State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter:  $147,590,539.





The
number of shares outstanding of the registrant’s common stock as of the latest
practicable date: 8,404,709 as of March 2,
2009.





Documents
Incorporated by Reference





Certain
information required by Part III of this annual report is incorporated herein by
reference to the definitive proxy statement for the 2009 Annual Meeting of
Stockholders.








INDEX





Part
      IItem
      1.
                              Business
                              2Item
      1A.
                              Risk
      Factors
                              10Item
      1B.
                              Unresolved
      Staff Comments
                              16Item
      2.
                              Properties
                              16Item
      3.
                              Legal
      Proceedings
                              17Item
      4.
                              Submission
      of Matters to a Vote of Security Holders
                              18Part
      IIItem
      5.
                              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                              18Item
      6.
                              Selected
      Financial Data
                              21Item
      7.
                              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                              21Item
      7A.
                              Quantitative
      and Qualitative Disclosures About Market Risk
                              38Item
      8.
                              Financial
      Statements and Supplementary Data
                              38Item
      9.
                              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                              72Item
      9A.
                              Controls
      and Procedures
                              72Item
      9B.
                              Other
      Information
                              72Part
      IIIItem
      10.
                              Directors,
      Executive Officers and Corporate Governance
                              72Item
      11.
                              Executive
      Compensation
                              72Item
      12.
                              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                              73Item
      13.
                              Certain
      Relationships and Related Transactions, and Director
      Independence
                              73Item
      14.
                              Principal
      Accountant Fees and Services
                              73Part
      IVItem
      15.
                              Exhibits
      and Financial Statement Schedules
                              73SIGNATURES
                              74EXHIBIT
      LIST
                              75







This
Annual Report of Shore Bancshares, Inc. (the “Company”) on Form 10-K contains
forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995.  Readers of this report should be aware
of the speculative nature of “forward-looking statements”.  Statements
that are not historical in nature, including the words “anticipate”, “estimate”,
“should”, “expect”, “believe”, “intend”, and similar expressions, are based on
current expectations, estimates and projections about (among other things) the
industry and the markets in which the Company and its subsidiaries operate; they
are not guarantees of future performance.  Whether actual results will
conform to expectations and predictions is subject to known and unknown risks
and uncertainties, including risks and uncertainties discussed in this Form
10-K, general economic, market or business conditions; changes in interest
rates, deposit flow, the cost of funds, and demand for loan products and
financial services; changes in our competitive position or competitive actions
by other companies; changes in the quality or composition of loan and investment
portfolios; the ability to mange growth; changes in laws or regulations or
policies of federal and state regulators and agencies; and other circumstances
beyond the Company’s control.  Consequently, all of the
forward-looking statements made in this document are qualified by these
cautionary statements, and there can be no assurance that the actual results
anticipated will be realized, or if substantially realized, will have the
expected consequences on the Company’s business or operations.  For a
more complete discussion of these and other risk factors, see Item 1A of Part I
of this report.  Except as required by applicable laws, we do not
intend to publish updates or revisions of forward-looking statements it makes to
reflect new information, future events or otherwise.





Except as
expressly provided otherwise, the term “Company” as used in this report refers
to Shore Bancshares, Inc. and the terms “we”, “us” and “our” refer collectively
to Shore Bancshares, Inc. and its consolidated subsidiaries.





PART
I





Item
1.      Business.





BUSINESS





General





The
Company was incorporated under the laws of Maryland on March 15, 1996 and is a
financial holding company registered under the Bank Holding Company Act of 1956,
as amended (the “BHC Act”).  The Company’s primary business is acting
as the parent company to several financial institution and insurance
entities.  The Company engages in the banking business through The
Centreville National Bank of Maryland, a national banking association
(“Centreville National Bank”), The Talbot Bank of Easton, Maryland, a Maryland
commercial bank (“Talbot Bank”), and The Felton Bank, a Delaware commercial
bank  (“Felton Bank” and, together with Centreville National Bank and
Talbot Bank, the “Banks”).  The Company engages in the insurance
business through two general insurance producer firms, The Avon-Dixon Agency,
LLC, a Maryland limited liability company, and Elliott Wilson Insurance, LLC, a
Maryland limited liability company; one marine insurance producer firm, Jack
Martin & Associates, Inc., a Maryland corporation; three wholesale insurance
firms, Tri-State General Insurance Agency, LTD, a Maryland corporation,
Tri-State General Insurance Agency of New Jersey, Inc., a New Jersey
corporation, and Tri-State General Insurance Agency of Virginia, Inc., a
Virginia corporation; and two insurance premium finance companies, Mubell
Finance, LLC, a Maryland limited liability company, and ESFS, Inc., a Maryland
corporation (all of the foregoing are collectively referred to as the “Insurance
Subsidiaries”).  On March 1, 2008, the Company established a mortgage
broker subsidiary, Wye Mortgage Group, LLC (the “Mortgage
Group”).  The Company also has two inactive subsidiaries, Wye
Financial Services, LLC and Shore Pension Services, LLC, both of which were
organized under Maryland law.





Talbot
Bank owns all of the issued and outstanding securities of Dover Street Realty,
Inc., a Maryland corporation that engages in the business of holding and
managing real property acquired by Talbot Bank as a result of loan
foreclosures.





We
operate in two business segments:  community banking and insurance
products and services.  Financial information related to our
operations in these segments for each of the two years ended December 31, 2008
is provided in Note 25 to the Company’s Consolidated Financial Statements
included in Item 8 of Part II of this report.





Banking
Products and Services





Centreville
National Bank is a national banking association that commenced operations in
1876.  Talbot Bank is a Maryland commercial bank that commenced
operations in 1885 and was acquired by the Company in its December 2000 merger
with Talbot Bancshares, Inc. (“Talbot Bancshares”).  Felton Bank is a
Delaware commercial bank that commenced operations in 1908 and was acquired by
the Company in April 2004 when it merged with Midstate Bancorp,
Inc.  The Banks operate 18 full service branches and 22 ATMs and
provide a full range of commercial and consumer banking products and services
to




2




individuals,
businesses, and other organizations in the Kent County, Queen Anne’s County,
Caroline County, Talbot County and Dorchester County in Maryland and in Kent
County, Delaware.  The Banks’ deposits are insured by the Federal
Deposit Insurance Corporation (the “FDIC”).


The Banks
are independent community banks and serve businesses and individuals in their
respective market areas.  Services offered are essentially the same as
those offered by larger regional institutions that compete with the Banks.
Services provided to businesses include commercial checking, savings,
certificate of deposit and overnight investment sweep accounts. The Banks offer
all forms of commercial lending, including secured and unsecured loans, working
capital loans, lines of credit, term loans, accounts receivable financing, real
estate acquisition development, construction loans and letters of
credit.  Merchant credit card clearing services are available as well
as direct deposit of payroll, internet banking and telephone banking
services.





Services
to individuals include checking accounts, various savings programs, mortgage
loans, home improvement loans, installment and other personal loans, credit
cards, personal lines of credit, automobile and other consumer financing, safe
deposit boxes, debit cards, 24 hour telephone banking, internet banking, and
24-hour automatic teller machine services.  The Banks also offer
nondeposit products, such as mutual funds and annuities, and discount brokerage
services to their customers.  Additionally, the Banks have Saturday
hours and extended hours on certain evenings during the week for added customer
convenience.





Lending
Activities





The Banks
originate secured and unsecured loans for business
purposes.  Commercial loans are typically secured by real estate,
accounts receivable, inventory equipment and/or other assets of the
business.  Commercial loans generally involve a greater degree of
credit risk than one to four family residential mortgage
loans.  Repayment is often dependent on the successful operation of
the business and may be affected by adverse conditions in the local economy or
real estate market. The financial condition and cash flow of commercial
borrowers is therefore carefully analyzed during the loan approval process, and
continues to be monitored by obtaining business financial statements, personal
financial statements and income tax returns.  The frequency of this
ongoing analysis depends upon the size and complexity of the credit and
collateral that secures the loan.  It is also the Company’s general
policy to obtain personal guarantees from the principals of the commercial loan
borrowers.





Commercial
real estate loans are primarily those secured by land for residential and
commercial development, agricultural purpose properties, service industry
buildings such as restaurants and motels, retail buildings and general purpose
business space.  The Banks attempt to mitigate the risks associated
with these loans through thorough financial analyses, conservative underwriting
procedures, including prudent loan to value ratio standards, obtaining
additional collateral when prudent, closely monitoring construction projects to
control disbursement of funds on loans, and management’s knowledge of the local
economy in which the Banks lend.





The Banks
provide residential real estate construction loans to builders and individuals
for single family dwellings. Residential construction loans are usually granted
based upon “as completed” appraisals and are secured by the property under
construction.  Additional collateral may be taken if loan to value
ratios exceed 80%.  Site inspections are performed to determine
pre-specified stages of completion before loan proceeds are
disbursed.  These loans typically have maturities of six to 12 months
and may have fixed or variable rate features.  Permanent financing
options for individuals include fixed and variable rate loans with three- and
five-year balloon features and one-, three- and five-year adjustable rate
mortgage loans.  The risk of loss associated with real estate
construction lending is controlled through conservative underwriting procedures
such as loan to value ratios of 80% or less, obtaining additional collateral
when prudent, and closely monitoring construction projects to control
disbursement of funds on loans.





The Banks
originate fixed and variable rate residential mortgage loans.  As with
any consumer loan, repayment is dependent on the borrower’s continuing financial
stability, which can be adversely impacted by job loss, divorce, illness, or
personal bankruptcy.  Underwriting standards recommend loan to value
ratios not to exceed 80% based on appraisals performed by approved
appraisers.  The Banks rely on title insurance to protect their lien
priorities and protect the property securing the loans by requiring fire and
casualty insurance.





The
Mortgage Group, which operated in 2007 as a division of Centreville National
Bank, brokers long-term fixed rate residential mortgage loans for sale on the
secondary market for which it receives commissions upon settlement.





A variety
of consumer loans are offered to customers, including home equity loans, credit
cards and other secured and unsecured lines of credit and term
loans.  Careful analysis of an applicant’s creditworthiness is
performed before granting credit, and on going monitoring of loans outstanding
is performed in an effort to minimize risk of loss by identifying problem loans
early.




3


Deposit
Activities





The Banks
offer a full array of deposit products including checking, savings and money
market accounts, regular and IRA certificates of deposit, and Christmas Savings
accounts.  The Banks also offer the CDARS program, providing up to $50
million of FDIC insurance to our customers.  In addition, we offer our
commercial customers packages which include Cash Management services and various
checking opportunities.





Trust
Services





Centreville
National Bank established a trust department during the second quarter of 2005
and markets trust, asset management and financial planning services to customers
within our market areas.





Insurance
Activities





The
Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC
were formed as a result of the Company’s acquisition of the assets of The
Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial
Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company
on May 1, 2002.  In November 2002, The Avon-Dixon Agency, LLC acquired
certain assets of W. M. Freestate & Son, Inc., a full-service insurance
producer firm located in Centreville, Maryland.  Jack Martin &
Associates, Inc., Tri-State General Insurance Agency, LTD, Tri-State General
Insurance Agency of New Jersey, Inc., Tri-State General Insurance Agency of
Virginia, Inc., and ESFS, Inc. were acquired on October 1, 2007.





The
Insurance Subsidiaries offer a full range of insurance products and services to
customers, including insurance premium financing.





Seasonality





Management
does not believe that our business activities are seasonal in
nature.  Demand for our products and services may vary depending on
local and national economic conditions, but management believes that any
variation will not have a material impact on our planning or policy-making
strategies.





Employees





At
February 28, 2009, we employed 369 persons, of which 337 were employed on a
full-time basis.





COMPETITION





The
banking business, in all of its phases, is highly competitive.  Within
our market areas, we compete with commercial banks (including local banks and
branches or affiliates of other larger banks), savings and loan associations and
credit unions for loans and deposits, with money market and mutual funds and
other investment alternatives for deposits, with consumer finance companies for
loans, with insurance companies, agents and brokers for insurance products, and
with other financial institutions for various types of products and
services.  There is also competition for commercial and retail banking
business from banks and financial institutions located outside our market
areas.





The
primary factors in competing for deposits are interest rates, personalized
services, the quality and range of financial services, convenience of office
locations and office hours.  The primary factors in competing for
loans are interest rates, loan origination fees, the quality and range of
lending services and personalized services.  The primary factors in
competing for insurance customers are competitive rates, the quality and range
of insurance products offered, and quality, personalized service.





To
compete with other financial services providers, we rely principally upon local
promotional activities, including advertisements in local newspapers, trade
journals and other publications and on the radio, personal relationships
established by officers, directors and employees with customers, and specialized
services tailored to meet its customers’ needs.  In those instances in
which we are unable to accommodate the needs of a customer, we will arrange for
those services to be provided by other financial services providers with which
we have a relationship.  We additionally rely on referrals from
satisfied customers.


4





The
following tables set forth deposit data for FDIC-insured institutions in Kent
County, Queen Anne’s County, Caroline County, Talbot County and Dorchester
County in Maryland and for Kent County, Delaware as of June 30, 2008, the
most recent date for which comparative information is available.




Kent County, Maryland
                    
                    Deposits
                    
                    
                    %
      of
                      Total(in
      thousands)Peoples
      Bank of Kent County, Maryland
                    
                    $
                    169,416
                    
                    
                    
                    33.86
                    %PNC
      Bank National Assn
                    
                    
                    166,204
                    
                    
                    
                    33.22Chesapeake
      Bank and Trust Co.
                    
                    
                    62,942
                    
                    
                    
                    12.58Branch
      Banking & Trust
                    
                    
                    43,590
                    
                    
                    
                    8.71The
      Centreville National Bank of Maryland
                    
                    
                    31,286
                    
                    
                    
                    6.25SunTrust
      Bank
                    
                    
                    26,921
                    
                    
                    
                    5.38Total
                    
                    $
                    500,359
                    
                    
                    
                    100.00
                    %





Source:  FDIC
DataBook





Queen Anne’s County,
    Maryland
                    
                    Deposits
                    
                    
                    %
      of
                      Total(in
      thousands)The
      Queenstown Bank of Maryland
                    
                    $
                    313,163
                    
                    
                    
                    42.69
                    %The
      Centreville National Bank of Maryland
                    
                    
                    191,853
                    
                    
                    
                    26.15PNC
      Bank National Assn
                    
                    
                    60,719
                    
                    
                    
                    8.28Bank
      of America, National Association
                    
                    
                    54,247
                    
                    
                    
                    7.40Bank
      Annapolis
                    
                    
                    40,340
                    
                    
                    
                    5.50M&T
                    
                    
                    40,138
                    
                    
                    
                    5.47Branch
      Banking & Trust
                    
                    
                    24,220
                    
                    
                    
                    3.30Sun
      Trust Bank
                    
                    
                    5,079
                    
                    
                    
                    0.69Branch
      Banking & Trust
                    
                    
                    3,780
                    
                    
                    
                    0.52Total
                    
                    $
                    733,539
                    
                    
                    
                    100.00
                    %





Source:  FDIC
DataBook





%
      ofCaroline County, Maryland
                      
                      Deposits
                      
                      
                      Total(in
      thousands)Provident
      State Bank of Preston, Maryland
                      
                      $
                      147,542
                      
                      
                      
                      36.07
                      %PNC
      Bank National Assn
                      
                      
                      106,091
                      
                      
                      
                      25.94The
      Centreville National Bank of Maryland
                      
                      
                      54,343
                      
                      
                      
                      13.29Branch
      Banking & Trust
                      
                      
                      44,325
                      
                      
                      
                      10.84M&T
                      
                      
                      28,629
                      
                      
                      
                      7.00Bank
      of America, National Association
                      
                      
                      16,877
                      
                      
                      
                      4.13Easton
      Bank & Trust
                      
                      
                      11,204
                      
                      
                      
                      2.74Total
                      
                      $
                      409,011
                      
                      
                      
                      100.00
                      %





Source:  FDIC
DataBook


5





%
      ofTalbot County, Maryland
                      
                      Deposits
                      
                      
                      Total(in
      thousands)The
      Talbot Bank of Easton, Maryland
                      
                      $
                      456,354
                      
                      
                      
                      45.46
                      %PNC
      Bank National Assn
                      
                      
                      145,184
                      
                      
                      
                      14.46Easton
      Bank & Trust
                      
                      
                      111,451
                      
                      
                      
                      11.10Bank
      of America, National Association
                      
                      
                      89,861
                      
                      
                      
                      8.95Branch
      Banking & Trust
                      
                      
                      57,787
                      
                      
                      
                      5.76SunTrust
      Bank
                      
                      
                      41,605
                      
                      
                      
                      4.14M&T
                      
                      
                      28,479
                      
                      
                      
                      2.84The
      Queenstown Bank of Maryland
                      
                      
                      26,912
                      
                      
                      
                      2.68First
      Mariner Bank
                      
                      
                      17,324
                      
                      
                      
                      1.73Chevy
      Chase Bank
                      
                      
                      14,765
                      
                      
                      
                      1.47Provident
      State Bank of Preston, Maryland
                      
                      
                      14,182
                      
                      
                      
                      1.41Total
                      
                      $
                      1,003,904
                      
                      
                      
                      100.00
                      %





Source:  FDIC
DataBook


%
      ofDorchester County, Maryland
                      
                      Deposits
                      
                      
                      Total(in
      thousands)The
      National Bank of Cambridge
                      
                      $
                      187,071
                      
                      
                      
                      31.97
                      %Bank
      of the Eastern Shore
                      
                      
                      182,882
                      
                      
                      
                      31.25Hebron
      Savings Bank
                      
                      
                      55,996
                      
                      
                      
                      9.57Branch
      Banking & Trust
                      
                      
                      42,290
                      
                      
                      
                      7.23Provident
      State Bank of Preston, Maryland
                      
                      
                      35,459
                      
                      
                      
                      6.06Bank
      of America, National Association
                      
                      
                      25,672
                      
                      
                      
                      4.39M&T
                      
                      
                      20,710
                      
                      
                      
                      3.54The
      Talbot Bank of Easton, Maryland
                      
                      
                      17,979
                      
                      
                      
                      3.07SunTrust
      Bank
                      
                      
                      17,109
                      
                      
                      
                      2.92Total
                      
                      $
                      585,168
                      
                      
                      
                      100.00
                      %





Source:  FDIC
DataBook


%
      ofKent County, Delaware
                      
                      Deposits
                      
                      
                      Total(in
      thousands)Wilmington
      Trust
                      
                      $
                      536,436
                      
                      
                      
                      31.39
                      %PNC
      Bank Delaware
                      
                      
                      250,866
                      
                      
                      
                      14.68RBS
      Citizens National Assn
                      
                      
                      243,050
                      
                      
                      
                      14.22First
      NB of Wyoming
                      
                      
                      201,660
                      
                      
                      
                      11.80Wachovia
      Bank of Delaware
                      
                      
                      158,922
                      
                      
                      
                      9.30The
      Felton Bank
                      
                      
                      80,282
                      
                      
                      
                      4.70Artisans
      Bank
                      
                      
                      69,307
                      
                      
                      
                      4.06Wilmington
      Savings Fund Society
                      
                      
                      65,890
                      
                      
                      
                      3.86TD
      Bank National Assn
                      
                      
                      57,824
                      
                      
                      
                      3.38County
      Bank
                      
                      
                      39,985
                      
                      
                      
                      2.34Fort Sill National Bank
                      
                      
                      4,517
                      
                      
                      
                      0.26Total
                      
                      $
                      1,708,739
                      
                      
                      
                      100.00
                      %





Source:  FDIC
DataBook





For
further information about competition in our market areas, see the Risk Factor
entitled “We operate in a highly competitive market” in Item 1A of Part I of
this annual report.





SUPERVISION
AND REGULATION





The
following is a summary of the material regulations and policies applicable to us
and is not intended to be a comprehensive discussion.  Changes in
applicable laws and regulations may have a material effect on our business,
financial condition and results of operation.


6





General





The
Company is a financial holding company registered with the Board of Governors of
the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is
subject to the supervision, examination and reporting requirements of the BHC
Act and the regulations of the FRB.





Talbot
Bank is a Maryland commercial bank subject to the banking laws of Maryland and
to regulation by the Commissioner of Financial Regulation of Maryland, who is
required by statute to make at least one examination in each calendar year (or
at 18-month intervals if the Commissioner determines that an examination is
unnecessary in a particular calendar year).  Centreville National Bank
is a national banking association subject to federal banking laws and
regulations enforced and/or promulgated by the Office of the Comptroller of the
Currency (the “OCC”), which is required by statute to make at least one
examination in each calendar year.  Felton Bank is a Delaware
commercial bank subject to the banking laws of Delaware and to regulation by the
Delaware Office of the State Bank Commissioner, who is entitled by statute to
make examinations of Felton Bank as and when deemed necessary or
expedient.  The primary federal regulator of both Talbot Bank and
Felton Bank is the FDIC, which is also entitled to conduct regular
examinations.  The deposits of the Banks are insured by the FDIC, so
certain laws and regulations administered by the FDIC also govern their deposit
taking operations.  In addition to the foregoing, the Banks are
subject to numerous state and federal statutes and regulations that affect the
business of banking generally.





Nonbank
affiliates of the Company are subject to examination by the FRB, and, as
affiliates of the Banks, may be subject to examination by the Banks’ regulators
from time to time.  In addition, the Insurance Subsidiaries are each
subject to licensing and regulation by the insurance authorities of the states
in which they do business.  Retail sales of insurance products by the
Insurance Subsidiaries to customers of the Banks are also subject to the
requirements of the Interagency Statement on Retail Sales of Nondeposit
Investment Products promulgated in 1994, as amended, by the FDIC, the FRB, the
OCC, and the Office of Thrift Supervision.  The Mortgage Group is
subject to supervision by the banking agencies of the states in which it does
business.  Wye Financial Services, LLC is subject to the registration
and examination requirements of federal and state laws governing investment
advisers.





Regulation
of Financial Holding Companies





In
November 1999, the federal Gramm-Leach-Bliley Act (the “GLB Act”) was signed
into law.  Effective in pertinent part on March 11, 2000, the GLB Act
revised the BHC Act and repealed the affiliation provisions of the
Glass-Steagall Act of 1933, which, taken together, limited the securities,
insurance and other non-banking activities of any company that controls an FDIC
insured financial institution.  Under the GLB Act, a bank holding
company can elect, subject to certain qualifications, to become a “financial
holding company”.  The GLB Act provides that a financial holding
company may engage in a full range of financial activities, including insurance
and securities sales and underwriting activities, and real estate development,
with new expedited notice procedures.





Under FRB
policy, the Company is expected to act as a source of strength to its subsidiary
banks, and the FRB may charge the Company with engaging in unsafe and unsound
practices for failure to commit resources to a subsidiary bank when
required.  In addition, under the Financial Institutions Reform,
Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured
by the FDIC can be held liable for any losses incurred by, or reasonably
anticipated to be incurred by, the FDIC in connection with (i) the default of a
commonly controlled FDIC-insured depository institution or (ii) any assistance
provided by the FDIC to a commonly controlled FDIC-insured depository
institution in danger of default.  Accordingly, in the event that any
insured subsidiary of the Company causes a loss to the FDIC, other insured
subsidiaries of the Company could be required to compensate the FDIC by
reimbursing it for the estimated amount of such loss.  Such cross
guaranty liabilities generally are superior in priority to obligations of a
financial institution to its stockholders and obligations to other
affiliates.





Federal
Regulation of Banks





Federal
and state banking regulators may prohibit the institutions over which they have
supervisory authority from engaging in activities or investments that the
agencies believes are unsafe or unsound banking practices.  These
banking regulators have extensive enforcement authority over the institutions
they regulate to prohibit or correct activities that violate law, regulation or
a regulatory agreement or which are deemed to be unsafe or unsound
practices.  Enforcement actions may include the appointment of a
conservator or receiver, the issuance of a cease and desist order, the
termination of deposit insurance, the imposition of civil money penalties on the
institution, its directors, officers, employees and institution-affiliated
parties, the issuance




7


of
directives to increase capital, the issuance of formal and informal agreements,
the removal of or restrictions on directors, officers, employees and
institution-affiliated parties, and the enforcement of any such mechanisms
through restraining orders or other court actions.




The Banks
are subject to the provisions of Section 23A and Section 23B of the Federal
Reserve Act.  Section 23A limits the amount of loans or extensions of
credit to, and investments in, the Company and its nonbank affiliates by the
Banks.  Section 23B requires that transactions between any of the
Banks and the Company and its nonbank affiliates be on terms and under
circumstances that are substantially the same as with
non-affiliates.





The Banks
are also subject to certain restrictions on extensions of credit to executive
officers, directors, and principal stockholders or any related interest of such
persons, which generally require that such credit extensions be made on
substantially the same terms as are available to third parties dealing with the
Banks and not involve more than the normal risk of repayment.  Other
laws tie the maximum amount that may be loaned to any one customer and its
related interests to capital levels.





As part
of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”),
each federal banking regulator adopted non-capital safety and soundness
standards for institutions under its authority.  These standards
include internal controls, information systems and internal audit systems, loan
documentation, credit underwriting, interest rate exposure, asset growth, and
compensation, fees and benefits.  An institution that fails to meet
those standards may be required by the agency to develop a plan acceptable to
meet the standards.  Failure to submit or implement such a plan may
subject the institution to regulatory sanctions.  The Company, on
behalf of the Banks, believes that the Banks meet substantially all standards
that have been adopted.  FDICIA also imposes new capital standards on
insured depository institutions.





The
Community Reinvestment Act (“CRA”) requires that, in connection with the
examination of financial institutions within their jurisdictions, the federal
banking regulators evaluate the record of the financial institution in meeting
the credit needs of their communities including low and moderate income
neighborhoods, consistent with the safe and sound operation of those
banks.  These factors are also considered by all regulatory agencies
in evaluating mergers, acquisitions and applications to open a branch or
facility.  As of the date of its most recent examination report, each
of the Banks has a CRA rating of “Satisfactory.”





On
October 14, 2008, the FDIC announced the creation of the Temporary Liquidity
Guarantee Program (the “TLGP”) to decrease the cost of bank funding and,
hopefully, normalize lending.  This program is comprised of two
components. The first component guarantees senior unsecured debt issued between
October 14, 2008 and June 30, 2009.  The guarantee will remain in
effect until June 30, 2012 for such debts that mature beyond June 30,
2009.  The second component provides full coverage for non-interest
bearing transaction deposit accounts, IOLTAs, and NOW accounts with interest
rates of 0.50 percent or less, regardless of account balance, until December 31,
2009.  We elected to participate in both programs and expect FDIC
premiums to increase in 2009 as a result.





Capital
Requirements





FDICIA
established a system of prompt corrective action to resolve the problems of
undercapitalized institutions.  Under this system, federal banking
regulators are required to rate supervised institutions on the basis of five
capital categories: “well -capitalized,” “adequately capitalized,”
“undercapitalized,” “significantly undercapitalized,” and “critically
undercapitalized;” and to take certain mandatory actions, and are authorized to
take other discretionary actions, with respect to institutions in the three
undercapitalized categories.  The severity of the actions will depend
upon the category in which the institution is placed.  A depository
institution is “well capitalized” if it has a total risk based capital ratio of
10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a
leverage ratio of 5% or greater and is not subject to any order, regulatory
agreement, or written directive to meet and maintain a specific capital level
for any capital measure.  An “adequately capitalized” institution is
defined as one that has a total risk based capital ratio of 8% or greater, a
Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or
greater (or 3% or greater in the case of a bank with a composite CAMELS rating
of 1).





FDICIA
generally prohibits a depository institution from making any capital
distribution, including the payment of cash dividends, or paying a management
fee to its holding company if the depository institution would thereafter be
undercapitalized.  Undercapitalized depository institutions are
subject to growth limitations and are required to submit capital restoration
plans.  For a capital restoration plan to be acceptable, the
depository institution’s parent holding company must guarantee (subject to
certain limitations) that the institution will comply with such capital
restoration plan.





Significantly
undercapitalized depository institutions may be subject to a number of other
requirements and restrictions, including orders to sell sufficient voting stock
to become adequately capitalized and requirements to reduce total assets and
stop accepting deposits from correspondent banks.  Critically
undercapitalized depository institutions are subject to the appointment of a
receiver or conservator; generally within 90 days of the date such institution
is determined to be critically undercapitalized.


8





As of
December 31, 2008, the Banks were each deemed to be “well
capitalized.”  For more information regarding the capital condition of
the Company, see Note 17 of Consolidated Financial Statements appearing in Item
8 of Part II of this report.





Deposit
Insurance





The
deposits of the Banks are insured to a maximum of $100,000 per depositor through
the Deposit Insurance Fund, which is administered by the FDIC, and the Banks are
required to pay semi-annual deposit insurance premium assessments to the
FDIC.  The Deposit Insurance Fund was created pursuant to the Federal
Deposit Insurance Reform Act of 2005, which was signed into law on February 8,
2006.  Under this new law, (i) the current $100,000 deposit insurance
coverage will be indexed for inflation (with adjustments every five years,
commencing January 1, 2011), and (ii) deposit insurance coverage for retirement
accounts was increased to $250,000 per participant subject to adjustment for
inflation.  In addition, the FDIC will be given greater latitude in
setting the assessment rates for insured depository institutions which could be
used to impose minimum assessments.  Effective October 3, 2008, the
Emergency Economic Stabilization Act of 2008 (the “EESA”) was enacted to
temporarily raise the basic limit on federal deposit insurance coverage from
$100,000 to $250,000 per depositor.  The legislation states the limit
will return to $100,000 after December 31, 2009.  The coverage for
retirement accounts did not change and remains at $250,000.  The Banks
paid a total of $377 thousand in FDIC premiums during 2008.  The
Banks’ portion of the one-time credit assessment was
$541,000.  Further information about deposit insurance premiums is
provided in Item 7 of Part II of this report under the heading “Recent
Developments”.





USA
PATRIOT Act





Congress
adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response
to the terrorist attacks that occurred on September 11, 2001.  Under
the Patriot Act, certain financial institutions, including banks, are required
to maintain and prepare additional records and reports that are designed to
assist the government’s efforts to combat terrorism.  The Patriot Act
includes sweeping anti-money laundering and financial transparency laws and
required additional regulations, including, among other things, standards for
verifying client identification when opening an account and rules to promote
cooperation among financial institutions, regulators and law enforcement
entities in identifying parties that may be involved in terrorism or money
laundering.





Federal
Securities Laws





The
shares of the Company’s common stock are registered with the Securities and
Exchange Commission (the “SEC”) under Section 12(b) of the Securities Exchange
Act of 1934, as amended (the “Exchange Act”), and listed on the NASDAQ Global
Select Market.  The Company is subject to information reporting
requirements, proxy solicitation requirements, insider trading restrictions and
other requirements of the Exchange Act, including the requirements imposed under
the federal Sarbanes-Oxley Act of 2002.  Among other things, loans to
and other transactions with insiders are subject to restrictions and heightened
disclosure, directors and certain committees of the Board must satisfy certain
independence requirements, and the Corporation is generally required to comply
with certain corporate governance requirements.





Governmental
Monetary and Credit Policies and Economic Controls





The
earnings and growth of the banking industry and ultimately of the Bank are
affected by the monetary and credit policies of governmental authorities,
including the FRB.  An important function of the FRB is to regulate
the national supply of bank credit in order to control recessionary and
inflationary pressures. Among the instruments of monetary policy used by the FRB
to implement these objectives are open market operations in U.S. Government
securities, changes in the federal funds rate, changes in the discount rate of
member bank borrowings, and changes in reserve requirements against member bank
deposits.  These means are used in varying combinations to influence
overall growth of bank loans, investments and deposits and may also affect
interest rates charged on loans or paid for deposits.  The monetary
policies of the FRB authorities have had a significant effect on the operating
results of commercial banks in the past and are expected to continue to have
such an effect in the future.  In view of changing conditions in the
national economy and in the money markets, as well as the effect of actions by
monetary and fiscal authorities, including the FRB, no prediction can be made as
to possible future changes in interest rates, deposit levels, loan demand or
their effect on the business and earnings of the Company and its
subsidiaries.





AVAILABLE
INFORMATION





The
Company 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.  In addition,
stockholders may access these reports and documents on the SEC’s web site at
www.sec.gov.


9





Item 1A.  RISK FACTORS





The
following factors may impact our business, financial condition and results of
operations and should be considered carefully in evaluating an investment in
shares of common stock of the Company.





Risks
Relating to Our Business





The
Company’s future depends on the successful growth of its
subsidiaries





The
Company’s primary business activity for the foreseeable future will be to act as
the holding company of Talbot Bank, Centreville National Bank, Felton Bank, and
its other subsidiaries.  Therefore, the Company’s future profitability
will depend on the success and growth of these subsidiaries.  In the
future, part of the Company’s growth may come from buying other banks and buying
or establishing other companies.  Such entities may not be profitable
after they are purchased or established, and they may lose money, particularly
at first.  A new bank or company may bring with it unexpected
liabilities, bad loans, or bad employee relations, or the new bank or company
may lose customers.





A
majority of our business is concentrated in Maryland and Delaware; a significant
amount of our business is concentrated in real estate lending





Because
most of our loans are made to customers who reside on the Eastern Shore of
Maryland and in Delaware, a decline in local economic conditions may have a
greater effect on our earnings and capital than on the earnings and capital of
larger financial institutions whose loan portfolios are geographically
diverse.  Further, we make many real estate secured loans, including
construction and land development loans, all of which are in greater demand when
interest rates are low and economic conditions are good.  The national
and local economies have significantly weakened during the past two years in
large part due to the widely-reported problems in the sub-prime mortgage loan
market and the more recent meltdown of the financial industry as a
whole.  As a result, real estate values across the country, including
in our market areas, have decreased and the general availability of credit,
especially credit to be secured by real estate, has also
decreased.  These conditions have made it more difficult for real
estate owners and owners of loans secured by real estate to sell their assets at
the times and at the prices they desire.  In addition, these
conditions have increased the risk that the market values of the real estate
securing our loans may deteriorate, which could cause us to lose money in the
event a borrower fails to repay a loan and we are forced to foreclose on the
property.  There can be no guarantee as to when or whether economic
conditions will improve.





Additionally,
the FRB and the FDIC, along with the other federal banking regulators, issued
final guidance on December 6, 2006 entitled “Concentrations in Commercial Real
Estate Lending, Sound Risk Management Practices” directed at institutions that
have particularly high concentrations of commercial real estate loans within
their lending portfolios.  This guidance suggests that institutions
whose commercial real estate loans exceed certain percentages of capital should
implement heightened risk management practices appropriate to their
concentration risk and may be required to maintain higher capital ratios than
institutions with lower concentrations in commercial real estate
lending.  Based on our commercial real estate concentration as of
December 31, 2008, we may be subject to further supervisory analysis during
future examinations.  We cannot guarantee that any risk management
practices we implement will be effective to prevent losses relating to our
commercial real estate portfolio.  Management cannot predict the
extent to which this guidance will impact our operations or capital
requirements.





Interest
rates and other economic conditions will impact our results of
operation





The
national economy and, to a lesser extent, the local economy have significantly
weakened during the past two years, primarily as a result of the widely reported
financial institution meltdown.  This weakening has caused real estate
values to drop, decreased the demand for credit, and caused public anxiety
regarding the health and future of the financial services industry as a
whole.





Our
results of operations may be materially and adversely affected by changes in
prevailing economic conditions, including declines in real estate values, rapid
changes in interest rates and the monetary and fiscal policies of the federal
government.  Our profitability is in part a function of the spread
between the interest rates earned on assets and the interest rates paid on
deposits and other interest-bearing liabilities (i.e., net interest income),
including advances from the Federal Home Loan Bank (the “FHLB”) of Atlanta and
the FHLB of Pittsburgh.  Interest rate risk arises from mismatches
(i.e., the interest
sensitivity gap) between the dollar amount of repricing or maturing assets and
liabilities and is measured in terms of the ratio of the interest rate
sensitivity gap to total assets.  More assets




10


repricing
or maturing than liabilities over a given time period is considered
asset-sensitive and is reflected as a positive gap, and more liabilities
repricing or maturing than assets over a given time period is considered
liability-sensitive and is reflected as negative gap.  An
asset-sensitive position (i.e., a positive gap) could
enhance earnings in a rising interest rate environment and could negatively
impact earnings in a falling interest rate environment, while a
liability-sensitive position (i.e., a negative gap) could
enhance earnings in a falling interest rate environment and negatively impact
earnings in a rising interest rate environment.  Fluctuations in
interest rates are not predictable or controllable.  We have attempted
to structure our asset and liability management strategies to mitigate the
impact on net interest income of changes in market interest rates, but there can
be no assurance that these attempts will be successful in the event of future
changes.




The
Banks may experience credit losses in excess of their allowances





The risk
of credit losses on loans varies with, among other things, general economic
conditions, the type of loan being made, the creditworthiness of the borrower
over the term of the loan and, in the case of a collateralized loan, the value
and marketability of the collateral for the loan.  Management of each
of the Banks bases the allowance for credit losses upon, among other things,
historical experience, an evaluation of economic conditions and regular reviews
of delinquencies and loan portfolio quality.  Based upon such factors,
management makes various assumptions and judgments about the ultimate
collectability of the loan portfolio and provides an allowance for credit losses
based upon a percentage of the outstanding balances and for specific loans when
their ultimate collectability is considered questionable.  If
management’s assumptions and judgments prove to be incorrect and the allowance
for credit losses is inadequate to absorb future losses, or if the bank
regulatory authorities, as a part of their examination process, require our bank
subsidiaries to increase their respective allowance for credit losses, our
earnings and capital could be significantly and adversely
affected.  Although management uses the best information available to
make determinations with respect to the allowance for credit losses, future
adjustments may be necessary if economic conditions differ substantially from
the assumptions used or adverse developments arise with respect to the Banks’
nonperforming or performing loans.  Material additions to the
allowance for credit losses of one of the Banks would result in a decrease in
that Bank’s net income and capital and could have a material adverse effect on
our financial condition.





The
market value of our investments might decline





As of
December 31, 2008, we had classified 89% of our investment securities as
available-for-sale pursuant to Statement of Financial Accounting Standards No.
115 (“SFAS 115”) relating to accounting for investments. SFAS 115 requires that
unrealized gains and losses in the estimated value of the available-for-sale
portfolio be “marked to market” and reflected as a separate item in
stockholders’ equity (net of tax) as accumulated other comprehensive
income.   The remaining investment securities are classified as
held-to-maturity in accordance with SFAS 115 and are stated at amortized
cost.





In the
past, gains on sales of investment securities have not been a significant source
of income for us.   There can be no assurance that future market
performance of our investment portfolio will enable us to realize income from
sales of securities.  Stockholders’ equity will continue to reflect
the unrealized gains and losses (net of tax) of these
investments.  There can be no assurance that the market value of our
investment portfolio will not decline, causing a corresponding decline in
stockholders’ equity.





Talbot
Bank and Centreville National Bank are members of the FHLB of Atlanta and Felton
Bank is a member of the FHLB of Pittsburgh.  A member of the FHLB system is
required to purchase stock issued by the relevant FHLB bank based on
how much it borrows from the FHLB and the quality of the collateral
pledged to secure that borrowing.  Accordingly, our investments
include stock issued by the FHLB of Atlanta and the FHLB of
Pittsburgh.  In recent months, the banking industry has become
concerned about the financial strength of the banks in the FHLB system, and some
FHLB banks have stopped paying dividends on and redeeming FHLB
stock.  On January 30, 2009, the FHLB of Atlanta announced that it was
deferring the declaration of a dividend on its stock for the quarter ended
December 31, 2008 until it completes its year-end analysis of
other-than-temporary impairment which is critical to its net income
determination.  The FHLB of Atlanta stated that it anticipates a
decision regarding the dividend to be made in March 2009.  Similarly,
the FHLB of Pittsburgh announced in December 2008 that it voluntarily suspended
the payment of dividends and the repurchase of excess capital stock from member
banks, citing a significant reduction in the level of core earnings resulting
from lower short-term interest rates, the increased cost of maintaining
liquidity and constrained access to the debt markets at attractive rates and
maturities as the main reasons for the decision to suspend dividends and the
repurchase of excess capital stock. The FHLB of Pittsburgh last paid a dividend
in the third quarter of 2008.  Accordingly, there can be no guaranty
that the FHLB of Atlanta or the FHLB of Pittsburgh will declare future
dividends.  Moreover, accounting guidance indicates that an investor
in FHLB stock should recognize impairment if it concludes that it is not
probable that it will ultimately recover the par value of its shares. The
decision of whether impairment exists is a matter of judgment that should
reflect the investor's view of an FHLB bank's long-term performance, which
includes factors such as its operating performance, the severity and duration of
declines in the market value of its net assets related to its capital stock
amount, its commitment to make payments required by law or regulation and the
level of such payments in relation to its operating performance, the impact of
legislation and regulatory changes on the FHLB bank, and accordingly, on the
members of that FHLB bank and its liquidity and funding position. After
evaluating all of these considerations, we believe the par value of our FHLB
stock will be recovered, but future evaluations of the above mentioned factors
could result in the Company recognizing an impairment charge.


11





Management
believes that several factors will affect the market values of our investment
portfolio.  These include, but are not limited to, changes in interest
rates or expectations of changes, the degree of volatility in the securities
markets, inflation rates or expectations of inflation and the slope of the
interest rate yield curve (the yield curve refers to the differences between
shorter-term and longer-term interest rates; a positively sloped yield curve
means shorter-term rates are lower than longer-term rates).  Also, the
passage of time will affect the market values of our investment securities, in
that the closer they are to maturing, the closer the market price should be to
par value.  These and other factors may impact specific categories of
the portfolio differently, and management cannot predict the effect these
factors may have on any specific category.





The
banking industry is heavily regulated; significant regulatory changes could
adversely affect our operations





Our
operations are and will be affected by current and future legislation and by the
policies established from time to time by various federal and state regulatory
authorities.  The Company is subject to supervision by the FRB; Talbot
Bank is subject to supervision and periodic examination by the Maryland
Commissioner and the FDIC; Centreville National Bank is subject to supervision
and periodic examination by the OCC and the FDIC; and Felton Bank is subject to
supervision and periodic examination by the Delaware Commissioner and the
FDIC.  Banking regulations, designed primarily for the safety of
depositors, may limit a financial institution’s growth and the return to its
investors by restricting such activities as the payment of dividends, mergers
with or acquisitions by other institutions, investments, loans and interest
rates, interest rates paid on deposits, expansion of branch offices, and the
offering of securities or trust services.  The Company and the Banks
are also subject to capitalization guidelines established by federal law and
could be subject to enforcement actions to the extent that those institutions
are found by regulatory examiners to be undercapitalized.  It is not
possible to predict what changes, if any, will be made to existing federal and
state legislation and regulations or the effect that such changes may have on
our future business and earnings prospects.  Management also cannot
predict the nature or the extent of the effect on our business and earnings of
future fiscal or monetary policies, economic controls, or new federal or state
legislation.  Further, the cost of compliance with regulatory
requirements may adversely affect our ability to operate
profitably.





We
operate in a highly competitive market





We
operate in a competitive environment, competing for loans, deposits, insurance
products and customers with commercial banks, savings associations and other
financial entities.  Competition for deposits comes primarily from
other commercial banks, savings associations, credit unions, money market and
mutual funds and other investment alternatives.  Competition for loans
comes primarily from other commercial banks, savings associations, mortgage
banking firms, credit unions and other financial
intermediaries.  Competition for other products, such as insurance and
securities products, comes from other banks, securities and brokerage companies,
insurance companies, insurance agents and brokers, and other nonbank financial
service providers in our market areas.  Many of these competitors are
much larger in terms of total assets and capitalization, have greater access to
capital markets, and/or offer a broader range of financial services than those
offered by us.  In addition, banks with a larger capitalization and
financial intermediaries not subject to bank regulatory restrictions have larger
lending limits and are thereby able to serve the needs of larger
customers.  Our growth and profitability will depend upon our ability
to attract and retain skilled managerial, marketing and technical
personnel.  Competition for qualified personnel in the financial
services industry is intense, and there can be no assurance that we will be
successful in attracting and retaining such personnel.





In
addition, current banking laws facilitate interstate branching, merger activity
among banks, and expanded activities.  Since September 1995, certain
bank holding companies have been authorized to acquire banks throughout the
United States.  Since June 1, 1997, certain banks have been permitted
to merge with banks organized under the laws of different states.  As
a result, interstate banking is now an accepted element of competition in the
banking industry and the Corporation may be brought into competition with
institutions with which it does not presently compete.  Moreover, as
discussed above, the GLB Act revised the BHC Act in 2000 and repealed the
affiliation provisions of the Glass-Steagall Act of 1933, which, taken together,
limited the securities, insurance and other non-banking activities of any
company that controls an FDIC insured financial institution.  These
laws may increase the competition we face in our market areas in the future,
although management cannot predict the degree to which such competition will
impact our financial conditions or results of operations.





Our
regulatory expenses will likely increase due to the enactment of the Emergency
Economic Stabilization Act and related government programs





Among
other things, the EESA included a provision to increase the amount of deposits
insured by FDIC to $250,000.  The TLGP provides, until December
31,




12


2009,
unlimited deposit insurance on funds in non-interest-bearing transaction deposit
accounts and certain IOLTAs and NOW accounts not otherwise covered by the
existing deposit insurance limit of $250,000, as well as a 100% guarantee of the
newly issued senior debt of all FDIC-insured institutions and their holding
companies issued between October 14, 2008 and June 30, 2009.  All
eligible institutions will be covered under the TLGP for the first 30 days
without incurring any costs. After the initial period, participating
institutions will be assessed a charge of 10 basis points per annum for the
additional insured deposits and a charge of 75 basis points per annum for
guaranteed senior unsecured debt.  We elected to participate in both
portions of the TLGP, so we expect to incur additional regulatory fees
associated with our participation.




Customer
concern about deposit insurance may cause a decrease in deposits held at the
Banks





With
recent increased concerns about bank failures, customers increasingly are
concerned about the extent to which their deposits are insured by the
FDIC.  Customers may withdraw deposits from the Banks in an effort to
ensure that the amount they have on deposit with us is fully
insured.  Decreases in deposits may adversely affect our funding costs
and net income.





Our
funding sources may prove insufficient to replace deposits and support our
future growth





We rely
on customer deposits, advances from the FHLB, and lines of credit at other
financial institutions to fund our operations.  Although we have
historically been able to replace maturing deposits and advances if desired, no
assurance can be given that we would be able to replace such funds in the future
if our financial condition or the financial condition of the FHLB or market
conditions were to change.  Our financial flexibility will be severely
constrained and/or our cost of funds will increase if we are unable to maintain
our access to funding or if financing necessary to accommodate future growth is
not available at favorable interest rates.  Finally, if we are
required to rely more heavily on more expensive funding sources to support
future growth, our revenues may not increase proportionately to cover our costs.
In this case, our profitability would be adversely affected.





The
loss of key personnel could disrupt our operations and result in reduced
earnings





Our
growth and profitability will depend upon our ability to attract and retain
skilled managerial, marketing and technical personnel.  Competition
for qualified personnel in the financial services industry is intense, and there
can be no assurance that we will be successful in attracting and retaining such
personnel.  Our current executive officers provide valuable services
based on their many years of experience and in-depth knowledge of the banking
industry.  Due to the intense competition for financial professionals,
these key personnel would be difficult to replace and an unexpected loss of
their services could result in a disruption to the continuity of operations and
a possible reduction in earnings.





We
may lose key personnel because of our participation in the Troubled Asset Relief
Program Capital Purchase Program





On
January 9, 2009, we participated in the Troubled Asset Relief Program (“TARP”)
Capital Purchase Program (the “CPP”) adopted by the U.S. Department of Treasury
(“Treasury”) by selling $25 million in shares of our Fixed Rate Cumulative
Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) to Treasury
and issuing a 10-year common stock purchase warrant (the “Warrant”) to
Treasury.  As part of these transactions, we adopted Treasury’s
standards for executive compensation and corporate governance for the period
during which Treasury holds any shares of the Series A Preferred Stock and/or
any shares of common stock that may be acquired upon exercise of the
Warrant.  On February 17, 2009, the American Recovery and Reinvestment
Act of 2009 (the “Recovery Act”) was signed into law, which, among other things,
imposes additional executive compensation restrictions on institutions that
participate in TARP for so long as any TARP assistance remains
outstanding.  Among these restrictions is a prohibition against making
most severance payments to our “senior executive officers”, which term includes
our Chairman and Chief Executive Officer, our Chief Financial Officer and,
generally, the three next most highly compensated executive officers, and to the
next five most highly compensated employees.  The restrictions also
limit the type, timing and amount of bonuses, retention awards and incentive
compensation that may be paid to our five most highly compensated employees.
These restrictions, coupled with the competition we face from other
institutions, including institutions that did not participate in TARP, may make
it more difficult for us to attract and/or retain exceptional key
employees.





Our
lending activities subject us to the risk of environmental
liabilities





A
significant portion of our loan portfolio is secured by real
property.  During the ordinary course of business, we may foreclose on
and take title to properties securing certain loans.  In doing so,
there is a risk that hazardous or toxic substances could be found on these
properties.  If hazardous or toxic substances are found, we may be
liable for remediation costs, as well as for personal injury and property
damage.  Environmental laws may require us to incur substantial
expenses and may materially reduce the affected property’s value or limit our
ability to use or sell the affected property.  In addition, future
laws or more stringent interpretations or enforcement policies with respect to
existing laws may increase our exposure to environmental
liability.  Although we have policies




13


and
procedures to perform an environmental review before initiating any foreclosure
action on real property, these reviews may not be sufficient to detect all
potential environmental hazards.  The remediation costs and any other
financial liabilities associated with an environmental hazard could have a
material adverse effect on our financial condition and results of
operations.




We
may be subject to other claims





We may
from time to time be subject to claims from customers for losses due to alleged
breaches of fiduciary duties, errors and omissions of employees, officers and
agents, incomplete documentation, the failure to comply with applicable laws and
regulations, or many other reasons.  Also, our employees may knowingly
or unknowingly violate laws and regulations.  Management may not be
aware of any violations until after their occurrence.  This lack of
knowledge may not insulate the Company or our subsidiaries from
liability.  Claims and legal actions may result in legal expenses and
liabilities that may reduce our profitability and hurt our financial
condition.





We
may be adversely affected by other recent legislation





As
discussed above, the GLB Act repealed restrictions on banks affiliating with
securities firms and it also permitted bank holding companies that become
financial holding companies to engage in additional financial activities,
including insurance and securities underwriting and agency activities, merchant
banking, and insurance company portfolio investment activities that are
currently not permitted for bank holding companies.  Although the
Company is a financial holding company, this law may increase the competition we
face from larger banks and other companies.  It is not possible to
predict the full effect that this law will have on us.





The
Sarbanes-Oxley Act of 2002 requires management of publicly traded companies to
perform an annual assessment of their internal controls over financial reporting
and to report on whether the system is effective as of the end of the Company’s
fiscal year.  Disclosure of significant deficiencies or material
weaknesses in internal controls could cause an unfavorable impact to shareholder
value by affecting the market value of our stock.





The
Patriot Act requires certain financial institutions, such as the Banks, to
maintain and prepare additional records and reports that are designed to assist
the government’s efforts to combat terrorism. This law includes sweeping
anti-money laundering and financial transparency laws and required additional
regulations, including, among other things, standards for verifying client
identification when opening an account and rules to promote cooperation among
financial institutions, regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.  If we
fail to comply with this law, we could be exposed to adverse publicity as well
as fines and penalties assessed by regulatory agencies.





We
may not be able to keep pace with developments in technology





We use
various technologies in our business, including telecommunication, data
processing, computers, automation, internet-based banking, and debit
cards.  Technology changes rapidly.  Our ability to compete
successfully with other banks and non-bank entities may depend on whether we can
exploit technological changes.  We may not be able to exploit
technological changes, and any investment we do make may not make us more
profitable.  We are planning to convert to a new core data processing
system during the second quarter of 2009.  Although management expects
that this new system will improve operating efficiencies, there can be no
guaranty that it will do so or that software, hardware or other technical
problems will not delay its implementation or effectiveness.





Risks
Relating to the Company’s Securities





The
Company’s shares of common stock, Series A Preferred Stock, and the Warrant are
not insured





The
shares of the Company’s common stock, including the shares that may be acquired
upon exercise of the Warrant, the Series A Preferred Stock and the Warrant are
not deposits and are not insured against loss by the FDIC or any other
governmental or private agency.





The
Company’s ability to pay dividends is limited by applicable banking and
corporate law





The
Company’s stockholders are entitled to dividends on their shares of common stock
if, when, and as declared by the Company’s Board of Directors out of funds
legally available for that purpose.  The Company’s current ability to
pay dividends to stockholders is largely dependent upon the receipt of dividends
from the Banks.  Both federal and state laws impose restrictions on
the ability of the Banks to pay dividends.  Federal law prohibits the
payment of a dividend by an




14


insured
depository institution if the depository institution is considered
“undercapitalized” or if the payment of the dividend would make the institution
“undercapitalized”.  For a Maryland state-chartered bank, dividends
may be paid out of undivided profits or, with the prior approval of the Maryland
Commissioner, from surplus in excess of 100% of required capital
stock.  If, however, the surplus of a Maryland bank is less than 100%
of its required capital stock, then cash dividends may not be paid in excess of
90% of net earnings. National banking associations are generally limited,
subject to certain exceptions, to paying dividends out of undivided
profits.  For a Delaware state-chartered bank, dividends may be paid
out of net profits, but only if its surplus fund is equal to or greater than 50%
of its required capital stock.  If a Delaware bank’s surplus is less
than 100% of capital stock when it declares a dividend, then it must carry 25%
of its net profits of the preceding period for which the dividend is paid to its
surplus fund until the surplus amounts to 100% of its capital
stock.  In addition to these specific restrictions, bank regulatory
agencies also have the ability to prohibit proposed dividends by a financial
institution that would otherwise be permitted under applicable regulations if
the regulatory body determines that such distribution would constitute an unsafe
or unsound practice.  Because of these limitations, there can be no
guarantee that the Company’s Board will declare dividends in any fiscal
quarter.




Because
of the Company’s participation in the CPP, it is subject to several restrictions
relating to shares of its capital stock, including restrictions on its ability
to declare or pay dividends on and repurchase its shares





As stated
above, the Company recently issued 25,000 shares of the Series A Preferred Stock
and a Warrant to purchase 172,970 shares of common stock to
Treasury.  Under the terms of the transaction documents, the Company’s
ability to declare or pay dividends on shares of its capital stock is
limited.  Specifically, the Company is unable to declare dividends on
common stock, other stock ranking junior to the Series A Preferred Stock
(“Junior Stock”), or preferred stock ranking on a parity with the Series A
Preferred Stock (“Parity Stock”) if the Company is in arrears on the dividends
on the Series A Preferred Stock.  Further, the Company is not
permitted to increase dividends on its common stock above the amount of the last
quarterly cash dividend per share declared prior to October 14, 2008 without
Treasury’s approval until January 9, 2012 unless all of the Series A Preferred
Stock has been redeemed or transferred.  In addition, the Company’s
ability to repurchase shares of common stock, Junior Stock or Parity Stock is
restricted.  Treasury’s consent generally is required for the Company
to make any such repurchase until January 9, 2012 unless all of the Series A
Preferred Stock has been redeemed or transferred.  Further, shares of
common stock, Junior Stock or Parity Stock may not be repurchased if the Company
is in arrears on the Series A Preferred Stock dividends.





There
is no market for the Series A Preferred Stock or the Warrant, and the common
stock is not heavily traded





There is
no established trading market for the shares of the Series A Preferred Stock or
the Warrant.  The Company does not intend to apply for listing of the
Series A Preferred Stock on any securities exchange or for inclusion of the
Series A Preferred Stock in any automated quotation system unless requested by
Treasury.  The Company’s common stock is listed on the NASDAQ Global
Select Market, but shares of the common stock are not heavily
traded.  Securities that are not heavily traded can be more volatile
than stock trading in an active public market.  Factors such as our
financial results, the introduction of new products and services by us or our
competitors, and various factors affecting the banking industry generally may
have a significant impact on the market price of the shares the common
stock.  Management cannot predict the extent to which an active public
market for any of the Company’s securities will develop or be sustained in the
future.  Accordingly, holders of the Company’s securities may not be
able to sell such securities at the volumes, prices, or times that they
desire.





The
Company’s Articles of Incorporation and By-Laws and Maryland law may discourage
a corporate takeover





The
Company’s Amended and Restated Articles of Incorporation, as supplemented (the
“Charter”), and Amended and Restated By-Laws, as amended (the “By-Laws”),
contain certain provisions designed to enhance the ability of the Board of
Directors to deal with attempts to acquire control of the
Company.  The Charter and By-Laws provide for the classification of
the Board into three classes; directors of each class generally serve for
staggered three-year periods.  No director may be removed except for
cause and then only by a vote of at least two-thirds of the total eligible
stockholder votes.  The Charter gives the Board certain powers in
respect of the Company’s securities.  First, the Board has the
authority to classify and reclassify unissued shares of stock of any class or
series of stock by setting, fixing, eliminating, or altering in any one or more
respects the preferences, rights, voting powers, restrictions and qualifications
of, dividends on, and redemption, conversion, exchange, and other rights of,
such securities.  Second, a majority of the Board, without action by
the stockholders, may amend the Charter to increase or decrease the aggregate
number of shares of stock or the number of shares of stock of any class that the
Company has authority to issue.  The Board could use these powers,
along with its authority to authorize the issuance of securities of any class or
series, to issue securities having terms favorable to management to persons
affiliated with or otherwise friendly to management.





Maryland
law also contains anti-takeover provisions that apply to the
Company.  The Maryland Business Combination Act generally prohibits,
subject to certain limited exceptions, corporations from being involved in any
“business combination” (defined as a variety of transactions, including a
merger,




15


consolidation,
share exchange, asset transfer or issuance or reclassification of equity
securities) with any “interested shareholder” for a period of five years
following the most recent date on which the interested shareholder became an
interested shareholder.  An interested shareholder is defined
generally as a person who is the beneficial owner of 10% or more of the voting
power of the outstanding voting stock of the corporation after the date on which
the corporation had 100 or more beneficial owners of its stock or who is an
affiliate or associate of the corporation and was the beneficial owner, directly
or indirectly, of 10% percent or more of the voting power of the then
outstanding stock of the corporation at any time within the two-year period
immediately prior to the date in question and after the date on which the
corporation had 100 or more beneficial owners of its stock.  The
Maryland Control Share Acquisition Act applies to acquisitions of “control
shares”, which, subject to certain exceptions, are shares the acquisition of
which entitle the holder, directly or indirectly, to exercise or direct the
exercise of the voting power of shares of stock of the corporation in the
election of directors within any of the following ranges of voting
power:  one-tenth or more, but less than one-third of all voting
power; one-third or more, but less than a majority of all voting power or a
majority or more of all voting power.  Control shares have limited
voting rights.  The By-Laws exempt the Company’s capital securities
from the Maryland Control Share Acquisition Act, but the Board has the authority
to eliminate the exemption without stockholder approval.




Although
these provisions do not preclude a takeover, they may have the effect of
discouraging, delaying or deferring a tender offer or takeover attempt that a
shareholder might consider in his or her best interest, including those attempts
that might result in a premium over the market price for the common
stock.  Such provisions will also render the removal of the Board of
Directors and of management more difficult and, therefore, may serve to
perpetuate current management.  These provisions could potentially
adversely affect the market price of the Company’s common stock.





Item
1B.   Unresolved Staff Comments





None.





Item
2.      Properties.





Our
offices are listed in the tables below.  The Company’s main office is
the same as Talbot Bank’s main office.  The Company owns real property
at 28969 Information Lane in Easton, Maryland, which houses the Operations,
Information Technology and Finance departments of the Company and its
subsidiaries, and certain operations of The Avon-Dixon Agency, LLC.





The
      Talbot Bank of Easton, MarylandBranchesMain
      Office
                18
      East Dover Street
                Easton,
      Maryland 21601
              Tred
      Avon Square Branch
                212
      Marlboro Road
                Easton,
      Maryland 21601
              St.
      Michaels Branch
                1013
      South Talbot Street
                St.
      Michaels, Maryland 21663Elliott
      Road Branch
                8275
      Elliott Road
                Easton,
      Maryland 21601
              Sunburst
      Branch
                424
      Dorchester Avenue
                Cambridge,
      Maryland 21613
              Tilghman
      Branch
                5804
      Tilghman Island Road
                Tilghman,
      Maryland 21671ATMsMemorial
      Hospital at Easton
                219
      South Washington Street
                Easton,
      Maryland 21601
              Sailwinds
      Amoco
                511
      Maryland Avenue
                Cambridge,
      Maryland 21613
              Talbottown
                218
      North Washington Street
                Easton,
      Maryland 21601
  16
  The
      Centreville National Bank of MarylandBranchesMain
      Office
                109
      North Commerce Street
                Centreville,
      Maryland 21617
              Route
      213 South Office
                2609
      Centreville Road
                Centreville,
      Maryland 21617
              Stevensville
      Office
                408
      Thompson Creek Road
                Stevensville,
      Maryland 21666Chestertown
      Office
                305
      East High Street
                Chestertown,
      Maryland 21620
              Hillsboro
      Office
                21913
      Shore Highway
                Hillsboro,
      Maryland 21641
              Denton
      Office
                850
      South 5th
      Street
                Denton,
      Maryland 21629Chester
      Office
                300
      Castle Marina Road
                Chester,
      Maryland 21619
              Grasonville
      Office
                202
      Pullman Crossing
                Grasonville,
      Maryland  21638
              Washington
      Square Office
                899
      Washington Avenue
                Chestertown,
      Maryland 21620Division
      Office-Wye Financial & Trust
                16
      North Washington StreetSuite 1
                Easton, Maryland 21601ATM
                Queenstown
      Harbor Golf Links
                Queenstown,
      Maryland 21658


The
      Felton BankMain
      Office
                120
      West Main Street
                Felton,
      Delaware 19943
              Milford
      Office
                698-A  North
      Dupont Highway
                Milford,
      Delaware 19963
              Camden
      Wal-Mart Supercenter
                263
      Wal-Mart Drive
                Camden,
      Delaware 19934The Avon-Dixon Agency,
      LLCEaston
      Office
                28969
      Information Lane
                Easton,
      Maryland 21601
              Grasonville
      Office
                202
      Pullman Crossing
                Grasonville,
      Maryland 21638
              Centreville
      Office
                105
      Lawyers Row
                Centreville,
      Maryland 21617Elliott-Wilson
      Insurance, LLC
              Mubell
      Finance, LLC
              Wye
      Financial Services, LLC106
      North Harrison Street
                Easton,
      Maryland 21601
              106
      North Harrison Street
                Easton,
      Maryland 21601
              16
      North Washington StreetSuite 1
                Easton,
      Maryland 21601Wye
      Mortgage Group, LLC
                17
      East Dover Street
                Easton,
      Maryland 21601
              Jack
      Martin & Associates, Inc.
                326
      First Street
                Annapolis,
      Maryland 21403
              Tri-State
      General Insurance Agencies and ESFS, Inc.
                One
      Plaza East, 4th
      Floor
                Salisbury,
      Maryland 21802





Talbot
Bank owns the real property on which all of its offices are located, except that
it operates under leases at its St. Michaels and Tilghman
branches.  Centreville National Bank owns the real property on which
all of its offices are located, except that it operates under leases at its
Hillsboro branch and the office of Wye Financial and Trust in
Easton.  Felton Bank leases the real property on which all of its
offices are located.  The Insurance Subsidiaries do not own any real
property, but operate under leases. Wye Mortgage occupies space in Talbot Bank’s
main office.  For information about rent expense for all leased
premises, see Note 6 to the Consolidated Financial Statements appearing in Item
8 of Part II of this report.





Item
3.      Legal Proceedings





We are at
times, in the ordinary course of business, subject to legal
actions.  Management, upon the advice of counsel, believes that
losses, if any, resulting from current legal actions will not have a material
adverse effect on our financial condition or results of
operation.


17


Item
4.      Submission of Matters to a Vote of
Security Holders.
 
 None.
  PART
II





Item
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities.





MARKET
PRICE, HOLDERS AND CASH DIVIDENDS





The
shares of the common stock of the Company are listed on the NASDAQ Global Select
Market under the symbol “SHBI”.  As of March 3, 2009, the Company had
approximately 1,684 holders of record.  The high and low sales prices
for the shares of common stock of the Company, as reported on the NASDAQ Global
Select Market, and the cash dividends declared on those shares for each
quarterly period of 2008 and 2007 are set forth in the table below.





2008
                  
                  
                  2007Price
      Range
                  
                  
                  Dividends
                  
                  
                  Price
      Range
                  
                  
                  DividendsHigh
                  
                  
                  Low
                  
                  
                  Paid
                  
                  
                  High
                  
                  
                  Low
                  
                  
                  PaidFirst
      Quarter
                  
                  $
                  23.40
                  
                  
                  $
                  20.00
                  
                  
                  $
                  0.16
                  
                  
                  $
                  30.76
                  
                  
                  $
                  23.54
                  
                  
                  $
                  0.16Second
      Quarter
                  
                  
                  26.47
                  
                  
                  
                  18.52
                  
                  
                  
                  0.16
                  
                  
                  
                  29.15
                  
                  
                  
                  23.98
                  
                  
                  
                  0.16Third
      Quarter
                  
                  
                  27.25
                  
                  
                  
                  18.00
                  
                  
                  
                  0.16
                  
                  
                  
                  27.05
                  
                  
                  
                  20.52
                  
                  
                  
                  0.16Fourth
      Quarter
                  
                  
                  25.97
                  
                  
                  
                  17.50
                  
                  
                  
                  0.16
                  
                  
                  
                  24.72
                  
                  
                  
                  20.00
                  
                  
                  
                  0.16$
                  0.64
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.64





On March
3, 2009, the closing sales price for the shares of common stock as reported on
the NASDAQ Global Select Market was $11.85 per share.





Stockholders
received cash dividends totaling $5.4 million in 2008 and in
2007.  The ratio of dividends per share to earnings per share was
46.72% in 2008, compared to 39.75% in 2007.  Cash dividends are
typically declared on a quarterly basis and are at the discretion of the Board
of Directors, based upon such factors as operating results, financial condition,
capital adequacy, regulatory requirements, and stockholder
return.  The Company’s ability to pay dividends is limited by federal
banking and state corporate law and is generally dependent on the ability of the
Company’s subsidiaries, particularly the Banks, to declare dividends to the
Company.  The Company’s ability to pay dividends is further limited by
the terms of its Series A Preferred Stock.  For more information
regarding these limitations, see Item 1A of Part I of this report under the
headings, “The Company’s ability to pay dividends is limited by applicable
banking and corporate law” and “Because of the Company’s participation in the
CPP, it is subject to several restrictions relating to shares of its capital
stock, including restrictions on its ability to declare or pay dividends on and
repurchase its shares”, which are incorporated herein by reference.





The
transfer agent for the Company’s common stock is:





Registrar
& Transfer Company


10
Commerce Drive


Cranford,
New Jersey 07016


Investor
Relations:  1-800-368-5948


E-mail
for investor inquiries: info@rtco.com.





The
performance graph below compares the cumulative total shareholder return on the
common stock of the Company with the cumulative total return on the equity
securities included in the NASDAQ Composite Index (reflecting overall stock
market performance), the NASDAQ Bank Index (reflecting changes in banking
industry stocks), and the SNL Small Cap Bank Index (reflecting changes in stocks
of banking institutions of a size similar to the Company) assuming in each case
an initial $100 investment on December 31, 2003 and reinvestment of dividends as
of the end of the Company’s fiscal years.  Returns are shown on a
total return basis.   The performance graph represents past
performance and should not be considered to be an indication of future
performance.


18











Period
      EndingIndex
                                
                                12/31/03
                                
                                
                                12/31/04
                                
                                
                                12/31/05
                                
                                
                                12/31/06
                                
                                
                                12/31/07
                                
                                
                                12/31/08Shore
      Bancshares, Inc.
                                
                                
                                100.00
                                
                                
                                
                                97.51
                                
                                
                                
                                87.37
                                
                                
                                
                                127.42
                                
                                
                                
                                95.10
                                
                                
                                
                                106.86NASDAQ
      Composite
                                
                                
                                100.00
                                
                                
                                
                                108.59
                                
                                
                                
                                110.08
                                
                                
                                
                                120.56
                                
                                
                                
                                132.39
                                
                                
                                
                                78.72NASDAQ
      Bank
                                
                                
                                100.00
                                
                                
                                
                                110.99
                                
                                
                                
                                106.18
                                
                                
                                
                                117.87
                                
                                
                                
                                91.85
                                
                                
                                
                                69.88SNL
      Small Cap Bank
                                
                                
                                100.00
                                
                                
                                
                                122.54
                                
                                
                                
                                120.69
                                
                                
                                
                                137.76
                                
                                
                                
                                99.60
                                
                                
                                
                                83.72





ISSUER
REPURCHASES





On
February 2, 2006, the Company’s Board of Directors authorized the Company to
repurchase up to 165,000 shares of its common stock over a period not to exceed
60 months.  Shares may be repurchased in the open market or in
privately negotiated transactions at such times and in such amounts per
transaction as the President of the Company determines to be appropriate,
subject to Board oversight.  The Company intends to use the
repurchased shares to fund the Company’s employee benefit plans and for other
general corporate purposes.  No shares were repurchased by or on
behalf of the Company and its affiliates (as defined by Exchange Act Rule
10b-18) during 2008.





EQUITY
COMPENSATION PLAN INFORMATION





The
Company has three equity compensation plans under which it may issue equity
awards to employees, officers, and/or directors of the Company and its
subsidiaries:  (i) the Shore Bancshares, Inc. 2006 Stock and Incentive
Compensation Plan (the “2006 Plan”), which authorizes the grant of stock
options, stock appreciation rights, stock awards, stock units, and performance
units; (ii) the Shore Bancshares, Inc. 1998 Stock Option Plan, which authorizes
the grant of stock options; and (iii) the Shore Bancshares, Inc. 1998 Employee
Stock Purchase Plan, which authorizes the grant of stock
options.  Each of these plans was approved by the Company’s Board of
Directors and its stockholders.


19





The
following table contains information about these equity compensation plans as of
December 31, 2008:





Plan
      Category
              
              Number
      of securities to be
                issued
      upon exercise of
                outstanding
      options,
                warrants
      and rights
              
              
              Weighted-average
      exercise
                price
      of outstanding
                options,
      warrants, and
                rights
              
              
              Number
      of securities
                remaining
      available for
                future
      issuance under
                equity
      compensation plans
                [excluding
      securities
                reflected
      in column (a)](a)
              
              
              (b)
              
              
              (c)Equity
      compensation plans approved by security holders (1)
              
              
              18,550
              
              
              $
              15.52
              
              
              
              611,176Equity
      compensation plans not approved by security holders
              
              
              0
              
              
              
              0.00
              
              
              
              0Total
              
              
              18,550
              
              
              $
              15.52
              
              
              
              611,176





(1)
            In
      addition to stock options and stock appreciation rights, the 2006 Plan
      permits the grant of stock awards, stock units, and performance units, and
      the shares available for issuance shown in column (c) may be granted
      pursuant to such awards.  Subject to the anti-dilution
      provisions of the Omnibus Plan, the maximum number of shares of restricted
      stock that may be granted to any participant in any calendar year is
      45,000; the maximum number of restricted stock units that may be granted
      to any one participant in any calendar year is 45,000; and the maximum
      dollar value of performance units that may be granted to any one
      participant in any calendar year is $1,500,000.  As of December
      31, 2008, the Company has granted 16,859 shares of restricted stock that
      are not reflected in column (a) of this
table.




20


Item
6.      Selected Financial Data.





The
following table sets forth certain selected financial data for the five years
ended December 31, 2008 and is qualified in its entirety by the detailed
statistical and other information contained in this report, including
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” appearing in Item 7 of Part II of this report and the financial
statements and notes thereto appearing in Item 8 of Part II of this
report.





Years
      Ended December 31,(Dollars
      in thousands, except per share data)
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004RESULTS
      OF OPERATIONS:Interest
      income
                
                $
                61,474
                
                
                $
                65,141
                
                
                $
                57,971
                
                
                $
                47,384
                
                
                $
                38,291Interest
      expense
                
                
                21,555
                
                
                
                24,105
                
                
                
                19,074
                
                
                
                11,899
                
                
                
                9,010Net
      interest income
                
                
                39,919
                
                
                
                41,036
                
                
                
                38,897
                
                
                
                35,485
                
                
                
                29,281Provision
      for credit losses
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493
                
                
                
                810
                
                
                
                931Net
      interest income after provision for credit losses
                
                
                36,582
                
                
                
                39,312
                
                
                
                37,404
                
                
                
                34,675
                
                
                
                28,350Noninterest
      income
                
                
                20,350
                
                
                
                14,679
                
                
                
                12,839
                
                
                
                11,498
                
                
                
                10,224Noninterest
      expense
                
                
                38,370
                
                
                
                32,539
                
                
                
                28,535
                
                
                
                25,431
                
                
                
                22,535Income
      before income taxes
                
                
                18,562
                
                
                
                21,452
                
                
                
                21,708
                
                
                
                20,742
                
                
                
                16,039Income
      tax expense
                
                
                7,092
                
                
                
                8,002
                
                
                
                8,154
                
                
                
                7,854
                
                
                
                5,841NET
      INCOME
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554
                
                
                $
                12,888
                
                
                $
                10,198PER
      SHARE DATA:Net
      income – basic
                
                $
                1.37
                
                
                $
                1.61
                
                
                $
                1.62
                
                
                $
                1.55
                
                
                $
                1.24Net
      income – diluted
                
                
                1.37
                
                
                
                1.60
                
                
                
                1.61
                
                
                
                1.54
                
                
                
                1.23Dividends
      paid
                
                
                0.64
                
                
                
                0.64
                
                
                
                0.59
                
                
                
                0.54
                
                
                
                0.48Book
      value (at year end)
                
                
                15.16
                
                
                
                14.35
                
                
                
                13.28
                
                
                
                12.17
                
                
                
                11.24Tangible
      book value (at year end)1
                
                
                12.55
                
                
                
                11.68
                
                
                
                11.67
                
                
                
                10.51
                
                
                
                9.53FINANCIAL
      CONDITION (at year end):Assets
                
                $
                1,044,641
                
                
                $
                956,911
                
                
                $
                945,649
                
                
                $
                851,638
                
                
                $
                790,598Deposits
                
                
                845,371
                
                
                
                765,895
                
                
                
                774,182
                
                
                
                704,958
                
                
                
                658,672Total
      loans, net of unearned income and allowance for credit
    losses
                
                
                879,208
                
                
                
                768,799
                
                
                
                693,419
                
                
                
                622,227
                
                
                
                590,766Long-term
      debt
                
                
                7,947
                
                
                
                12,485
                
                
                
                25,000
                
                
                
                4,000
                
                
                
                5,000Stockholders’
      equity
                
                
                127,385
                
                
                
                120,235
                
                
                
                111,327
                
                
                
                101,448
                
                
                
                92,976PERFORMANCE
      RATIOS (for the year):Return
      on average assets
                
                
                1.13
                %
                
                
                1.42
                %
                
                
                1.52
                %
                
                
                1.51
                %
                
                
                1.32
                %Return
      on average stockholders’ equity
                
                
                9.22
                
                
                
                11.79
                
                
                
                12.66
                
                
                
                13.20
                
                
                
                11.17Net
      interest margin
                
                
                4.23
                
                
                
                4.64
                
                
                
                4.70
                
                
                
                4.69
                
                
                
                4.10Efficiency
      ratio2
                
                
                63.66
                
                
                
                58.40
                
                
                
                55.15
                
                
                
                54.13
                
                
                
                57.04Dividend
      payout ratio
                
                
                46.72
                
                
                
                39.75
                
                
                
                36.42
                
                
                
                34.84
                
                
                
                38.71Average
      stockholders’ equity to average total assets
                
                
                12.30
                
                
                
                12.04
                
                
                
                11.98
                
                
                
                11.86
                
                
                
                11.79





1
            Total
      stockholders’ equity, net of goodwill and other intangible assets, divided
      by the number of shares of common stock outstanding at year
      end.


2
            Noninterest
      expense as a percentage of total revenue (net interest income plus total
      noninterest income).  Lower ratios indicate improved
      productivity.





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





The
following discussion compares the Company’s financial condition at December 31,
2008 to its financial condition at December 31, 2007 and the results of
operations for the years ended December 31, 2008, 2007, and
2006.  This discussion should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto appearing in Item 8 of
Part II of this report.


21





RECENT
DEVELOPMENTS





Capital
Purchase Program





As
discussed above, on January 9, 2009 the Company participated in the TARP CPP by
issuing 25,000 shares of Series A Preferred Stock and a Warrant covering 172,970
shares of common stock to the Treasury for a total sales price of $25
million.  The Warrant may be exercised at any time until January 9,
2019 at an exercise price of $21.68 per share, or an aggregate exercise price of
approximately $3.75 million.  The Series A Preferred Stock qualifies
as Tier 1 capital.  The Warrant counts as tangible common
equity.





Holders
of the Series A Preferred Stock are entitled to receive if, as and when declared
by the Board of Directors, out of assets legally available for payment,
cumulative cash dividends at a rate per annum of 5% per share on a liquidation
amount of $1,000 per share of Series A Preferred Stock with respect to each
dividend period from January 9, 2009 to, but excluding, February 15,
2014.  From and after February 15, 2014, holders of Series A Preferred
Stock are entitled to receive cumulative cash dividends at a rate per annum of
9% per share on a liquidation amount of $1,000 per share with respect to each
dividend period thereafter. Under the terms of the Series A Preferred Stock, on
and after February 15, 2012, the Company may, at its option, redeem shares of
Series A Preferred Stock, in whole or in part, at any time and from time to
time, for cash at a per share amount equal to the sum of the liquidation
preference per share plus any accrued and unpaid dividends to but excluding the
redemption date.  The terms of the Series A Preferred Stock further
provide that, prior to February 15, 2012, the Company may redeem shares of
Series A Preferred Stock only if it has received aggregate gross proceeds of not
less than $6.25 million from one or more qualified equity offerings, and the
aggregate redemption price may not exceed the net proceeds received by the
Company from such offerings.  The redemption of the Series A Preferred
Stock requires prior regulatory approval.





Until the
earlier of (i) January 9, 2012 or (ii) the date on which the Series A Preferred
Stock has been redeemed in full or Treasury has transferred all of the Series A
Preferred Stock to non-affiliates, the terms of the Series A Preferred
Securities prohibit the Company from increasing its quarterly cash dividend paid
on common stock above $0.16 per share or repurchasing any shares of common stock
or other capital stock or equity securities or trust preferred securities
without the consent of the Treasury.  Accordingly, the Company’s
previously-announced common stock repurchase plan has been suspended effective
January 9, 2009.





On
February 17, 2009, President Obama signed the Recovery Act into
law.  The Recovery Act permits any institution that receives
assistance under TARP (including pursuant to the CPP), after consultation with
the appropriate banking regulators, to repay any such assistance at any time
notwithstanding any repayment restrictions contained in the instruments defining
such assistance.  Recent guidance issued by Treasury states that, as a
general rule, any partial repayment must equal at least 25% of the outstanding
assistance.  Treasury may waive this minimum repayment
amount.  Accordingly, the Company may, at any time and notwithstanding
the restrictions on redemption discussed above, and assuming its regulators do
not object, repay all of or a portion of (in 25% increments, unless waived by
Treasury) the $25 million it received as consideration for the Series A
Preferred Stock and the Warrant.  If the Company were to repay any
assistance, it could also repurchase any or all of the portion of the Warrant
that relates to the repayment.  Any portion of the Warrant that
relates to the repayment that the Company chooses not to repurchase must be
liquidated by Treasury, at the current market price.





FDIC
Deposit Insurance Fund Restoration Plan Announced





On
February 27, 2009, the FDIC announced a proposed rule outlining its plan to
implement an emergency special assessment of 20 basis points on all insured
depository institutions in order to restore the Deposit Insurance Fund to an
acceptable level.  The assessment, which would be payable on September
30, 2009, would be in addition to a planned increase in premiums and a change in
the way regular premiums are assessed which the FDIC also approved on February
27, 2009.  In addition, the proposed rule provides that, after June
30, 2009, if the reserve ratio of the Deposit Insurance Fund is estimated to
fall to a level that that the FDIC believes would adversely affect public
confidence or to a level which is close to or less than zero at the end of a
calendar quarter, then an additional emergency special assessment of up to 10
basis points may be imposed on all insured depository
institutions.  If this rule is adopted as proposed, it will
significantly increase the Banks’ FDIC premiums in 2009.





PERFORMANCE
OVERVIEW





The
Company recorded a decline in net income for 2008 when compared to
2007.  Net income for the year ended December 31, 2008 was $11.47
million, compared to $13.45 million and $13.55 million for the years ended
December 31, 2007 and 2006, respectively.  Basic earnings per share
for 2008 was $1.37, a decrease of 14.9% from 2007.  Basic earnings per
share was $1.61 and $1.62 for 2007 and 2006, respectively.  Diluted
earnings per share for 2008 was also $1.37, a decrease of 14.4% when compared to
2007.  Diluted earnings per share was $1.60 and $1.61 for 2007 and
2006, respectively.


22





Return on
average assets was 1.13% for 2008, compared to 1.42% for 2007 and 1.52% for
2006.  Return on stockholders’ equity for 2008 was 9.22%, compared to
11.79% for 2007 and 12.66% for 2006.  Comparing the year ended
December 31, 2008 to the year ended December 31, 2007, average assets increased
6.7% to $1.011 billion, average loans increased 15.0% to $837.7 million, average
deposits increased 6.0% to $815.7 million, and average stockholders’ equity
increased 9.1% to $124.4 million.





CRITICAL
ACCOUNTING POLICIES





The
Company’s consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and
follow general practices within the industries in which it operates. Application
of these principles requires management to make estimates, assumptions, and
judgments that affect the amounts reported in the financial statements and
accompanying notes.  These estimates, assumptions, and judgments are
based on information available as of the date of the financial statements;
accordingly, as this information changes, the financial statements could reflect
different estimates, assumptions, and judgments.  Certain policies
inherently have a greater reliance on the use of estimates, assumptions, and
judgments and as such have a greater possibility of producing results that could
be materially different than originally reported. Estimates, assumptions, and
judgments are necessary when assets and liabilities are required to be recorded
at fair value, when a decline in the value of an asset not carried on the
financial statements at fair value warrants an impairment write-down or
valuation reserve to be established, or when an asset or liability needs to be
recorded contingent upon a future event.  Carrying assets and
liabilities at fair value inherently results in more financial statement
volatility.  The fair values and the information used to record
valuation adjustments for certain assets and liabilities are based either on
quoted market prices or are provided by other third-party sources, when
available.





The most
significant accounting policies that the Company follows are presented in Note 1
to the Consolidated Financial Statements.  These policies, along with
the disclosures presented in the other financial statement notes and in this
discussion, provide information on how significant assets and liabilities are
valued in the financial statements and how those values are
determined.  Based on the valuation techniques used and the
sensitivity of financial statement amounts to the methods, assumptions, and
estimates underlying those amounts, management has determined that the
accounting policy with respect to the allowance for credit losses to be the
accounting area that requires the most subjective or complex judgments, and, as
such, could be most subject to revision as new information becomes
available.  Accordingly, the allowance for credit losses is considered
to be a critical accounting policy, as discussed below.





The
allowance for credit losses represents management’s estimate of credit losses
inherent in the loan portfolio as of the balance sheet
date.  Determining the amount of the allowance for credit losses is
considered a critical accounting estimate because it requires significant
judgment and the use of estimates related to the amount and timing of expected
future cash flows on impaired loans, estimated losses on pools of homogeneous
loans based on historical loss experience, and consideration of current economic
trends and conditions, all of which may be susceptible to significant
change.  The loan portfolio also represents the largest asset type on
the consolidated balance sheets.  Note 1 to the Consolidated Financial
Statements describes the methodology used to determine the allowance for credit
losses and a discussion of the factors driving changes in the amount of the
allowance for credit losses is included in the Provision for Credit Losses and
Risk Management section of this discussion.





RECENT
ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS





Note 1 to
the Consolidated Financial Statements discusses new accounting policies that the
Company adopted during 2008 and the expected impact of accounting policies
recently issued or proposed but not yet required to be adopted.  To
the extent the adoption of new accounting standards materially affects our
financial condition, results of operations or liquidity, the impacts are
discussed in the applicable section(s) of this discussion and Notes to the
Consolidated Financial Statements.


23


RESULTS
OF OPERATIONS





Net
Interest Income and Net Interest Margin





During
2008, the FRB reduced the fed funds rate by 400 basis points.  The FRB
began its current reductions in the fed funds rate by decreasing rates 100 basis
points in 2007.  The New York Prime rate, the primary index used for
variable rate loans, declined by 400 basis points during 2008 and 100 basis
points during 2007.  These rate changes had a significant impact on
our overall yields earned and rates paid.





Net
interest income remains the most significant component of our
earnings.  It is the excess of interest and fees earned on loans,
investment securities, and federal funds sold over interest owed on deposits and
borrowings.  Tax equivalent net interest income for 2008 was $40.3
million, representing a 2.7% decrease from 2007.  Tax equivalent net
interest income for 2007 was $41.4 million, a 5.6% increase over
2006.   A decrease in yields on earning assets was the reason for
the decline in 2008; the increase in the volume of earning assets was not enough
to offset the decrease in yields.  An increase in the volume of
earning assets was the reason for the growth in 2007.  The tax
equivalent yield on earning assets was 6.49% for 2008, compared to 7.34% and
6.98% for 2007 and 2006, respectively. Average earning assets increased to
$954.0 million during 2008, compared to $893.0 million and $835.5 million for
2007 and 2006, respectively.





The rate
paid for interest bearing liabilities was 2.81% for the year ended December 31,
2008, representing a decrease of 55 basis points from the 3.36% paid for the
year ended December 31, 2007.  Conversely, in 2007, the overall rate
paid for interest bearing liabilities increased 50 basis points when compared to
the rate paid for the year ended December 31, 2006.


24





The
following table sets forth the major components of net interest income, on a tax
equivalent basis, for the years ended December 31, 2008, 2007, and
2006.





2008
                      
                      
                      2007
                      
                      
                      2006Average
                      
                      
                      Interest
                      
                      
                      Yield/
                      
                      
                      Average
                      
                      
                      Interest
                      
                      
                      Yield/
                      
                      
                      Average
                      
                      
                      Interest
                      
                      
                      Yield(Dollars
      in thousands)
                      
                      Balance
                      
                      
                      
                      (1)
                      
                      
                      Rate
                      
                      
                      Balance
                      
                      
                      
                      (1)
                      
                      
                      Rate
                      
                      
                      Balance
                      
                      
                      
                      (1)
                      
                      
                      /RateEarning
      assetLoans
      (2) (3)
                      
                      $
                      837,739
                      
                      
                      $
                      57,041
                      
                      
                      
                      6.81
                      %
                      
                      $
                      728,666
                      
                      
                      $
                      57,637
                      
                      
                      
                      7.91
                      %
                      
                      $
                      664,244
                      
                      
                      $
                      50,633
                      
                      
                      
                      7.62
                      %Investment
      securities:Taxable
                      
                      
                      85,105
                      
                      
                      
                      3,788
                      
                      
                      
                      4.45
                      
                      
                      
                      112,384
                      
                      
                      
                      5,105
                      
                      
                      
                      4.54
                      
                      
                      
                      110,354
                      
                      
                      
                      4,486
                      
                      
                      
                      4.07Tax-exempt
                      
                      
                      11,031
                      
                      
                      
                      646
                      
                      
                      
                      5.86
                      
                      
                      
                      13,424
                      
                      
                      
                      786
                      
                      
                      
                      5.85
                      
                      
                      
                      13,593
                      
                      
                      
                      791
                      
                      
                      
                      5.82Federal
      funds sold
                      
                      
                      16,427
                      
                      
                      
                      308
                      
                      
                      
                      1.87
                      
                      
                      
                      21,312
                      
                      
                      
                      1,108
                      
                      
                      
                      5.20
                      
                      
                      
                      28,663
                      
                      
                      
                      1,459
                      
                      
                      
                      5.09Interest
      bearing deposits
                      
                      
                      3,666
                      
                      
                      
                      92
                      
                      
                      
                      2.51
                      
                      
                      
                      17,086
                      
                      
                      
                      893
                      
                      
                      
                      5.23
                      
                      
                      
                      18,665
                      
                      
                      
                      939
                      
                      
                      
                      5.03Total
      earning assets
                      
                      
                      953,968
                      
                      
                      
                      61,875
                      
                      
                      
                      6.49
                      %
                      
                      
                      892,972
                      
                      
                      
                      65,529
                      
                      
                      
                      7.34
                      %
                      
                      
                      835,519
                      
                      
                      
                      58,308
                      
                      
                      
                      6.98
                      %Cash
      and due from banks
                      
                      
                      14,829
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      16,938
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      20,589Other
      assets
                      
                      
                      50,275
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      44,136
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      42,962Allowance
      for credit losses
                      
                      
                      (8,270
                      )
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (6,898
                      )
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (5,653
                      )Total
      assets
                      
                      $
                      1,010,802
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      947,148
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      893,417Interest
      bearing liabilitiesDemand
      deposits
                      
                      $
                      113,002
                      
                      
                      $
                      437
                      
                      
                      
                      0.39
                      %
                      
                      $
                      112,553
                      
                      
                      $
                      1,069
                      
                      
                      
                      0.95
                      %
                      
                      $
                      104,371
                      
                      
                      $
                      702
                      
                      
                      
                      0.67
                      %Money
      market and savings deposits
                      
                      
                      175,376
                      
                      
                      
                      2,406
                      
                      
                      
                      1.37
                      
                      
                      
                      177,256
                      
                      
                      
                      3,175
                      
                      
                      
                      1.79
                      
                      
                      
                      189,699
                      
                      
                      
                      2,724
                      
                      
                      
                      1.44Certificates
      of deposit $100,000 or more
                      
                      
                      193,678
                      
                      
                      
                      7,955
                      
                      
                      
                      4.11
                      
                      
                      
                      159,532
                      
                      
                      
                      7,748
                      
                      
                      
                      4.86
                      
                      
                      
                      135,568
                      
                      
                      
                      5,988
                      
                      
                      
                      4.42Other
      time deposits
                      
                      
                      226,201
                      
                      
                      
                      9,079
                      
                      
                      
                      4.01
                      
                      
                      
                      213,823
                      
                      
                      
                      9,701
                      
                      
                      
                      4.54
                      
                      
                      
                      191,234
                      
                      
                      
                      7,714
                      
                      
                      
                      4.03Interest
      bearing deposits
                      
                      
                      708,257
                      
                      
                      
                      19,877
                      
                      
                      
                      2.81
                      
                      
                      
                      663,164
                      
                      
                      
                      21,693
                      
                      
                      
                      3.27
                      
                      
                      
                      620,872
                      
                      
                      
                      17,128
                      
                      
                      
                      2.76Short-term
      borrowings
                      
                      
                      47,765
                      
                      
                      
                      1,147
                      
                      
                      
                      2.40
                      
                      
                      
                      33,138
                      
                      
                      
                      1,264
                      
                      
                      
                      3.81
                      
                      
                      
                      29,302
                      
                      
                      
                      1,002
                      
                      
                      
                      3.42Long-term
      debt
                      
                      
                      11,598
                      
                      
                      
                      531
                      
                      
                      
                      4.58
                      
                      
                      
                      21,271
                      
                      
                      
                      1,148
                      
                      
                      
                      5.40
                      
                      
                      
                      17,831
                      
                      
                      
                      944
                      
                      
                      
                      5.29Total
      interest bearing liabilities
                      
                      
                      767,620
                      
                      
                      
                      21,555
                      
                      
                      
                      2.81
                      %
                      
                      
                      717,573
                      
                      
                      
                      24,105
                      
                      
                      
                      3.36
                      %
                      
                      
                      668,005
                      
                      
                      
                      19,074
                      
                      
                      
                      2.86
                      %Noninterest
      bearing deposits
                      
                      
                      107,430
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      106,462
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      110,657Other
      liabilities
                      
                      
                      11,388
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      9,074
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      7,709Stockholders’
      equity
                      
                      
                      124,364
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      114,039
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      107,046Total
      liabilities and stockholders’ equity
                      
                      $
                      1,010,802
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      947,148
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      893,417Net
      interest spread
                      
                      
                      
                      
                      
                      $
                      40,320
                      
                      
                      
                      3.68
                      %
                      
                      
                      
                      
                      
                      $
                      41,424
                      
                      
                      
                      3.98
                      %
                      
                      
                      
                      
                      
                      $
                      39,234
                      
                      
                      
                      4.12
                      %Net
      interest margin
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.23
                      %
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.64
                      %
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.70
                      %





(1)
All amounts are reported on a tax equivalent basis computed using the statutory
federal income tax rate of 35% exclusive of the alternative minimum tax rate and
nondeductible interest expense.  The taxable equivalent adjustment
amounts utilized in the above table to compute yields aggregated $401,000 in
2008, $388,000 in 2007, and $337,000 in 2006.


(2)
Average loan balances include nonaccrual loans.


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





On a tax
equivalent basis, total interest income was $61.9 million for 2008, compared to
$65.5 million for 2007 and $58.3 million for 2006. The Company’s largest source
of interest income is loans.  The tax equivalent yield on loans
decreased to 6.81% for 2008, compared to 7.91% for 2007 and 7.62 % for
2006.   The $109.0 million increase in average loans was not
enough to offset the decrease of 110 basis points in the yield on loans which
was the primary reason for the decline in interest income in 2008.  An
increase in both the volume and yield on loans was the reason for the increase
in interest income in 2007. Volume and yields on all other earning assets
decreased during 2008. In 2007, volume decreased but yields increased for all
other earning assets.  During 2008, the overall decrease in yields on
earning assets produced $3.7 million less in interest income, $5.8 million of
which was due to lower rates net of $2.1 million due to increased
volume.  In 2007, increased volume and yields on earning assets
generated $7.2 million in additional interest income.  Of that amount,
increased volume generated an additional $4.7 million in interest income, while
$2.5 million was attributable to increased yields on earning
assets.


25


Interest
expense was $21.6 million for 2008, compared to $24.1 million for 2007 and $19.1
million for 2006. Although overall volume increased, lower rates paid for
interest bearing liabilities, primarily deposits, was the main reason for the
decrease in interest expense in 2008. An increase in volume and higher rates
paid for interest bearing liabilities resulted in an increase in interest
expense for 2007 when compared to 2006.  The Company incurs the
largest amount of interest expense from time deposits. The average rate paid for
certificates of deposit of $100,000 or more decreased 75 basis points to 4.11%
for 2008 from 4.86% for 2007.  The average rate paid for certificates
of deposit of $100,000 or more increased 44 basis points in 2007 from
2006.  The  rate paid for all other time deposits decreased
to 4.01% for 2008, compared to 4.54% for 2007.  The rate paid for all
other time deposits increased 51 basis points in 2007 from
2006.  During 2008, the overall decrease in rates on interest bearing
liabilities produced $2.5 million less in interest expense, $3.9 million of
which was due to lower rates net of $1.4 million due to increased
volume.  In 2007, increased volume and rates on deposits and other
interest bearing liabilities generated $5.0 million in additional interest
expense.  Of that amount, increased volume generated an additional
$2.3 million in interest expense, while $2.7 million was attributable to
increased rates.





Average
earning assets grew $61.0 million, or 6.8%, for the year ended December 31,
2008, driven primarily by growth in loans.  In 2007, average earning
assets increased $57.5 million, or 6.9%, when compared to 2006, also mainly due
to loan growth. Average loans increased $109.0 million, or 15.0%, totaling
$837.7 million for the year ended December 31, 2008, compared to an increase of
$64.5 million, or 9.7%, for 2007. For the year ended December 31, 2008, average
investment securities decreased $30.0 million and federal funds sold and
interest bearing deposits in other banks decreased $18.3 million when compared
to 2007. Average investment securities increased $1.9 million and federal funds
sold and interest bearing deposits in other banks decreased $8.9 million for
2007 when compared to 2006.   As a percentage of total average
earning assets, loans and investment securities were 87.8% and 10.1%,
respectively, for 2008, compared to 81.6% and 14.1%, respectively, for 2007 and
79.5% and 14.8%, respectively, for 2006.





The
following Rate/Volume Variance Analysis identifies the portion of the changes in
tax equivalent net interest income attributable to changes in volume of average
balances or to changes in the yield on earning assets and rates paid on interest
bearing liabilities.




2008 over (under) 2007
                  
                  
                  2007 over (under) 2006Total
                  
                  
                  Caused By
                  
                  
                  Total
                  
                  
                  Caused By(Dollars
      in thousands)
                  
                  Variance
                  
                  
                  Rate
                  
                  
                  Volume
                  
                  
                  Variance
                  
                  
                  Rate
                  
                  
                  VolumeInterest
      income from earning assets:Loans
                  
                  $
                  (596
                  )
                  
                  $
                  (4,880
                  )
                  
                  $
                  4,284
                  
                  
                  $
                  7,004
                  
                  
                  $
                  1,878
                  
                  
                  $
                  5,126Taxable
      investment securities
                  
                  
                  (1,317
                  )
                  
                  
                  (111
                  )
                  
                  
                  (1,206
                  )
                  
                  
                  619
                  
                  
                  
                  549
                  
                  
                  
                  70Tax-exempt
      investment securities
                  
                  
                  (140
                  )
                  
                  
                  1
                  
                  
                  
                  (141
                  )
                  
                  
                  (5
                  )
                  
                  
                  5
                  
                  
                  
                  (10
                  )Federal
      funds sold
                  
                  
                  (800
                  )
                  
                  
                  (455
                  )
                  
                  
                  (345
                  )
                  
                  
                  (351
                  )
                  
                  
                  30
                  
                  
                  
                  (381
                  )Interest
      bearing deposits
                  
                  
                  (801
                  )
                  
                  
                  (320
                  )
                  
                  
                  (481
                  )
                  
                  
                  (46
                  )
                  
                  
                  40
                  
                  
                  
                  (86
                  )Total
      interest income
                  
                  
                  (3,654
                  )
                  
                  
                  (5,765
                  )
                  
                  
                  2,111
                  
                  
                  
                  7,221
                  
                  
                  
                  2,502
                  
                  
                  
                  4,719Interest
      expense on depositsand
      borrowed funds:Interest
      bearing demand deposits
                  
                  
                  (632
                  )
                  
                  
                  (636
                  )
                  
                  
                  4
                  
                  
                  
                  367
                  
                  
                  
                  317
                  
                  
                  
                  50Money
      market and savings deposits
                  
                  
                  (769
                  )
                  
                  
                  (801
                  )
                  
                  
                  32
                  
                  
                  
                  451
                  
                  
                  
                  647
                  
                  
                  
                  (196
                  )Time
      deposits
                  
                  
                  (415
                  )
                  
                  
                  (1,727
                  )
                  
                  
                  1,312
                  
                  
                  
                  3,747
                  
                  
                  
                  1,655
                  
                  
                  
                  2,092Short-term
      borrowings
                  
                  
                  (117
                  )
                  
                  
                  (627
                  )
                  
                  
                  510
                  
                  
                  
                  262
                  
                  
                  
                  52
                  
                  
                  
                  210Long-term
      debt
                  
                  
                  (617
                  )
                  
                  
                  (155
                  )
                  
                  
                  (462
                  )
                  
                  
                  204
                  
                  
                  
                  19
                  
                  
                  
                  185Total
      interest expense
                  
                  
                  (2,550
                  )
                  
                  
                  (3,946
                  )
                  
                  
                  1,396
                  
                  
                  
                  5,031
                  
                  
                  
                  2,690
                  
                  
                  
                  2,341Net
      interest income
                  
                  $
                  (1,104
                  )
                  
                  $
                  (1,819
                  )
                  
                  $
                  715
                  
                  
                  $
                  2,190
                  
                  
                  $
                  (188
                  )
                  
                  $
                  2,378





The
rate and volume variance for each category has been allocated on a consistent
basis between rate and volume variances, based on a percentage of rate, or
volume, variance to the sum of the absolute two variances.





Our net
interest margin (i.e.,
tax equivalent net interest income divided by average earning assets) represents
the net yield on earning assets.   The net interest margin is
managed through loan and deposit pricing and asset/liability
strategies.  The net interest margin was 4.23% for 2008, compared to
4.64% for 2007 and 4.70% for 2006.  The main reason for the lower net
interest margin in 2008 was decreased yields on earning assets. The increased
cost of interest bearing liabilities in 2007 slightly decreased the net interest
margin from 2006.  The net interest spread, which is the difference
between the average yield on earning assets and the rate paid for interest
bearing liabilities, was 3.68% for 2008, 3.98% for 2007 and 4.12% for
2006.


26





Noninterest
Income





Noninterest
income increased $5.7 million, or 38.6%, in 2008, compared to an increase of
$1.8 million, or 14.3%, in 2007.  The increases were primarily related
to the acquisition of two insurance entities during the fourth quarter of
2007.  Service charges on deposit accounts increased $228 thousand in
2008, relatively unchanged from the increase of $235 thousand in 2007. Other
service charges and fees increased $834 thousand in 2008 and $677 thousand in
2007.  Approximately half of the 2008 increase was from the new
insurance entities, 30% was from the trust division, and the remainder was from
banking activities.  The 2007 increase was the result of an increase
in interchange income relating to bank debit and ATM cards ($166 thousand), and
fee income generated by the trust division ($303
thousand).  Investment securities losses were $15 thousand in 2008,
compared to gains of $5 thousand  and $3 thousand in 2007 and 2006,
respectively.  The securities losses in 2008 were from the sale of
10,000 shares of Federal Home Loan Mortgage Corporation (Freddie Mac) preferred
stock.  The Company also incurred a $371 thousand other than temporary
impairment loss on these securities during 2008.  Insurance agency
commissions income was $12.1 million in 2008, compared to $7.7 million and $6.7
million in 2007 and 2006, respectively.  The increase in 2008 and 2007
was primarily due to the two insurance entities acquired in the fourth quarter
of 2007.  Gains on disposals of premises and equipment were $1.2
million in 2008, compared to losses of $136 thousand in 2007 and gains of $6
thousand in 2006.  The gains on disposals in 2008 included the sale of
a bank branch to the state of Maryland as part of a road widening project. The
branch remains open but management expects to move branch operations to a new
facility in the future.  During 2008, the Company sold its investment
in Delmarva Bank Data Processing Center, Inc., an unconsolidated subsidiary, for
a loss of $337 thousand.  Other noninterest income decreased $438
thousand in 2008 and increased $114 thousand in 2007.  The decrease in
2008 was primarily due to less income generated by the mortgage
subsidiary.





The
following table summarizes our noninterest income for the years ended December
31:





Years
      Ended
                                                                    
                                                                    
                                                                    Change
      from Prior Year2008/07
                                                                    
                                                                    
                                                                    2007/06(Dollars
      in thousands)
                                                                    
                                                                    2008
                                                                    
                                                                    
                                                                    2007
                                                                    
                                                                    
                                                                    2006
                                                                    
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    Percent
                                                                    
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    PercentService
      charges on deposit accounts
                                                                    
                                                                    $
                                                                    3,600
                                                                    
                                                                    
                                                                    $
                                                                    3,372
                                                                    
                                                                    
                                                                    $
                                                                    3,137
                                                                    
                                                                    
                                                                    $
                                                                    228
                                                                    
                                                                    
                                                                    
                                                                    6.8
                                                                    %
                                                                    
                                                                    $
                                                                    235
                                                                    
                                                                    
                                                                    
                                                                    7.5
                                                                    %Other
      service charges and fees
                                                                    
                                                                    
                                                                    3,029
                                                                    
                                                                    
                                                                    
                                                                    2,195
                                                                    
                                                                    
                                                                    
                                                                    1,518
                                                                    
                                                                    
                                                                    
                                                                    834
                                                                    
                                                                    
                                                                    
                                                                    38.0
                                                                    
                                                                    
                                                                    
                                                                    677
                                                                    
                                                                    
                                                                    
                                                                    44.6(Losses)
      gains on sales of investment securities
                                                                    
                                                                    
                                                                    (15
                                                                    )
                                                                    
                                                                    
                                                                    5
                                                                    
                                                                    
                                                                    
                                                                    3
                                                                    
                                                                    
                                                                    
                                                                    (20
                                                                    )
                                                                    
                                                                    
                                                                    (400.0
                                                                    )
                                                                    
                                                                    
                                                                    2
                                                                    
                                                                    
                                                                    
                                                                    66.7Other
      than temporary impairment of securities
                                                                    
                                                                    
                                                                    (371
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (371
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -Insurance
      agency commissions income
                                                                    
                                                                    
                                                                    12,090
                                                                    
                                                                    
                                                                    
                                                                    7,698
                                                                    
                                                                    
                                                                    
                                                                    6,744
                                                                    
                                                                    
                                                                    
                                                                    4,392
                                                                    
                                                                    
                                                                    
                                                                    57.1
                                                                    
                                                                    
                                                                    
                                                                    954
                                                                    
                                                                    
                                                                    
                                                                    14.1Gains
      (losses) on disposals of premises and equipment
                                                                    
                                                                    
                                                                    1,247
                                                                    
                                                                    
                                                                    
                                                                    (136
                                                                    )
                                                                    
                                                                    
                                                                    6
                                                                    
                                                                    
                                                                    
                                                                    1,383
                                                                    
                                                                    
                                                                    
                                                                    1,016.9
                                                                    
                                                                    
                                                                    
                                                                    (142
                                                                    )
                                                                    
                                                                    
                                                                    (2,366.7
                                                                    )Loss
      on sale of investment in unconsolidated subsidiary
                                                                    
                                                                    
                                                                    (337
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (337
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -Other
      noninterest income
                                                                    
                                                                    
                                                                    1,107
                                                                    
                                                                    
                                                                    
                                                                    1,545
                                                                    
                                                                    
                                                                    
                                                                    1,431
                                                                    
                                                                    
                                                                    
                                                                    (438
                                                                    )
                                                                    
                                                                    
                                                                    (28.3
                                                                    )
                                                                    
                                                                    
                                                                    114
                                                                    
                                                                    
                                                                    
                                                                    8.0Total
                                                                    
                                                                    $
                                                                    20,350
                                                                    
                                                                    
                                                                    $
                                                                    14,679
                                                                    
                                                                    
                                                                    $
                                                                    12,839
                                                                    
                                                                    
                                                                    $
                                                                    5,671
                                                                    
                                                                    
                                                                    
                                                                    38.6
                                                                    
                                                                    
                                                                    
                                                                    1,840
                                                                    
                                                                    
                                                                    
                                                                    14.3





Noninterest
Expense





Total
noninterest expense increased $5.8 million or 17.9% in 2008, compared to an
increase of $4.0 million or 14.0% in 2007.  The increase in 2008 was
primarily attributable to the operating costs of the two insurance entities
acquired during the fourth quarter of 2007. These operating costs included
salaries, benefits, occupancy, amortization of intangibles, insurance agency
commissions and other noninterest expenses.  Furniture and equipment,
data processing and directors’ fees expenses either decreased or remained
relatively flat compared to 2007.  The majority of the noninterest
expense increase in 2007 was related to salaries and employee benefits
expense.  In 2007, the salaries and benefits cost increases that were
not related to acquisitions resulted from an increase in the number of full-time
equivalent employees, the increased cost of operating two additional bank
branches, increased commission expense related to the increased income from the
trust and advisory services and secondary market mortgage programs, the
additional costs associated with segregating the CEO positions at the Company
and The Talbot Bank, and the costs associated with hiring a new CEO at Talbot
Bank in the third quarter of 2006.  Increases in occupancy and
equipment expense, data processing and other noninterest expenses in 2007 were
attributable to overall growth.  Amortization of other intangible
assets relate to




27


Felton
Bank and the operation of the Insurance Subsidiaries.  See Note 8 to
the Consolidated Financial Statements for further information regarding the
impact of goodwill and other intangible assets on the financial
statements.  We had 333 full-time equivalent employees at December 31,
2008, compared to 338 and 292 at December 31, 2007 and 2006,
respectively.




The
following table summarizes our noninterest expense for the years ended December
31:





Years Ended
            
            
            Change from Prior Year2008/07
            
            
            2007/06(Dollars in thousands)
            
            2008
            
            
            2007
            
            
            2006
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentSalaries
      and employee benefits
            
            $
            23,321
            
            
            $
            19,991
            
            
            $
            17,693
            
            
            $
            3,330
            
            
            
            16.7
            %
            
            $
            2,298
            
            
            
            13.0
            %Occupancy
      and equipment
            
            
            3,364
            
            
            
            3,274
            
            
            
            2,948
            
            
            
            90
            
            
            
            2.7
            
            
            
            326
            
            
            
            11.1Data
      processing
            
            
            1,872
            
            
            
            1,820
            
            
            
            1,559
            
            
            
            52
            
            
            
            2.9
            
            
            
            261
            
            
            
            16.7Directors’
      fees
            
            
            558
            
            
            
            605
            
            
            
            536
            
            
            
            (47
            )
            
            
            (7.8
            )
            
            
            69
            
            
            
            12.9Amortization
      of intangible assets
            
            
            515
            
            
            
            333
            
            
            
            337
            
            
            
            182
            
            
            
            54.7
            
            
            
            (4
            )
            
            
            (1.2
            )Insurance
      agency commissions expense
            
            
            2,248
            
            
            
            557
            
            
            
            -
            
            
            
            1,691
            
            
            
            303.6
            
            
            
            557
            
            
            
            -Other
      noninterest expense
            
            
            6,492
            
            
            
            5,959
            
            
            
            5,462
            
            
            
            533
            
            
            
            8.9
            
            
            
            497
            
            
            
            9.1Total
            
            $
            38,370
            
            
            $
            32,539
            
            
            $
            28,535
            
            
            $
            5,831
            
            
            
            17.9
            
            
            $
            4,004
            
            
            
            14.0





Income
Taxes





Income
tax expense was $7.1 million for 2008, compared to $8.0 million for 2007 and
$8.2 million for 2006. The effective tax rates on earnings were 38.2%, 37.3% and
37.6% for 2008, 2007, and 2006, respectively.  The increase in the
effective tax rate in 2008 was primarily due to a 1.25% increase in the Maryland
corporate income tax rate at the beginning of 2008.





REVIEW
OF FINANCIAL CONDITION





Asset and
liability composition, asset quality, capital resources, liquidity, market risk
and interest sensitivity are all factors that affect our financial
condition.





Assets





Total
assets increased 9.2% during 2008 to $1.045 billion at December 31, 2008,
compared to an increase of 1.2% for 2007.  Average total assets for
the year ended December 31, 2008 were $1.011 billion, an increase of 6.7% over
2007.  Average total assets increased 6.0% in 2007, totaling $947.1
million for the year.  The loan portfolio is the primary source of our
income, and it represented 87.8%, 81.6% and 79.6% of average earning assets for
2008, 2007 and 2006, respectively.





Funding
for loans is provided primarily by core deposits.  Additional funding
is obtained through short-term and long-term borrowings.  Average
total deposits increased 6.0% to $815.7 million at December 31, 2008, compared
to a 5.2% increase for 2007.Deposits provided funding
for approximately 85.5%, 86.2% and 87.6% of average earning assets for 2008,
2007 and 2006, respectively.





The
following table sets forth the average balance of the components of average
earning assets as a percentage of total average earning assets for the year
ended December 31.





2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Loans
                  
                  
                  87.8
                  %
                  
                  
                  81.6
                  %
                  
                  
                  79.6
                  %
                  
                  
                  79.6
                  %
                  
                  
                  76.8
                  %Investment
      securities
                  
                  
                  10.1
                  
                  
                  
                  14.1
                  
                  
                  
                  14.8
                  
                  
                  
                  15.9
                  
                  
                  
                  19.7Federal
      funds sold
                  
                  
                  1.7
                  
                  
                  
                  2.4
                  
                  
                  
                  3.4
                  
                  
                  
                  4.1
                  
                  
                  
                  2.8Interest
      bearing deposits with other banks
                  
                  
                  0.4
                  
                  
                  
                  1.9
                  
                  
                  
                  2.2
                  
                  
                  
                  0.4
                  
                  
                  
                  0.7100.0
                  %
                  
                  
                  100.0
                  %
                  
                  
                  100.0
                  %
                  
                  
                  100.0
                  %
                  
                  
                  100.0
                  %





Interest
Bearing Deposits With Other Banks and Federal Funds Sold





We invest
excess cash balances in interest bearing accounts and federal funds sold offered
by our correspondent banks.  These liquid investments are maintained
at a level necessary to meet immediate liquidity needs.  Average
interest bearing deposits with other banks and federal funds sold decreased
$18.3 million to $20.1 million for the year ended December 31, 2008, compared to
a decrease of $8.9 million in 2007.


28





Investment
Securities





The
investment portfolio is structured to provide us with liquidity and also plays
an important role in the overall management of interest rate
risk.    Investment securities available for sale are stated
at estimated fair value based on quoted market prices.  They represent
securities which may be sold as part of the asset/liability management strategy
or which may be sold in response to changing interest rates.  Net
unrealized holding gains and losses on these securities are reported net of
related income taxes as accumulated other comprehensive income, a separate
component of stockholders’ equity.  Investment securities in the held
to maturity category are stated at cost adjusted for amortization of premiums
and accretion of discounts.  We have the intent and current ability to
hold such securities until maturity. At December 31, 2008, 89% of the portfolio
was classified as available for sale and 11% as held to maturity, compared to
88% and 12%, respectively, at December 31, 2007 and 89% and 11%, respectively,
at December 31, 2006.  The percentage of securities designated as
available for sale reflects the amount needed to support our anticipated growth
and liquidity needs.  With the exception of municipal securities, our
general practice is to classify all newly purchased securities as available for
sale.





Investment
securities available for sale decreased $17.9 million or 18.5% in 2008, totaling
$79.2 million at December 31, 2008, compared to $97.1 million at December 31,
2007.  In 2007, investment securities available for sale decreased
$19.1 million or 16.5%.





Investment
securities held to maturity, consisting primarily of tax-exempt municipal bonds,
totaled $10.3 million at December 31, 2008, compared to $12.9 million at
December 31, 2007 and $14.0 million at December 31, 2006.  We do not
typically invest in structured notes or other derivative
securities.





The
following table sets forth the maturities and weighted average yields of the
bond investment portfolio as of December 31, 2008.





1
      Year or Less
                        
                        
                        1-5
      Years
                        
                        
                        5-10
      Years
                        
                        
                        Over
      10 YearsCarrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average(Dollars
      in thousands)
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        YieldAvailable
      for sale:U.S.
      Treasury and Government agencies
                        
                        $
                        7,892
                        
                        
                        
                        4.68
                        %
                        
                        $
                        44,555
                        
                        
                        
                        4.07
                        %
                        
                        $
                        -
                        
                        
                        
                        -
                        %
                        
                        $
                        -
                        
                        
                        
                        -
                        %Mortgage-backed
      securities
                        
                        
                        1,042
                        
                        
                        
                        4.48
                        
                        
                        
                        4,066
                        
                        
                        
                        4.77
                        
                        
                        
                        5,155
                        
                        
                        
                        4.86
                        
                        
                        
                        12,636
                        
                        
                        
                        5.21Total
      available for sale
                        
                        $
                        8,934
                        
                        
                        
                        4.66
                        
                        
                        $
                        48,621
                        
                        
                        
                        4.13
                        
                        
                        $
                        5,155
                        
                        
                        
                        4.86
                        
                        
                        $
                        12,636
                        
                        
                        
                        5.21Held
      to maturity:Obligations of states
      and political subdivisions1
                        
                        $
                        4,357
                        
                        
                        
                        5.44
                        %
                        
                        $
                        4,753
                        
                        
                        
                        5.68
                        %
                        
                        $
                        1,142
                        
                        
                        
                        5.26
                        %
                        
                        $
                        -
                        
                        
                        
                        -
                        %





1 Yields
adjusted to reflect a tax equivalent basis assuming a federal tax rate of
35%.





Loans





During
2008, we continued to experience strong growth trends in real estate
lending.  The markets in which we operate have experienced a
considerable amount of construction and land development activity over the last
several years, which has been a significant factor behind overall loan
growth.  Loans, net of unearned income, totaled $888.5 million at
December 31, 2008, an increase of $112.2 million or 14.4% over
2007.  Loans increased $76.6 million or 11.0% in 2007 when compared to
2006.  Real estate construction loans increased $24.3 million or 15.6%
in 2008, compared to a decrease of $3.4 million or 2.2% in 2007. Residential
real estate mortgage loans increased $33.3 million or 13.0% in 2008, similar to
the increase of $33.5 million or 15.0% in 2007.  Commercial real
estate mortgage loans increased $55.4 million or 22.3% in 2008, compared to an
increase of $31.2 million or 14.3% in 2007. Commercial loans, which include
financial and agricultural loans, decreased $614 thousand or less than 1% in
2008, compared to an increase of $12.1 million or 15.1% in
2007.  Consumer loans, a small percentage of the overall loan
portfolio, decreased $300 thousand in 2008 and increased $3.3 million in
2007.  At December 31, 2008, 56.5% of the loan




29




portfolio
had fixed interest rates and 43.5% had adjustable interest rates.  We
have brokered long-term fixed rate residential mortgage loans for sale on the
secondary market since 2002.  At December 31, 2008, 2007 and 2006,
there were no loans held for sale. We do not engage in foreign or subprime
lending activities.




The table
below sets forth trends in the composition of the loan portfolio over the past
five years (including net deferred loan fees/costs).





December
      31,(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Real
      estate – construction
                
                $
                179,847
                
                
                $
                155,513
                
                
                $
                158,943
                
                
                $
                134,380
                
                
                $
                97,021Real
      estate – residential
                
                
                289,510
                
                
                
                256,195
                
                
                
                222,687
                
                
                
                212,769
                
                
                
                240,464Real
      estate – commercial
                
                
                304,396
                
                
                
                248,953
                
                
                
                217,781
                
                
                
                187,860
                
                
                
                165,589Commercial
                
                
                91,644
                
                
                
                92,258
                
                
                
                80,186
                
                
                
                75,527
                
                
                
                73,757Consumer
                
                
                23,131
                
                
                
                23,431
                
                
                
                20,122
                
                
                
                16,927
                
                
                
                18,627Total
                
                $
                888,528
                
                
                $
                776,350
                
                
                $
                699,719
                
                
                $
                627,463
                
                
                $
                595,458





The table
below sets forth the maturities and interest rate sensitivity of the loan
portfolio at December 31, 2008.





MaturingMaturing
                
                
                after
      one
                
                
                Maturingwithin
                
                
                but
      within
                
                
                after
      five(Dollars
      in thousands)
                
                one
      year
                
                
                five
      years
                
                
                years
                
                
                TotalReal
      estate – construction
                
                $
                111,598
                
                
                $
                63,406
                
                
                $
                4,843
                
                
                $
                179,847Real
      estate – residential
                
                
                92,752
                
                
                
                93,645
                
                
                
                103,113
                
                
                
                289,510Real
      estate – commercial
                
                
                91,323
                
                
                
                194,962
                
                
                
                18,111
                
                
                
                304,396Commercial
                
                
                48,650
                
                
                
                35,016
                
                
                
                7,978
                
                
                
                91,644Consumer
                
                
                13,618
                
                
                
                8,201
                
                
                
                1,312
                
                
                
                23,131Total
                
                $
                357,941
                
                
                $
                395,230
                
                
                $
                135,357
                
                
                $
                888,528Rate
      terms:Fixed-interest
      rate loans
                
                $
                145,532
                
                
                $
                304,480
                
                
                $
                51,650
                
                
                $
                501,662Adjustable-interest
      rate loans
                
                
                212,410
                
                
                
                90,750
                
                
                
                83,706
                
                
                
                386,866Total
                
                $
                357,942
                
                
                $
                395,230
                
                
                $
                135,356
                
                
                $
                888,528





Deposits





We use
core deposits primarily to fund loans and to purchase investment
securities.   Average deposits increased $46.1 million or 6.0% in
2008, compared to a 5.2% increase in 2007.  The majority of the
deposit growth was in certificates of deposit during 2008 and
2007.  Certificates of deposit $100,000 or more increased $34.1
million or 21.4% in 2008, compared to an increase of $24.0 million or 17.7% in
2007.  Other time deposits increased $12.4 million in 2008,
considerably less than the increase of $22.6 million in 2007.  Average
noninterest bearing demand deposits increased slightly in 2008, compared to a
decrease of 3.8% in 2007.  Average interest bearing demand deposits
increased less than one percent in 2008, compared to an increase of 7.8% in
2007.  For 2008, the average balances of money market and savings
accounts decreased by $1.9 million, somewhat less of a decline than the $12.4
million for 2007.  In 2007, the competitive environment and higher
rates offered for certificates of deposit caused a shifting of balances from
money market to certificates of deposit.  This shifting continued to
occur in 2008.





We have
not historically relied on brokered deposits or purchased deposits as funding
sources for loans.





30




The
following table sets forth the average balances of deposits and the percentage
of each category to total average deposits for the years ended December
31.





(Dollars
      in thousands)
                  
                  Average
      Balances2008
                  
                  
                  2007
                  
                  
                  2006Noninterest
      bearing demand
                  
                  $
                  107,430
                  
                  
                  
                  13.2
                  %
                  
                  $
                  106,462
                  
                  
                  
                  13.9
                  %
                  
                  $
                  110,657
                  
                  
                  
                  15.1
                  %Interest
      bearing depositsDemand
                  
                  
                  113,002
                  
                  
                  
                  13.9
                  
                  
                  
                  112,553
                  
                  
                  
                  14.6
                  
                  
                  
                  104,371
                  
                  
                  
                  14.3Money
      market and savings
                  
                  
                  175,376
                  
                  
                  
                  21.5
                  
                  
                  
                  177,256
                  
                  
                  
                  23.0
                  
                  
                  
                  189,699
                  
                  
                  
                  25.9Certificates
      of deposit $100,000 or more
                  
                  
                  193,678
                  
                  
                  
                  23.7
                  
                  
                  
                  159,532
                  
                  
                  
                  20.7
                  
                  
                  
                  135,568
                  
                  
                  
                  18.5Other
      time deposits
                  
                  
                  226,201
                  
                  
                  
                  27.7
                  
                  
                  
                  213,823
                  
                  
                  
                  27.8
                  
                  
                  
                  191,234
                  
                  
                  
                  26.2$
                  815,687
                  
                  
                  
                  100.0
                  %
                  
                  $
                  769,626
                  
                  
                  
                  100.0
                  %
                  
                  $
                  731,529
                  
                  
                  
                  100.0
                  %




The
following table sets forth the maturity ranges of certificates of deposit with
balances of $100,000 or more as of December 31, 2008.





(Dollars
      in thousands)Three
      months or less
                      
                      $
                      63,062Over
      three through twelve months
                      
                      
                      116,975Over
      twelve months
                      
                      
                      55,198$
                      235,235





Short-Term
Borrowings





Short-term
borrowings primarily consist of securities sold under agreements to repurchase
and short-term borrowings from the FHLB.  Securities sold under
agreements to repurchase are issued in conjunction with cash management services
for commercial depositors.  We also borrow from the FHLB on a
short-term basis and occasionally borrow from correspondent banks under federal
fund lines of credit arrangements to meet short-term liquidity
needs.





The
average balance of short-term borrowings increased $14.6 million or 44.1% in
2008, considerably more than the increase of  $3.8 million or 13.1% in
2007.





The
following table sets forth our position with respect to short-term
borrowings.





2008
                
                
                2007
                
                
                2006Interest
                
                
                
                
                
                Interest
                
                
                
                
                
                Interest(Dollars
      in thousands)
                
                Balance
                
                
                Rate
                
                
                Balance
                
                
                Rate
                
                
                Balance
                
                
                RateAverage
      outstanding for the year
                
                $
                47,765
                
                
                
                2.40
                %
                
                $
                33,138
                
                
                
                3.81
                %
                
                $
                29,302
                
                
                
                3.42
                %Outstanding
      at year end
                
                
                52,969
                
                
                
                0.49
                
                
                
                47,694
                
                
                
                3.86
                
                
                
                28,524
                
                
                
                3.97Maximum
      outstanding at any month end
                
                
                73,094
                
                
                
                -
                
                
                
                57,036
                
                
                
                -
                
                
                
                42,273
                
                
                
                -





Long-Term
Debt





We use
long-term borrowings from the FHLB to meet longer term liquidity needs,
specifically to fund loan growth where deposit growth is not
sufficient.  At December 31, 2008, our long-term debt was $7.9
million, a decrease of $4.5 million from year-end 2007.  Long-term
debt at December 31, 2007 decreased $12.5 million when compared to year-end
2006.  Acquisition-related debt was $1.9 million and $2.5 million of
total long-term debt at year-end 2008 and 2007, respectively. There was no
acquisition- related debt at December 31, 2006.





Capital
Management





Total
stockholders’ equity for the Company was $127.4 million at December 31, 2008,
5.9% higher than the previous year.  Stockholders’ equity at December
31, 2007 increased 8.0% over December 31, 2006.  The increases in
stockholders’ equity in 2008 and 2007 were due primarily to earnings for those
years, reduced by dividends paid on shares of the common stock of the Company.
The Banks paid dividends to the Company in 2007 in order to facilitate the
acquisition of two new insurance entities, which reduced their overall capital
levels and resulted in lower capital ratios at December 31, 2007. However, the
Company and the Banks continue to maintain capital at levels in excess of the
risk-based capital guidelines adopted by the federal banking agencies. At
year-end 2008, the Company remained well in excess of regulatory requirements
for well capitalized institutions.





31




We record
unrealized holding gains (losses), net of tax, on investment securities
available for sale as accumulated other comprehensive income (loss), a separate
component of stockholders’ equity.  At December 31, 2008, the portion
of the investment portfolio designated as “available for sale” had net
unrealized holding gains, net of tax, of $1.4 million, compared to net
unrealized holding gains, net of tax, of $247 thousand at December 31, 2007 and
net unrealized holding losses, net of tax, of $724 thousand at December 31,
2006.




The
following table compares the Company’s capital ratios as of December 31 to the
minimum regulatory requirements.





MinimumRegulatory(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  RequirementsTier
      1 capital
                  
                  $
                  104,117
                  
                  
                  $
                  97,744
                  
                  
                  $
                  98,766Tier
      2 capital
                  
                  
                  9,755
                  
                  
                  
                  7,950
                  
                  
                  
                  6,636Total
      risk-based capital
                  
                  
                  113,872
                  
                  
                  
                  105,694
                  
                  
                  
                  105,402Net
      risk weighted assets
                  
                  
                  894,024
                  
                  
                  
                  804,240
                  
                  
                  
                  750,471Adjusted
      average total assets
                  
                  
                  1,013,815
                  
                  
                  
                  930,619
                  
                  
                  
                  928,551Risk-based
      capital ratios:Tier
      1
                  
                  
                  11.65
                  %
                  
                  
                  12.15
                  %
                  
                  
                  13.16
                  %
                  
                  
                  4.0
                  %Total
      capital
                  
                  
                  12.74
                  
                  
                  
                  13.14
                  
                  
                  
                  14.04
                  
                  
                  
                  8.0Tier
      1 leverage ratio
                  
                  
                  10.27
                  
                  
                  
                  10.50
                  
                  
                  
                  10.64
                  
                  
                  
                  4.0





Management
knows of no trends or demands, commitments, events or uncertainties that are
likely to have a material adverse impact on capital.  See Note 17 to
the Consolidated Financial Statements for further information about the
regulatory capital positions of the Company and the Banks.





Provision
for Credit Losses and Risk Management





Originating
loans involves a degree of risk that credit losses will occur in varying amounts
according to, among other factors, the types of loans being made, the
credit-worthiness of the borrowers over the term of the loans, the quality of
the collateral for the loan, if any, as well as general economic
conditions.  The Company’s Board of Directors demands accountability
of management, keeping the interests of stockholders in
focus.  Through its Asset/Liability Management and Audit Committee,
the Board actively reviews critical risk positions, including market, credit,
liquidity and operational risk.  The Company’s goal in managing risk
is to reduce earnings volatility, control exposure to unnecessary risk, and
ensure appropriate returns for risk assumed.  Senior members of
management actively manage risk at the product level, supplemented with
corporate level oversight through the Asset/Liability Management Committee and
internal audit function.  The risk management structure is designed to
identify risk issues through a systematic process, enabling timely and
appropriate action to avoid and mitigate risk.





Credit
risk is mitigated through portfolio diversification, limiting exposure to any
single industry or customer, collateral protection and standard lending policies
and underwriting criteria.  The following discussion provides
information and statistics on the overall quality of the Company’s loan
portfolio.  Note 1 to the Consolidated Financial Statements describes
the accounting policies related to nonperforming loans and charge-offs and
describes the methodologies used to develop the allowance for credit losses,
including the specific, formula and nonspecific
components.  Management believes the policies governing nonperforming
loans and charge-offs are consistent with regulatory standards.  The
amount of the allowance for credit losses and the resulting provision are
reviewed monthly by senior members of management and approved quarterly by the
Board of Directors.





The
allowance is increased by provisions for credit losses charged to expense and
recoveries of loans previously charged-off.  It is decreased by loans
charged-off in the current period.  Provisions for credit losses are
made to bring the allowance for credit losses within the range of balances that
are considered appropriate based upon the allowance methodology and to reflect
losses within the loan portfolio as of the balance sheet date.





The
adequacy of the allowance for credit losses is determined based upon
management’s estimate of the inherent risks associated with lending activities,
estimated fair value of collateral, past experience and present indicators such
as loan delinquency trends, nonaccrual loans and current market
conditions.  Management believes the allowance is adequate; however,
future changes in the composition of the loan portfolio and financial condition
of borrowers may result in additions to the allowance.  Examination of
the portfolio and allowance by various regulatory agencies and consultants
engaged by the Company may result in the need for additional provisions based
upon information available at the time of the examination.





32




Each of
the Banks maintains a separate allowance for credit losses, which is only
available to absorb losses from their respective loan portfolios.  The
allowance set by each of the Banks is subject to regulatory examination and
determination as to its adequacy.




The
allowance for credit losses is comprised of three parts: the specific allowance,
the formula allowance and the nonspecific allowance.  The specific
allowance is the portion of the allowance that results from management’s
evaluation of specific loss allocations for identified problem loans and pooled
reserves based on historical loss experience for each loan
category.  The formula allowance is determined based on management’s
assessment of industry trends and economic factors in the markets in which we
operate.  The determination of the formula allowance involves a higher
risk of uncertainty and considers current risk factors that may not have yet
manifested themselves in our historical loss factors.  The nonspecific
allowance captures losses that have impacted the portfolio but have yet to be
recognized in either the specific or formula allowance.





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 allowance 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.





As stated
elsewhere in this report, the economy has significantly weakened over the past
two years.  Although the local economy does not appear to show to the
same extent of weakness as in other parts of the country, the effects of
continued weakness in the national economy and/or an increasing weakness in the
local economy could result in even higher loss levels for us in the
future.





At
December 31, 2008, the allowance for credit losses was $9.3 million, or 1.11% of
average outstanding loans, and 115% of total nonaccrual loans. This compares to
an allowance of $7.6 million, or 1.04% of average outstanding loans and 213% of
nonaccrual loans, at December 31, 2007, and an allowance for credit losses of
$6.3 million, or 0.90% of outstanding loans and 82% of nonaccrual loans, at
December 31, 2006.  The ratio of net charge-offs to average loans was
0.19% in 2008 and 0.06% in both 2007 and 2006.





The
provision for credit losses was $3.3 million for 2008, compared to $1.7 million
and $1.5 million for 2007 and 2006, respectively. The increased provision in
2008 reflected the overall growth of the loan portfolio, an increase in loan
charge-offs and nonperforming assets, and a deterioration in overall economic
conditions.  Net loan charge-offs totaled $1.6 million for 2008, a
$1.1 million increase when compared to $473 thousand in net charge-offs for
2007. Net charge-offs were $429 thousand in 2006.


33





The
following table sets forth a summary of our loan loss experience for the years
ended December 31.





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Balance,
      beginning of year
                
                $
                7,551
                
                
                $
                6,300
                
                
                $
                5,236
                
                
                $
                4,692
                
                
                $
                4,060Loans
      charged offReal
      estate –construction
                
                
                (536
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                (316
                )
                
                
                (137
                )
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – commercial
                
                
                (238
                )
                
                
                -
                
                
                
                (2
                )
                
                
                -
                
                
                
                (131
                )Commercial
                
                
                (447
                )
                
                
                (276
                )
                
                
                (539
                )
                
                
                (266
                )
                
                
                (662
                )Consumer
                
                
                (276
                )
                
                
                (301
                )
                
                
                (137
                )
                
                
                (183
                )
                
                
                (94
                )(1,813
                )
                
                
                (714
                )
                
                
                (678
                )
                
                
                (449
                )
                
                
                (887
                )RecoveriesReal
      estate –construction
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                19
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – commercial
                
                
                -
                
                
                
                -
                
                
                
                46
                
                
                
                2
                
                
                
                20Commercial
                
                
                136
                
                
                
                165
                
                
                
                123
                
                
                
                110
                
                
                
                79Consumer
                
                
                90
                
                
                
                76
                
                
                
                80
                
                
                
                71
                
                
                
                63245
                
                
                
                241
                
                
                
                249
                
                
                
                183
                
                
                
                162Net
      loans charged off
                
                
                (1,568
                )
                
                
                (473
                )
                
                
                (429
                )
                
                
                (266
                )
                
                
                (725
                )Allowance
      of acquired institution
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                426Provision
      for credit losses
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493
                
                
                
                810
                
                
                
                931Balance,
      end of year
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300
                
                
                $
                5,236
                
                
                $
                4,692Average
      loans outstanding
                
                $
                837,739
                
                
                $
                728,766
                
                
                $
                664,244
                
                
                $
                607,017
                
                
                $
                555,259Percentage
      of net charge-offs to average loans outstanding during the
      year
                
                
                0.19
                %
                
                
                0.06
                %
                
                
                0.06
                %
                
                
                0.04
                %
                
                
                0.13
                %Percentage
      of allowance for loan losses at year-end to average loans
                
                
                1.11
                %
                
                
                1.04
                %
                
                
                0.90
                %
                
                
                0.86
                %
                
                
                0.85
                %





Total
nonaccrual loans increased to 0.91% of total loans at December 31, 2008,
compared to 0.46% at December 31, 2007 and 1.09% at December 31,
2006.  Specific valuation allowances totaling $341 thousand, $819
thousand and $883 thousand were established to address nonaccrual loans at
December 31, 2008, 2007 and 2006, respectively.  Loans 90 days past
due and still accruing were $1.4 million, $1.6 million and $641 thousand at
year-end 2008, 2007 and 2006, respectively. Nonaccrual loans and loans 90
days past due and still accruing at December 31, 2008 are represented primarily
by real estate loans.  Management believes these loans have been
adequately provided for in the allowance for credit losses.





The
following table summarizes our past due and nonperforming assets as of December
31.





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Non-performing
      assetNon-accrual
      loans
                
                $
                8,115
                
                
                $
                3,540
                
                
                $
                7,658
                
                
                $
                846
                
                
                $
                1,469Other
      real estate and other assets owned
                
                
                148
                
                
                
                176
                
                
                
                398
                
                
                
                302
                
                
                
                391Total
      non-performing assets
                
                
                8,263
                
                
                
                3,716
                
                
                
                8,056
                
                
                
                1,148
                
                
                
                1,860Loans
      90 days past due and still accruing
                
                
                1,381
                
                
                
                1,606
                
                
                
                641
                
                
                
                818
                
                
                
                2,969Total
      non-performing assets and past due loans
                
                $
                9,644
                
                
                $
                5,322
                
                
                $
                8,697
                
                
                $
                1,966
                
                
                $
                4,829Non-accrual
      loans to total loans at period end
                
                
                0.91
                %
                
                
                0.46
                %
                
                
                1.09
                %
                
                
                0.13
                %
                
                
                0.25
                %Non-accrual
      loans and past due loans, to total loans at period end
                
                
                1.07
                %
                
                
                0.66
                %
                
                
                1.19
                %
                
                
                0.27
                %
                
                
                0.75
                %




34


During
2008, there was no change in the methods or assumptions affecting the allowance
methodology.  The amount of the provision is determined based upon
management’s analysis of the portfolio, growth and changes in the condition of
credits and their resultant specific loss allocations.  Historically,
we have experienced the majority of our losses in the commercial loan portfolio,
which are typically not secured by real estate.  However, during 2008
the Company experienced significantly higher losses on real estate secured loans
due to declining real estate values and the slowing economy.





As seen
in the table below, the unallocated portion of the allowance for credit losses
was $216 thousand at December 31, 2008.  There  was no
unallocated portion of the allowance at December 31, 2007 and
2006.  At December 31, 2008, 65.3% and 21.8% of our total loans were
real estate mortgage loans and real estate construction and land development
loans, respectively, compared to 65.1% and 20.0% at December 31, 2007 and 62.9%
and 22.7% at December 31, 2006.





The
following table sets forth the allocation of the allowance for credit losses and
the percentage of loans in each category to total loans for the years ended
December 31,





2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006
                                    
                                    
                                    2005
                                    
                                    
                                    2004%
      of
                                    
                                    
                                    
                                    
                                    
                                    %
      of
                                    
                                    
                                    
                                    
                                    
                                    %
      of
                                    
                                    
                                    
                                    
                                    
                                    %
      of
                                    
                                    
                                    
                                    
                                    
                                    %
      of(Dollars
      in thousands)
                                    
                                    Amount
                                    
                                    
                                    Loans
                                    
                                    
                                    Amount
                                    
                                    
                                    Loans
                                    
                                    
                                    Amount
                                    
                                    
                                    Loans
                                    
                                    
                                    Amount
                                    
                                    
                                    Loans
                                    
                                    
                                    Amount
                                    
                                    
                                    LoansReal
      estate - construction
                                    
                                    $
                                    2,749
                                    
                                    
                                    
                                    21.8
                                    %
                                    
                                    $
                                    1,398
                                    
                                    
                                    
                                    20.0
                                    %
                                    
                                    $
                                    1,229
                                    
                                    
                                    
                                    22.7
                                    %
                                    
                                    $
                                    945
                                    
                                    
                                    
                                    21.4
                                    %
                                    
                                    $
                                    429
                                    
                                    
                                    
                                    16.3
                                    %Real
      estate - mortgage
                                    
                                    
                                    4,001
                                    
                                    
                                    
                                    65.3
                                    
                                    
                                    
                                    4,075
                                    
                                    
                                    
                                    65.1
                                    
                                    
                                    
                                    3,275
                                    
                                    
                                    
                                    62.9
                                    
                                    
                                    
                                    2,299
                                    
                                    
                                    
                                    63.9
                                    
                                    
                                    
                                    2,262
                                    
                                    
                                    
                                    68.3Commercial
                                    
                                    
                                    2,073
                                    
                                    
                                    
                                    10.3
                                    
                                    
                                    
                                    1,826
                                    
                                    
                                    
                                    11.9
                                    
                                    
                                    
                                    1,525
                                    
                                    
                                    
                                    11.5
                                    
                                    
                                    
                                    1,780
                                    
                                    
                                    
                                    12.0
                                    
                                    
                                    
                                    1,863
                                    
                                    
                                    
                                    12.3Consumer
                                    
                                    
                                    281
                                    
                                    
                                    
                                    2.6
                                    
                                    
                                    
                                    252
                                    
                                    
                                    
                                    3.0
                                    
                                    
                                    
                                    271
                                    
                                    
                                    
                                    2.9
                                    
                                    
                                    
                                    212
                                    
                                    
                                    
                                    2.7
                                    
                                    
                                    
                                    138
                                    
                                    
                                    
                                    3.1Unallocated
                                    
                                    
                                    216
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -$
                                    9,320
                                    
                                    
                                    
                                    100.0
                                    %
                                    
                                    $
                                    7,551
                                    
                                    
                                    
                                    100.0
                                    %
                                    
                                    $
                                    6,300
                                    
                                    
                                    
                                    100.0
                                    %
                                    
                                    $
                                    5,236
                                    
                                    
                                    
                                    100.0
                                    %
                                    
                                    $
                                    4,692
                                    
                                    
                                    
                                    100.0
                                    %





Market
Risk Management





Market
risk is the risk of loss arising from adverse changes in the fair value of
financial instruments due to changes in interest rates, exchange rates or equity
pricing.  Our principal market risk is interest rate risk that arises
from our lending, investing and deposit taking activities.  Our
profitability is largely dependent on the Banks’ net interest
income.  Interest rate risk can significantly affect net interest
income to the degree that interest bearing liabilities mature or reprice at
different intervals than interest earning assets.  The Banks’
Asset/Liability Management Committees oversee the management of interest rate
risk.  The primary purpose of these committees is to manage the
exposure of net interest margins to unexpected changes due to interest rate
fluctuations.  These efforts affect our loan pricing and deposit rate
policies as well as the asset mix, volume guidelines, and liquidity and capital
planning.





We do not
utilize derivative financial or commodity instruments or hedging strategies in
the management of interest rate risk.  Because we are not exposed to
market risk from trading activities and do not utilize hedging strategies or
off-balance sheet management strategies, the Asset/Liability Management
Committees of the Banks rely on “gap” analysis as its primary tool in managing
interest rate risk. Gap analysis summarizes the amount of interest sensitive
assets and liabilities, which will reprice over various time
intervals.  The excess between the volume of assets and liabilities
repricing in each interval is the interest sensitivity
“gap”.  “Positive gap” occurs when more assets reprice in a given time
interval, while “negative gap” occurs when more liabilities
reprice.  As of December 31, 2008, we had an overall negative gap
position within the one-year repricing interval because the interest sensitive
liabilities exceeded the interest sensitive assets within the one-year repricing
interval by $101.3 million, or 9.7% of total assets, similar to the negative gap
position within the one-year interval at December 31, 2007, which totaled $99.1
million, or 10.4% of total assets.  The negative gap position within
the one-year interval at December 31, 2006, totaled $80.9 million, or 8.6% of
total assets.


35





The
following table summarizes our interest sensitivity at December 31,
2008.  Loans, federal funds sold, time deposits and short-term
borrowings are classified based upon contractual maturities if fixed-rate or
earliest repricing date if variable rate.  Investment securities are
classified by contractual maturities or, if they have call provisions, by the
most likely repricing date.




3
      Months
                                                      
                                                      
                                                      1
      Year
                                                      
                                                      
                                                      3
      Years
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      Non-Within
                                                      
                                                      
                                                      through
                                                      
                                                      
                                                      through
                                                      
                                                      
                                                      through
                                                      
                                                      
                                                      After
                                                      
                                                      
                                                      SensitiveDecember
      31, 2008
                                                      
                                                      3
      Months
                                                      
                                                      
                                                      12
      Months
                                                      
                                                      
                                                      3
      Years
                                                      
                                                      
                                                      5
      Years
                                                      
                                                      
                                                      5
      Years
                                                      
                                                      
                                                      Funds
                                                      
                                                      
                                                      Total(Dollars
      in thousands)ASSETSLoans,
      net
                                                      
                                                      $
                                                      419,646
                                                      
                                                      
                                                      $
                                                      92,401
                                                      
                                                      
                                                      $
                                                      235,945
                                                      
                                                      
                                                      $
                                                      100,303
                                                      
                                                      
                                                      $
                                                      40,233
                                                      
                                                      
                                                      $
                                                      (9,320
                                                      )
                                                      
                                                      $
                                                      879,208Investment
      securities
                                                      
                                                      
                                                      19,054
                                                      
                                                      
                                                      
                                                      18,402
                                                      
                                                      
                                                      
                                                      23,516
                                                      
                                                      
                                                      
                                                      10,509
                                                      
                                                      
                                                      
                                                      17,975
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      89,456Federal
      funds sold
                                                      
                                                      
                                                      10,010
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      10,010Interest
      bearing deposits with other banks
                                                      
                                                      
                                                      481
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      481Other
      assets
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      65,486
                                                      
                                                      
                                                      
                                                      65,486Total
      assets
                                                      
                                                      
                                                      449,191
                                                      
                                                      
                                                      
                                                      110,803
                                                      
                                                      
                                                      
                                                      259,461
                                                      
                                                      
                                                      
                                                      110,812
                                                      
                                                      
                                                      
                                                      58,208
                                                      
                                                      
                                                      
                                                      56,166
                                                      
                                                      
                                                      
                                                      1,044,641LIABILITIESNoninterest
      bearing demand deposits
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      102,584
                                                      
                                                      
                                                      
                                                      102,584Interest
      bearing demand deposits
                                                      
                                                      
                                                      125,370
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      125,370Money
      market and savings deposits
                                                      
                                                      
                                                      150,958
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      150,958Certificates
      of deposit, $100,000 or more
                                                      
                                                      
                                                      63,062
                                                      
                                                      
                                                      
                                                      116,975
                                                      
                                                      
                                                      
                                                      39,150
                                                      
                                                      
                                                      
                                                      16,048
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      235,235Other
      time deposits
                                                      
                                                      
                                                      32,032
                                                      
                                                      
                                                      
                                                      116,392
                                                      
                                                      
                                                      
                                                      57,274
                                                      
                                                      
                                                      
                                                      25,526
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      231,224Short-term
      borrowings
                                                      
                                                      
                                                      52,969
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      52,969Long-term
      debt
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      3,487
                                                      
                                                      
                                                      
                                                      3,973
                                                      
                                                      
                                                      
                                                      487
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      7,947Other
      liabilities
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      10,969
                                                      
                                                      
                                                      
                                                      10,969STOCKHOLDERS’
      EQUITY
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      127,385
                                                      
                                                      
                                                      
                                                      127,385Total
      Liabilities and Stockholders’ Equity
                                                      
                                                      
                                                      424,391
                                                      
                                                      
                                                      
                                                      236,854
                                                      
                                                      
                                                      
                                                      100,397
                                                      
                                                      
                                                      
                                                      42,061
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      240,938
                                                      
                                                      
                                                      
                                                      1,044,641Excess
                                                      
                                                      $
                                                      24,800
                                                      
                                                      
                                                      $
                                                      (126,051
                                                      )
                                                      
                                                      $
                                                      159,064
                                                      
                                                      
                                                      $
                                                      68,751
                                                      
                                                      
                                                      $
                                                      58,208
                                                      
                                                      
                                                      $
                                                      (184,772
                                                      )
                                                      
                                                      $
                                                      -Cumulative
      excess
                                                      
                                                      $
                                                      24,800
                                                      
                                                      
                                                      $
                                                      (101,251
                                                      )
                                                      
                                                      $
                                                      57,813
                                                      
                                                      
                                                      $
                                                      126,564
                                                      
                                                      
                                                      $
                                                      184,772
                                                      
                                                      
                                                      $
                                                      -
                                                      
                                                      
                                                      $
                                                      -Cumulative
      excess as percent of total assets
                                                      
                                                      
                                                      2.4
                                                      %
                                                      
                                                      
                                                      (9.7
                                                      )%
                                                      
                                                      
                                                      5.5
                                                      %
                                                      
                                                      
                                                      12.1
                                                      %
                                                      
                                                      
                                                      17.7
                                                      %
                                                      
                                                      
                                                      -
                                                      %
                                                      
                                                      
                                                      -
                                                      %





In
addition to gap analysis, the Banks utilize simulation models to quantify the
effect a hypothetical immediate plus or minus 300 basis point change in rates
would have on their net interest income and the fair value of
capital.  The model takes into consideration the effect of call
features of investment securities as well as prepayments of loans in periods of
declining rates.  When actual changes in interest rates occur, the
changes in interest earning assets and interest bearing liabilities may differ
from the assumptions used in the model.  The chart below provides the
sensitivity profiles for net interest income and the fair value of capital as of
year-end 2008 and 2007.  As of December 31, 2008, due to the low
interest-rate environment, we believe the results of the minus 300 basis point
change in rates is not meaningful.





Immediate
      Change in Rates-300
                              
                              
                              -200
                              
                              
                              -100
                              
                              
                              +100
                              
                              
                              +200
                              
                              
                              +300Basis
      Points
                              
                              
                              Basis
      Points
                              
                              
                              Basis
      Points
                              
                              
                              Basis
      Points
                              
                              
                              Basis
      Points
                              
                              
                              Basis
      Points2008%
      Change in Net Interest Income
                              
                              
                              N/A
                              
                              
                              
                              (16.65
                              )%
                              
                              
                              (7.10
                              )%
                              
                              
                              6.49
                              %
                              
                              
                              12.55
                              %
                              
                              
                              17.54
                              %%
      Change in Value of Capital
                              
                              
                              N/A
                              
                              
                              
                              5.31
                              %
                              
                              
                              1.20
                              %
                              
                              
                              2.51
                              %
                              
                              
                              5.43
                              %
                              
                              
                              7.25
                              %2007%
      Change in Net Interest Income
                              
                              
                              (14.58
                              )%
                              
                              
                              (9.25
                              )%
                              
                              
                              (4.37
                              )%
                              
                              
                              3.49
                              %
                              
                              
                              6.82
                              %
                              
                              
                              9.58
                              %%
      Change in Value of Capital
                              
                              
                              (9.42
                              )%
                              
                              
                              (4.69
                              )%
                              
                              
                              (1.73
                              )%
                              
                              
                              1.37
                              %
                              
                              
                              2.30
                              %
                              
                              
                              1.99
                              %




36


Off-Balance
Sheet Arrangements
 
 In the
normal course of business, to meet the financing needs of its customers, the
Banks are parties to financial instruments with off-balance sheet
risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  The Banks’ exposure to credit
loss in the event of nonperformance by the other party to these financial
instruments is represented by the contractual amount of the
instruments.  The Banks use the same credit policies in making
commitments and conditional obligations as they use for on-balance sheet
instruments.  The Banks generally require collateral or other security
to support the financial instruments with credit risk.  The amount of
collateral or other security is determined based on management’s credit
evaluation of the counterparty.  The Banks evaluate each customer’s
creditworthiness on a case-by-case basis.
  Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Letters of
credit are conditional commitments issued by the Banks to guarantee the
performance of a customer to a third party.  Letters of credit and
other commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee.  Because many of the letters
of credit and commitments are expected to expire without being drawn upon, the
total commitment amount does not necessarily represent future cash
requirements.  Further information about these arrangements is
provided in Note 21 to the Consolidated Financial Statements.





Management
does not believe that any of the foregoing arrangements have or are reasonably
likely to have a current or future effect on our financial condition, revenues
or expenses, results of operations, liquidity, capital expenditures or capital
resources that is material to investors.





Liquidity
Management





Liquidity
describes our ability to meet financial obligations that arise during the normal
course of business.  Liquidity is primarily needed to meet the
borrowing and deposit withdrawal requirements of customers and to fund current
and planned expenditures.  Liquidity is derived through increased
customer deposits, maturities in the investment portfolio, loan repayments and
income from earning assets.  To the extent that deposits are not
adequate to fund customer loan demand, liquidity needs can be met in the
short-term funds markets.  We have arrangements with correspondent
banks whereby we have $57.5 million available in federal funds lines of credit
and a reverse repurchase agreement available to meet any short-term needs which
may not otherwise be funded by the Banks’ portfolio of readily marketable
investments that can be converted to cash.  The Banks are also members
of the Federal Home Loan Bank, which provides another source of
liquidity.  At December 31, 2008, the Banks had credit availability of
approximately $62.1 million from the Federal Home Loan Bank.





At
December 31, 2008, our loan to deposit ratio was approximately 105%, compared to
101% and 90% at year-end 2007 and 2006, respectively.  Investment
securities available for sale totaling $79.2 million at the end of 2008 were
available for the management of liquidity and interest rate risk.  The
comparable amounts were $97.1 million and $116.3 million at December 31, 2007
and 2006, respectively.  Cash and cash equivalents were $27.3 million
at December 31, 2008, compared to $26.9 million at year-end 2007 and $79.7
million at year-end 2006.  Management is not aware of any demands,
commitments, events or uncertainties that will materially affect our ability to
maintain liquidity at satisfactory levels.





We have
various financial obligations, including contractual obligations and commitments
that may require future cash payments. The purchase obligations in the table
below include costs associated with a new core data processing
system.  The conversion to the new system is scheduled for the second
quarter of 2009.  With the new system, we expect to achieve automation
efficiencies and cost savings.





The
following table presents, as of December 31, 2008, significant fixed and
determinable contractual obligations to third parties by payment
date.





(Dollars
      in thousands)
              
              Within
                one
      year
              
              
              One
      to
                three
      years
              
              
              Three
      to
                five
      years
              
              
              Over
                five
      years
              
              
              TotalDeposits
      without a stated maturity (a)
              
              $
              378,917
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              378,917Certificates
      of deposit (a)
              
              
              330,712
              
              
              
              96,518
              
              
              
              41,574
              
              
              
              -
              
              
              
              468,804Short-term
      borrowings
              
              
              52,969
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              52,969Long-term
      debt
              
              
              3,518
              
              
              
              3,497
              
              
              
              932
              
              
              
              -
              
              
              
              7,947Operating
      leases
              
              
              721
              
              
              
              1,020
              
              
              
              685
              
              
              
              2,098
              
              
              
              4,524Purchase
      obligations
              
              
              2,306
              
              
              
              3,534
              
              
              
              3,466
              
              
              
              9,647
              
              
              
              18,953$
              769,143
              
              
              $
              104,569
              
              
              $
              46,657
              
              
              $
              11,745
              
              
              $
              932,114(a) Includes
      accrued interest payable




37




Item
7A.     Quantitative and Qualitative Disclosures About
Market Risk.


The
information required by this item may be found in Item 7 of Part II of this
report under the caption “Market Risk Management”, which is incorporated herein
by reference.


Item
8.        Financial Statements and
Supplementary Data.





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS





Management’s
      Report on Internal Control over Financial Reporting
                39Report
      of Independent Registered Public Accounting Firm
                40Consolidated
      Balance Sheets
                41Consolidated
      Statements of Income
                42Consolidated
      Statements of Changes in Stockholders’ Equity
                43Consolidated
      Statements of Cash Flows
                44Notes
      to Consolidated Financial Statements
                46


38





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Management
of Shore Bancshares, Inc. (the “Company”) is responsible for the preparation,
integrity and fair presentation of the consolidated financial statements
included in this annual report.  The Company’s consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America and, as such, include some amounts that
are based on the best estimates and judgments of management.





The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting.  This internal control
system is designed to provide reasonable assurance to management and the Board
of Directors regarding the reliability of the Company’s financial reporting and
the preparation and presentation of financial statements for external reporting
purposes in conformity with accounting principles generally accepted in the
United States of America, as well as to safeguard assets from unauthorized use
or disposition.  The system of internal control over financial
reporting is evaluated for effectiveness by management and tested for
reliability through a program of internal audit with actions taken to correct
potential deficiencies as they are identified.  Because of inherent
limitations in any internal control system, no matter how well designed,
misstatement due to error or fraud may occur and not be detected, including the
possibility of the circumvention or overriding of
controls.  Accordingly, even an effective internal control system can
provide only reasonable assurance with respect to financial statement
preparation.  Further, because of changes in conditions, internal
control effectiveness may vary over time.





Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2008 based upon criteria set forth inInternal Control –
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).





Based on this assessment
and on the foregoing criteria, management has concluded that, as of December 31,
2008, the Company’s internal control over financial reporting is
effective.Stegman & Company, the Company’s independent
registered public accounting firm that audited the financial statements included
in this annual report, has issued a report on the Company’s internal control
over financial reporting, which appears on the
following page.





March 12,
2009





/s/ W. Moorhead Vermilye
              
              /s/ Susan E. LeavertonW.
      Moorhead Vermilye
              
              Susan
      E. Leaverton, CPAPresident
      and Chief Executive Officer
              
              Principal
      Accounting Officer


39


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Shore Bancshares, Inc.




We have
audited the accompanying consolidated balance sheets of Shore Bancshares, Inc.
(the “Company”) as of, December 31, 2008 and 2007, and the consolidated
statements of income, changes in stockholders’ equity and cash flows for each of
the years in the three-year period ended December 31, 2008. We also have audited
the Company’s internal control over financial reporting as of December 31, 2008,
based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Company’s management is responsible
for these financial statements, for maintaining effective internal control over
financial reporting, and for its assessment of the effectiveness of internal
control over financial reporting, included in the accompanying Management’s
Report on Internal Control over Financial Reporting.  Our
responsibility is to express an opinion on these consolidated financial
statements and an opinion on the Company’s internal control over financial
reporting based on our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects.  Our audits of the consolidated financial statements
included examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation.  Our audit of internal control over
financial reporting included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk.  Our audits also included
performing such other procedures as we considered necessary in the
circumstances. We believe that our audits provide a reasonable basis for our
opinions.




A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company’s internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Shore Bancshares, Inc. as of
December 31, 2008 and 2007, and the results of its operations and its cash flows
for each of the years in the three-year period ended December 31, 2008 in
conformity with accounting principles generally accepted in the United States of
America.  Also in our opinion, Shore Bancshares, Inc. maintained, in
all material respects, effective internal control over financial reporting as of
December 31, 2008, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).









Baltimore,
Maryland


March 12,
2009


40


SHORE
BANCSHARES, INC.


CONSOLIDATED
BALANCE SHEETS


December
31,


(In
      thousands, except share data)
                  
                  2008
                  
                  
                  2007ASSETSCash
      and due from banks
                  
                  $
                  16,803
                  
                  
                  $
                  17,198Interest-bearing
      deposits with other banks
                  
                  
                  481
                  
                  
                  
                  3,036Federal
      funds sold
                  
                  
                  10,010
                  
                  
                  
                  6,646Investment
      securities:Available
      for sale, at fair value
                  
                  
                  79,204
                  
                  
                  
                  97,137Held
      to maturity, at amortized cost –fair value of$10,390
      (2008) and $12,924 (2007)
                  
                  
                  10,252
                  
                  
                  
                  12,896Loans
                  
                  
                  888,528
                  
                  
                  
                  776,350Less:  allowance
      for credit losses
                  
                  
                  (9,320
                  )
                  
                  
                  (7,551
                  )Loans,
      net
                  
                  
                  879,208
                  
                  
                  
                  768,799Insurance
      premiums receivable
                  
                  
                  1,348
                  
                  
                  
                  1,083Premises
      and equipment, net
                  
                  
                  13,855
                  
                  
                  
                  15,617Accrued
      interest receivable
                  
                  
                  4,606
                  
                  
                  
                  5,008Investment
      in unconsolidated subsidiary
                  
                  
                  -
                  
                  
                  
                  937Goodwill
                  
                  
                  15,954
                  
                  
                  
                  15,954Other
      intangible assets, net
                  
                  
                  5,921
                  
                  
                  
                  6,436Deferred
      income taxes
                  
                  
                  1,579
                  
                  
                  
                  1,847Other
      real estate owned
                  
                  
                  148
                  
                  
                  
                  176Other
      assets
                  
                  
                  5,272
                  
                  
                  
                  4,141Total
      assets
                  
                  $
                  1,044,641
                  
                  
                  $
                  956,911LIABILITIESDeposits:Noninterest-bearing
      demand
                  
                  $
                  102,584
                  
                  
                  $
                  104,081Interest-bearing
      demand
                  
                  
                  125,370
                  
                  
                  
                  115,623Money
      market and savings
                  
                  
                  150,958
                  
                  
                  
                  169,896Certificates
      of deposit, $100,000 or more
                  
                  
                  235,235
                  
                  
                  
                  161,568Other
      time
                  
                  
                  231,224
                  
                  
                  
                  214,727Total
      deposits
                  
                  
                  845,371
                  
                  
                  
                  765,895Accrued
      interest payable
                  
                  
                  2,350
                  
                  
                  
                  2,793Short-term
      borrowings
                  
                  
                  52,969
                  
                  
                  
                  47,694Long-term
      debt
                  
                  
                  7,947
                  
                  
                  
                  12,485Other
      liabilities
                  
                  
                  8,619
                  
                  
                  
                  7,809Total
      liabilities
                  
                  
                  917,256
                  
                  
                  
                  836,676STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01, authorized 35,000,000 shares; shares issued and
      outstanding–8,404,684 (2008) and 8,380,530 (2007)
                  
                  
                  84
                  
                  
                  
                  84Additional
      paid in capital
                  
                  
                  29,768
                  
                  
                  
                  29,539Retained
      earnings
                  
                  
                  96,140
                  
                  
                  
                  90,365Accumulated
      other comprehensive income
                  
                  
                  1,393
                  
                  
                  
                  247Total
      stockholders’ equity
                  
                  
                  127,385
                  
                  
                  
                  120,235Total
      liabilities and stockholders’ equity
                  
                  $
                  1,044,641
                  
                  
                  $
                  956,911





The notes
to the consolidated financial statements are an integral part of these
statements.


41


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME


For the
Years Ended December 31,





(Dollars
      in thousands, except per share data)
                
                2008
                
                
                2007
                
                
                2006INTEREST
      INCOMEInterest
      and fees on loans
                
                $
                56,866
                
                
                $
                57,524
                
                
                $
                50,572Interest
      and dividends on investment securities:Taxable
                
                
                3,788
                
                
                
                5,105
                
                
                
                4,452Tax-exempt
                
                
                420
                
                
                
                511
                
                
                
                549Interest
      in federal funds sold
                
                
                308
                
                
                
                1,108
                
                
                
                1,459Interest
      in deposits with other banks
                
                
                92
                
                
                
                893
                
                
                
                939Total
      interest income
                
                
                61,474
                
                
                
                65,141
                
                
                
                57,971INTEREST
      EXPENSEInterest
      on deposits
                
                
                19,877
                
                
                
                21,693
                
                
                
                17,128Interest
      on short-term borrowings
                
                
                1,147
                
                
                
                1,264
                
                
                
                1,034Interest
      on long-term debt
                
                
                531
                
                
                
                1,148
                
                
                
                912Total
      interest expense
                
                
                21,555
                
                
                
                24,105
                
                
                
                19,074NET
      INTEREST INCOME
                
                
                39,919
                
                
                
                41,036
                
                
                
                38,897Provision
      for credit losses
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                
                
                36,582
                
                
                
                39,312
                
                
                
                37,404NONINTEREST
      INCOMEService
      charges on deposit accounts
                
                
                3,600
                
                
                
                3,372
                
                
                
                3,137Other
      service charges and fees
                
                
                3,029
                
                
                
                2,195
                
                
                
                1,518(Losses)
      gains on sales of investment securities
                
                
                (15
                )
                
                
                5
                
                
                
                3Other
      than temporary impairment of securities
                
                
                (371
                )
                
                
                -
                
                
                
                -Insurance
      agency commissions income
                
                
                12,090
                
                
                
                7,698
                
                
                
                6,744Gains(losses)
      on disposals of premises and equipment
                
                
                1,247
                
                
                
                (136
                )
                
                
                6Loss
      on sale of investment in unconsolidated subsidiary
                
                
                (337
                )
                
                
                -
                
                
                
                -Other
      noninterest income
                
                
                1,107
                
                
                
                1,545
                
                
                
                1,431Total
      noninterest income
                
                
                20,350
                
                
                
                14,679
                
                
                
                12,839NONINTEREST
      EXPENSESalaries
      and wages
                
                
                18,426
                
                
                
                15,947
                
                
                
                14,103Employee
      benefits
                
                
                4,895
                
                
                
                4,044
                
                
                
                3,590Occupancy
      expense
                
                
                2,179
                
                
                
                1,962
                
                
                
                1,655Furniture
      and equipment expense
                
                
                1,185
                
                
                
                1,312
                
                
                
                1,293Data
      processing
                
                
                1,872
                
                
                
                1,820
                
                
                
                1,559Directors’
      fees
                
                
                558
                
                
                
                605
                
                
                
                536Amortization
      of intangible assets
                
                
                515
                
                
                
                333
                
                
                
                337Insurance
      agency commissions expense
                
                
                2,248
                
                
                
                557
                
                
                
                -Other
      noninterest expenses
                
                
                6,492
                
                
                
                5,959
                
                
                
                5,462Total
      noninterest expense
                
                
                38,370
                
                
                
                32,539
                
                
                
                28,535INCOME
      BEFORE INCOME TAXES
                
                
                18,562
                
                
                
                21,452
                
                
                
                21,708Income
      tax expense
                
                
                7,092
                
                
                
                8,002
                
                
                
                8,154NET
      INCOME
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554Basic
      earnings per common share
                
                $
                1.37
                
                
                $
                1.61
                
                
                $
                1.62Diluted
      earnings per common share
                
                $
                1.37
                
                
                $
                1.60
                
                
                $
                1.61Cash
      dividends paid per common share
                
                $
                0.64
                
                
                $
                0.64
                
                
                $
                0.59





The notes
to the consolidated financial statements are an integral part of these
statements.


42





SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


For the
Years Ended December 31, 2008, 2007, and 2006





(Dollars
      in thousands, except per share data)
                          
                          Common
                            Stock
                          
                          
                          Additional
                            Paid
      In
                            Capital
                          
                          
                          Retained
                            Earnings
                          
                          
                          Accumulated
                            Other
                            Comprehensive
                            Income
      (Loss)
                          
                          
                          Total
                            Stockholders’
                            EquityBalances,
      January 1, 2006
                          
                          $
                          56
                          
                          
                          $
                          29,014
                          
                          
                          $
                          73,642
                          
                          
                          $
                          (1,264
                          )
                          
                          $
                          101,448Comprehensive
      income:Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          13,554
                          
                          
                          
                          -
                          
                          
                          
                          13,554Unrealized
      gains on available-for-salesecurities,
      net of reclassificationadjustment
      of $14, net of taxes
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          540
                          
                          
                          
                          540Total
      comprehensive income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          14,094Shares
      issued for employee stock-based awards
                          
                          
                          -
                          
                          
                          
                          654
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          654Stock-based
      compensation expense
                          
                          
                          -
                          
                          
                          
                          48
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          48Stock
      dividend and cash in lieu of fractionalshares
      paid
                          
                          
                          28
                          
                          
                          
                          (28
                          )
                          
                          
                          (9
                          )
                          
                          
                          -
                          
                          
                          
                          (9
                          )Cash
      dividends paid ($0.59 per share)
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (4,908
                          )
                          
                          
                          -
                          
                          
                          
                          (4,908
                          )Balances,
      December 31, 2006
                          
                          
                          84
                          
                          
                          
                          29,688
                          
                          
                          
                          82,279
                          
                          
                          
                          (724
                          )
                          
                          
                          111,327Comprehensive
      income:Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          13,450
                          
                          
                          
                          -
                          
                          
                          
                          13,450Unrealized
      gains on available-for-salesecurities,
      net of reclassification adjustment of $21, net of taxes
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          971
                          
                          
                          
                          971Total
      comprehensive income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          14,421Shares
      issued for employee stock-based awards
                          
                          
                          -
                          
                          
                          
                          54
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          54Stock-based
      compensation expense
                          
                          
                          -
                          
                          
                          
                          63
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          63Stock
      repurchased and retired
                          
                          
                          -
                          
                          
                          
                          (266
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (266
                          )Cash
      dividends paid ($0.64 per share)
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (5,364
                          )
                          
                          
                          -
                          
                          
                          
                          (5,364
                          )Balances,
      December 31, 2007
                          
                          
                          84
                          
                          
                          
                          29,539
                          
                          
                          
                          90,365
                          
                          
                          
                          247
                          
                          
                          
                          120,235Adjustment
      to initially apply EITF Issue 06-4
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (318
                          )
                          
                          
                          -
                          
                          
                          
                          (318
                          )Comprehensive
      income:Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          11,470
                          
                          
                          
                          -
                          
                          
                          
                          11,470Unrealized
      gains on available-for-salesecurities,
      net of reclassification adjustment of $(326), net of taxes
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,146
                          
                          
                          
                          1,146Total
      comprehensive income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          12,616Shares
      issued for employee stock-based awards
                          
                          
                          -
                          
                          
                          
                          138
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          138Stock-based
      compensation expense
                          
                          
                          -
                          
                          
                          
                          91
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          91Cash
      dividends paid ($0.64 per share)
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (5,377
                          )
                          
                          
                          
                          
                          
                          
                          (5,377
                          )Balances,
      December 31, 2008
                          
                          $
                          84
                          
                          
                          $
                          29,768
                          
                          
                          $
                          96,140
                          
                          
                          $
                          1,393
                          
                          
                          $
                          127,385





The notes
to the consolidated financial statements are an integral part of these
statements.


43


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


For the
Years Ended December 31,





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                
                
                1,784
                
                
                
                1,523
                
                
                
                1,445Discount
      accretion on debt securities
                
                
                (199
                )
                
                
                (190
                )
                
                
                (143
                )Provision
      for credit losses
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493Stock-based
      compensation expense
                
                
                91
                
                
                
                63
                
                
                
                48Excess
      tax benefits from stock-based arrangements
                
                
                (4
                )
                
                
                (3
                )
                
                
                (279
                )Deferred
      income taxes
                
                
                (498
                )
                
                
                (377
                )
                
                
                (424
                )Loss
      (gain) on sales of securities
                
                
                15
                
                
                
                (5
                )
                
                
                (3
                )Other
      than temporary impairment of securities
                
                
                371
                
                
                
                -
                
                
                
                -(Gain)
      loss on disposals of premises and equipment
                
                
                (1,247
                )
                
                
                136
                
                
                
                (6
                )Loss
      on sale of investment in unconsolidated subsidiary
                
                
                337
                
                
                
                -
                
                
                
                -Loss
      (gain) on sale of other real estate owned
                
                
                50
                
                
                
                (51
                )
                
                
                -Net
      changes in:Insurance
      premiums receivable
                
                
                (265
                )
                
                
                (510
                )
                
                
                517Accrued
      interest receivable
                
                
                402
                
                
                
                (116
                )
                
                
                (995
                )Other
      assets
                
                
                (1,683
                )
                
                
                1,503
                
                
                
                (342
                )Accrued
      interest payable
                
                
                (443
                )
                
                
                550
                
                
                
                1,029Other
      liabilities
                
                
                491
                
                
                
                30
                
                
                
                240Net
      cash provided by operating activities
                
                
                14,009
                
                
                
                17,727
                
                
                
                16,134CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                
                
                82,063
                
                
                
                92,293
                
                
                
                48,648Proceeds
      from sales of securities available for sale
                
                
                2
                
                
                
                3,500
                
                
                
                51Purchases
      of securities available for sale
                
                
                (62,551
                )
                
                
                (74,897
                )
                
                
                (57,833
                )Proceeds
      from maturities and principal payments of securities held to
      maturity
                
                
                3,666
                
                
                
                1,174
                
                
                
                1,127Purchases
      of securities held to maturity
                
                
                (1,026
                )
                
                
                (117
                )
                
                
                (203
                )Net
      increase in loans
                
                
                (114,033
                )
                
                
                (77,977
                )
                
                
                (73,036
                )Purchases
      of premises and equipment
                
                
                (331
                )
                
                
                (695
                )
                
                
                (1,886
                )Proceeds
      from sales of premises and equipment
                
                
                2,773
                
                
                
                -
                
                
                
                40Proceeds
      from sale of investment in unconsolidated subsidiary
                
                
                600
                
                
                
                -
                
                
                
                -Proceeds
      from sales of other real estate owned
                
                
                264
                
                
                
                1,148
                
                
                
                255Acquisition,
      net of cash acquired
                
                
                -
                
                
                
                (5,259
                )
                
                
                -Net
      cash used in investing activities
                
                
                (88,573
                )
                
                
                (60,830
                )
                
                
                (82,837
                )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      decrease in demand, money market and savings deposits
                
                
                (10,688
                )
                
                
                (18,843
                )
                
                
                (12,428
                )Net
      increase in certificates of deposit
                
                
                90,163
                
                
                
                10,556
                
                
                
                81,652Excess
      tax benefits from stock-based arrangements
                
                
                4
                
                
                
                3
                
                
                
                279Net
      increase (decrease) in short-term borrowings
                
                
                5,276
                
                
                
                19,170
                
                
                
                (7,323
                )Proceeds
      from issuance of long-term debt
                
                
                3,000
                
                
                
                3,000
                
                
                
                21,000Repayment
      of long-term debt
                
                
                (7,538
                )
                
                
                (18,000
                )
                
                
                -Proceeds
      from issuance of common stock
                
                
                138
                
                
                
                54
                
                
                
                654Stock
      repurchased and retired
                
                
                -
                
                
                
                (266
                )
                
                
                -Dividends
      paid
                
                
                (5,377
                )
                
                
                (5,364
                )
                
                
                (4,917
                )Net
      cash provided (used) by financing activities
                
                
                74,978
                
                
                
                (9,690
                )
                
                
                78,917


44


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (CONTINUED)


For the
Years Ended December 31,





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                
                
                414
                
                
                
                (52,793
                )
                
                
                12,214CASH
      AND CASH EQUIVALENTS AT BEGINNING OF YEAR
                
                
                26,880
                
                
                
                79,673
                
                
                
                67,459CASH
      AND CASH EQUIVALENTS AT END OF YEAR
                
                $
                27,294
                
                
                $
                26,880
                
                
                $
                79,673Supplemental
      cash flow information:Interest
      paid
                
                $
                21,998
                
                
                $
                23,555
                
                
                $
                18,045Income
      taxes paid
                
                $
                9,704
                
                
                $
                8,462
                
                
                $
                8,281Transfers
      from loans to other real estate owned
                
                $
                286
                
                
                $
                874
                
                
                $
                352Details
      of acquisitions:Fair
      value of assets acquired
                
                $
                -
                
                
                $
                3,705
                
                
                $
                -Fair
      value of liabilities assumed
                
                
                -
                
                
                
                (3,404
                )
                
                
                -Fair
      value of debt issued
                
                
                -
                
                
                
                (2,485
                )
                
                
                -Purchase
      price in excess of net assets acquired
                
                
                -
                
                
                
                9,215
                
                
                
                -Net
      cash paid for acquisition
                
                $
                -
                
                
                $
                7,031
                
                
                $
                -





The notes
to consolidated financial statements are an integral part of these
statements.


45


SHORE
BANCSHARES, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


For the
Years Ended December 31, 2008, 2007 and 2006





NOTE
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





The
consolidated financial statements include the accounts of Shore Bancshares, Inc.
and its subsidiaries (collectively referred to in these Notes as the “Company”),
with all significant intercompany transactions eliminated. The investments in
subsidiaries are recorded on the Company’s books (Parent only) on the basis of
its equity in the net assets of the subsidiaries. The accounting and reporting
policies of the Company conform to accounting principles generally accepted in
the United States of America. For purposes of comparability, certain
reclassifications have been made to amounts previously reported to conform with
the current period presentation.





Nature
of Operations





The
Company provides commercial banking services from its Maryland locations in
Talbot County, Queen Anne’s County, Kent County, Caroline County, and Dorchester
County, and from its locations in Kent County, Delaware. Its primary source of
revenue is interest earned on commercial, real estate and consumer loans made to
customers located on the Delmarva Peninsula. A full range of insurance and
investment services are offered through the Company’s nonbank
subsidiaries.





Use
of Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.





The
allowance for credit losses is a material estimate that is particularly
susceptible to significant changes in the near term. Management believes that
the allowance for credit losses is sufficient to address the probable losses in
the current portfolio. While management uses available information to recognize
losses on loans, future additions to the allowance may be necessary based on
changes in economic conditions. In addition, various regulatory agencies, as an
integral part of their examination processes, periodically review the Company’s
allowance for credit losses. Such agencies may require the Company to recognize
additions to the allowance based on their judgments about information available
to them at the time of their examination.





Investment
Securities Available for Sale


Investment
securities available for sale are stated at estimated fair value based on quoted
market prices. They represent those securities which management may sell as part
of its asset/liability strategy or which may be sold in response to changing
interest rates, changes in prepayment risk or other similar factors. The cost of
securities sold is determined by the specific identification method. Purchase
premiums and discounts are recognized in interest income using the interest
method over the terms of the securities. Net unrealized holding gains and losses
on these securities are reported as accumulated other comprehensive income, a
separate component of stockholders’ equity, net of related income taxes.
Declines in the fair value of individual available-for-sale securities below
their cost that are other than temporary result in write-downs of the individual
securities to their fair value and are reflected in earnings as realized losses.
Factors affecting the determination of whether an other-than-temporary
impairment has occurred include a downgrading of the security by a rating
agency, a significant deterioration in the financial condition of the issuer, or
that management would not have the intent and ability to hold a security for a
period of time sufficient to allow for any anticipated recovery in fair value.
Equity securities include Federal Home Loan Bank stock, Federal Reserve Bank
stock and Atlantic Central Banker’s Bank stock which are considered restricted
as to marketability and are recorded at cost.





Investment
Securities Held to Maturity





Investment
securities held to maturity are stated at cost adjusted for amortization of
premiums and accretion of discounts. Purchase premiums and discounts are
recognized in interest income using the interest method over the terms of the
securities. The Company intends and has the ability to hold such securities
until maturity. Declines in the fair value of individual held-to-maturity
securities below their cost that are other than temporary result in write-downs
of the individual securities to their fair value. Factors affecting the
determination of whether an other-than-temporary impairment has occurred include
a downgrading of the security by the rating agency, a significant deterioration
in the financial condition of the issuer, or that management would not have the
ability to hold a security for a period of time sufficient to allow for any
anticipated recovery in fair value.


46


Loans





Loans are
stated at their principal amount outstanding net of any deferred fees and costs.
Interest income on loans is accrued at the contractual rate based on the
principal amount outstanding. Fees charged and costs capitalized for originating
loans are being amortized substantially on the interest method over the term of
the loan. A loan is placed on nonaccrual when it is specifically determined to
be impaired or when principal or interest is delinquent for 90 days or more,
unless the loan is well secured and in the process of collection. Any unpaid
interest previously accrued on those loans is reversed from income. Interest
income generally is not recognized on specific impaired loans unless the
likelihood of further loss is remote. Interest payments received on nonaccrual
loans are applied as a reduction of the loan principal balance unless
collectability of the principal amount is reasonably assured, in which case
interest is recognized on a cash basis. Loans are returned to accrual status
when all principal and interest amounts contractually due are brought current
and future payments are reasonably assured.





Loans are
considered impaired when it is probable that the Company will not collect all
principal and interest payments according to the loan’s contractual 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. Generally, the Company measures impairment on such loans by reference
to the fair value of the collateral. Income on impaired loans is recognized on a
cash basis, and payments are first applied against the principal balance
outstanding. Impaired loans do not include groups of smaller balance homogeneous
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.





Allowance
for Credit Losses





The
allowance for credit losses is maintained at a level believed adequate by
management to absorb losses inherent in the loan portfolio as of the balance
sheet date and is based on the size and current risk characteristics of the loan
portfolio, an assessment of individual problem loans and actual loss experience,
current economic events in specific industries and geographical areas, including
unemployment levels, and other pertinent factors, including regulatory guidance
and general economic conditions and other observable data. Determination of the
allowance is inherently subjective as it requires significant estimates,
including the amounts and timing of expected future cash flows or collateral
value of impaired loans, estimated losses on pools of homogeneous loans that are
based on historical loss experience, and consideration of current economic
trends, all of which may be susceptible to significant change. Loan losses are
charged off against the allowance, while recoveries of amounts previously
charged off are credited to the allowance. A provision for credit losses is
charged to operations based on management’s periodic evaluation of the factors
previously mentioned, as well as other pertinent factors. Evaluations are
conducted at least quarterly and more often if deemed necessary.





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





The
allowance for credit losses is comprised of three parts: the specific allowance,
the formula allowance and the nonspecific allowance. The specific allowance is
the portion of the allowance that results from management’s evaluation of
specific loss allocations for identified problem loans and pooled reserves based
on historical loss experience for each loan category. The formula allowance is
determined based on management’s assessment of industry trends and economic
factors in the markets in which we operate. The determination of the formula
allowance involves a higher risk of uncertainty and considers current risk
factors that may not have yet manifested themselves in our historical loss
factors. The nonspecific allowance captures losses that have impacted the
portfolio but have yet to be recognized in either the specific or formula
allowance.


47


Premises
and Equipment





Premises
and equipment are stated at cost less accumulated depreciation and amortization.
Depreciation and amortization are calculated using the straight-line method over
the estimated useful lives of the assets. Useful lives range from three to ten
years for furniture, fixtures and equipment; three to five years for computer
hardware and data handling equipment; and ten to forty years for buildings and
building improvements. Land improvements are amortized over a period of fifteen
years and leasehold improvements are amortized over the term of the respective
lease. Sale-leaseback transactions are considered normal leasebacks and any
realized gains are deferred and amortized to other income on a straight-line
basis over the initial leave term. Maintenance and repairs are charged to
expense as incurred, while improvements which extend the useful life of an asset
are capitalized and depreciated over the estimated remaining life of the
asset.





Long-lived
assets are evaluated periodically for impairment when events or changes in
circumstances indicate the carrying amount may not be recoverable. Impairment
exists when the expected undiscounted future cash flows of a long-lived asset
are less than its carrying value. In that event, the Company recognizes a loss
for the difference between the carrying amount and the estimated fair value of
the asset.





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. Under the provisions of SFAS No. 142, “Goodwill and Other
Intangible Assets”, goodwill and other intangible assets with indefinite lives
are no longer ratably amortized into the income statement over an estimated
life, but rather tested at least annually for impairment. Intangible assets that
have finite lives continue to be amortized over their estimated useful lives and
also continue to be subject to impairment testing. The Company’s other
intangible assets that have finite lives are amortized on a straight-line basis
over varying periods not exceeding 21 years. Prior to adoption of SFAS No. 142,
the Company’s goodwill was amortized on a straight-line basis over fifteen
years. Note 8 includes a summary of the Company’s goodwill and other intangible
assets.




Other
Real Estate Owned





Other
real estate owned represents assets acquired in satisfaction of loans either by
foreclosure or deeds taken in lieu of foreclosure. Properties acquired are
recorded at the lower of cost or fair value less estimated selling costs at the
time of acquisition with any deficiency charged to the allowance for credit
losses. Thereafter, costs incurred to operate or carry the properties as well as
reductions in value as determined by periodic appraisals are charged to
operating expense. Gains and losses resulting from the final disposition of
the properties are included in noninterest income.





Short-Term
Borrowings





Short-term
borrowings are comprised primarily of Federal Home Loan Bank advances and
repurchase agreements. The repurchase agreements are securities sold to the
Company’s customers, at the customers’ request, under a continuing “roll-over”
contract that matures in one business day. The underlying securities sold are
U.S. Government agency securities, which are segregated from the Company’s other
investment securities by its safekeeping agents.





Long-Term
Debt





Long-term
debt primarily consists of advances from the Federal Home Loan Bank. These
borrowings are used to fund earning asset growth of the Company.





Income
Taxes





The
Company and its subsidiaries file a consolidated federal income tax return. The
Company accounts for income taxes using the liability method pursuant to
Statement of Financial Accounting Standards No. 109, “Accounting for Income
Taxes”. Under this method, deferred tax assets and liabilities are determined by
applying the applicable federal and state income tax rates to its cumulative
temporary differences. These temporary differences represent differences between
financial statement carrying amounts and the corresponding tax bases of certain
assets and liabilities. Deferred taxes are provided as a result of such
temporary differences.




48




Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in the period that includes the enactment
date.




The
Company adopted the provisions of Financial Accounting Standards Board (“FASB”)
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”)
on January 1, 2007. The adoption of FIN 48 did not have a material impact on the
Company’s consolidated financial statements. The Company recognizes accrued
interest and penalties related to unrecognized tax benefits as a component of
tax expense.





Basic
and Diluted Earnings Per Common Share





Basic
earnings per share is derived by dividing net income available to common
stockholders by the weighted-average number of common shares outstanding and
does not include the effect of any potentially dilutive common stock
equivalents. Diluted earnings per share is derived by dividing net income by the
weighted-average number of shares outstanding, adjusted for the dilutive effect
of outstanding stock options and restricted stock awards.





Transfers
of Financial Assets





Transfers
of financial assets are accounted for as sales, when control over the assets has
been surrendered. Control over transferred assets is deemed to be surrendered
when (1) the assets have been isolated from the Company, (2) the transferee
obtains the right (free of conditions that constrain it from taking advantage of
that right) to pledge or exchange the transferred assets, and (3) the Company
does not maintain effective control over the transferred assets through an
agreement to repurchase them before their maturity.





Statement
of Cash Flows





Cash and
due from banks, interest bearing deposits with other banks and federal funds
sold are considered “cash and cash equivalents” for financial reporting
purposes.





Stock-Based
Compensation




The
Company adopted the provisions of SFAS No. 123, “Share-Based Payment (Revised
2004),” on January 1, 2006. SFAS 123R eliminates the ability to account for
stock-based compensation using APB 25 and requires that such transactions be
recognized as compensation cost in the income statement based on their fair
values on the measurement date which, for the Company, is the date of the grant.
The Company transitioned to fair-value based accounting for stock-based
compensation using a modified version of prospective application (“modified
prospective application”). Under modified prospective application, as it is
applicable to the Company, SFAS 123R applies to new awards and to awards
modified, repurchased, or cancelled after January 1, 2006. Additionally,
compensation cost for the portion of awards for which the requisite service has
not been rendered (generally referring to non-vested awards) that were
outstanding as of January 1, 2006 will be recognized as the remaining requisite
service is rendered during the period of and/or the periods after the adoption
of SFAS 123R. The attribution of compensation cost for those earlier awards is
based on the same method and on the same grant-date fair values previously
determined for the pro forma disclosures required for companies that did not
previously adopt the fair value accounting method for stock-based employee
compensation. Compensation expense for non-vested stock awards is based on the
fair value of the awards, which is generally the market price of the stock on
the measurement date, which, for the Company, is the date of grant, and is
recognized ratably over the service period of the award.




Advertising
Costs





Advertising
costs are generally expensed as incurred. The Company incurred advertising costs
of approximately $513 thousand, $473 thousand and $430 thousand for the years
ended December 31, 2008, 2007 and 2006, respectively.




49


New
Accounting Pronouncements





Pronouncements
adopted




SFAS No. 157, “Fair
Value Measurements.”SFAS
157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS 157 requires disclosures about the fair value of assets
and liabilities recognized in the balance sheet in periods subsequent to initial
recognition, whether the measurements are made on a recurring basis (for
example, available for sale investment securities) or on a nonrecurring basis
(for example, impaired loans). SFAS 157 defines fair value as the exchange price
that would be received for an asset or paid to transfer a liability (an exit
price) in the principal or most advantageous market for the asset or liability
in an orderly transaction between market participants on the measurement date.
SFAS 157 also establishes a fair value hierarchy, which requires an entity to
maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value. The adoption of SFAS 157 on January 1, 2008,
did not have a significant impact on the Company’s consolidated financial
statements.




FASB Financial Staff Postition
(“FSP”) No. 157-2, “Partial Deferral of the Effective
Date of Statement 157.”FSP 157-2 defers the effective date of SFAS 157
for all nonfinancial assets and nonfinancial liabilities to fiscal years
beginning after November 15, 2008.




SFAS No. 158, “Employers’ Accounting
for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB
Statements No. 87, 88 106, and 132(R).”SFAS 158 requires an employer to
recognize the overfunded or underfunded status of defined benefit
post-retirement benefit plans as an asset or a liability in its statement of
financial position. The funded status is measured as the difference between plan
assets at fair value and the benefit obligation (the projected benefit
obligation for pension plans or the accumulated benefit obligation for other
post-retirement benefit plans). An employer is also required to measure the
funded status of a plan as of the date of its year-end statement of financial
position with changes in the funded status recognized through comprehensive
income. SFAS 158 also requires certain disclosures regarding the effects on net
periodic benefit cost for the next fiscal year that arise from delayed
recognition of gains or losses, prior service costs or credits, and the
transition asset or obligation. The adoption of SFAS 158’s requirement to
recognize the funded status in the financial statements for fiscal years ending
after December 15, 2006 did not have a significant impact on the Company’s
consolidated financial statements. SFAS 158’s requirement to use the fiscal
year-end date as the measurement date was effective for fiscal years ending
after December 15, 2008, and did not have a significant impact on the Company’s
consolidated financial statements.





SFAS No. 159, "The Fair Value Option
for Financial Assets and Financial Liabilities-Including an amendment of FASB
Statement No. 115."SFAS 159 permits entities to choose to measure
eligible items at fair value at specified election dates. Unrealized gains and
losses on items for which the fair value option has been elected are reported in
earnings at each subsequent reporting date. The fair value option (1) may be
applied instrument by instrument, with certain exceptions, (2) is irrevocable
(unless a new election date occurs) and (3) is applied only to entire
instruments and not to portions of instruments. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement is expected to expand the use of fair value
measurement, which is consistent with the FASB’s long-term measurement
objectives for accounting for financial instruments. The Company adopted SFAS
159 on January 1, 2008, and has not elected the fair value option for any
financial assets or liabilities at December 31, 2008.





The
Emerging Issues Task Force (“EITF”) of the FASB issued EITF Issue No. 06-4,“Accounting for Deferred Compensation
and Postretirement
Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements,”
which was effective January 1, 2008. EITF 06-4 requires the recognition of a
liability and related compensation costs for endorsement split-dollar life
insurance policies that provide a benefit to an employee that extends to
postretirement periods as defined in SFAS 106, " Employers' Accounting for
Postretirement Benefits Other Than Pensions." The EITF reached a consensus that
Bank Owned Life Insurance policies purchased for this purpose do not effectively
settle the entity's obligation to the employee in this regard and thus the
entity must record compensation cost and a related liability. Entities should
recognize the effects of applying this Issue through either, (1) a change in
accounting principle through a cumulative-effect adjustment to retained earnings
or to other components of equity or net assets in the balance sheet as of the
beginning of the year of adoption, or (2) a change in accounting principle
through retrospective application to all prior periods. This Issue was effective
for fiscal years beginning after December 15, 2007. The effects of the guidance
have been applied as a change in accounting principle through a
cumulative-effect adjustment to retained earnings of $318 thousand.




EITF Issue No. 06-11, “Accounting for Income Tax Benefits
of Dividends on Share-Based Payment Awards.” EITF 06-11 requires that tax
benefits generated by




50


dividends
paid during the vesting period on certain equity-classified share-based
compensation awards be classified as additional paid-in capital and included in
a pool of excess tax benefits available to absorb tax deficiencies from
share-based payment awards. EITF 06-11 was effective for years beginning after
December 31, 2007. The adoption of EITF 06-11 did not have a material impact on
the Company’s consolidated financial position or results of
operations.
 
 FSP No. 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset is not Active.” This FSP
clarifies the application of SFAS 157, “Fair Value Measurements,” in a market
that is not active and provides an example to illustrate key considerations in
determining the fair value of a financial asset when the market for that
financial asset is not active. This FSP shall be effective upon issuance,
including prior periods for which financial statements have not been issued.
Revisions resulting from a change in the valuation technique or its application
shall be accounted for as a change in accounting estimate in accordance with
SFAS 154, “Accounting Changes and Error Corrections.” The disclosure provisions
of SFAS 154 for a change in accounting estimate are not required for revisions
resulting from a change in valuation technique or its application. The adoption
of this Statement did not have a material impact on the Company’s consolidated
financial statements.




The SEC
issued Staff Accounting
Bulletin (“SAB”) No. 109, “Written Loan Commitments Recorded at
Fair Value through Earnings.” Previously,
SAB 105, “Application of Accounting Principles to Loan Commitments,”stated that in
measuring the fair value of a derivative loan commitment, a company should not
incorporate the expected net future cash flows related to the associated
servicing of the loan. SAB 109 supersedes SAB 105 and indicates that
the expected net future cash flows related to the associated servicing of the
loan should be included in measuring fair value for all written loan commitments
that are accounted for at fair value through earnings. SAB 105 also
indicated that internally-developed intangible assets should not be recorded as
part of the fair value of a derivative loan commitment, and SAB 109 retains
that view. SAB 109 is effective for derivative loan commitments issued or
modified in fiscal quarters beginning after December 15, 2007. The impact
of SAB 109 did not have a material impact on the Company’s consolidated
financial statements.





Pronouncements
issued but not yet effective





SFAS No. 141R, “Business
Combinations.” SFAS 141R’s objective is to improve the relevance,
representational faithfulness, and comparability of the information that a
reporting entity provides in its financial reports about a business combination
and its effects. SFAS 141R applies prospectively to business combinations for
which the acquisition date is on or after December 31, 2008. This statement will
change the Company’s accounting treatment for business combinations on a
prospective basis.





SFAS No. 160, “Noncontrolling
Interests in Consolidated Financial Statements.” SFAS 160’s objective is
to improve the relevance, comparability, and transparency of the financial
information that a reporting entity provides in its consolidated financial
statements by establishing accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. SFAS 160 was effective for fiscal years and interim periods within
those fiscal years, beginning on or after December 15, 2008. The Company does
not expect the adoption of SFAS 160 to have a material impact on its
consolidated financial statements.





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





SFAS No. 162, “The Hierarchy of
Generally Accepted Accounting Principles.”SFAS 162 identifies the
sources of accounting principles and the framework for selecting the principles
to be used in the preparation of financial statements of nongovernmental
entities that are presented in conformity with GAAP in the United States (the
“GAAP hierarchy”). The FASB concluded that the GAAP hierarchy should reside in
the accounting literature established by the FASB and is issuing this Statement
to achieve that result. This Statement is effective 60 days following the
Security and Exchange Commission’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles.The Company
does not expect the implementation of SFAS 162 to have a material impact on its
consolidated financial statements.





SFAS No. 163, “Accounting for
Financial Guarantee Insurance Contracts – an interpretation of FASB Statement
No. 60.”SFAS 163 requires that an insurance enterprise recognize a claim
liability prior to an event of default (insured event) when there is evidence
that credit deterioration has occurred in an insured financial obligation. This
Statement also clarifies how Statement 60 applies to financial guarantee
insurance contracts, including the recognition and


51




measurement
to be used to account for premium revenue and claim liabilities. The accounting
and expanded disclosure requirements of SFAS 163 will improve the quality and
comparability of financial information that will be provided to users of
financial statements. This Statement is effective for financial statements
issued for fiscal years beginning after December 15, 2008, and all interim
periods within those fiscal years. This Statement also requires that disclosures
about the risk-management activities of the insurance enterprise be effective
for the first period (including interim periods) beginning after issuance of
this Statement. The Company does not expect the implementation of SFAS 163 to
have a material impact on its consolidated financial statements.





FSP No. FAS 140-3, “ Accounting for Transfers of
Financial Assets and Repurchase Financing Transactions.” This FSP
concludes that a transferor and transferee should not separately account for a
transfer of a financial asset and a related repurchase financing unless
(a) the two transactions have a valid and distinct business or economic
purpose for being entered into separately and (b) the repurchase financing
does not result in the initial transferor regaining control over the financial
asset. The FSP is effective for financial statements issued for fiscal years
beginning on or after November 15, 2008, and interim periods within those
fiscal years. The adoption of this FSP is not expected to have a material effect
on the Company’s consolidated financial statements.




FSP No. 142-3, “ Determination
of the Useful Life of Intangible Assets.” FSP 142-3 amends the factors
that should be considered in developing assumptions about renewal or extension
used in estimating the useful life of a recognized intangible asset under SFAS
142,“Goodwill and Other
Intangible Assets.” This standard is intended to improve the consistency between
the useful life of a recognized intangible asset under SFAS 142 and the period
of expected cash flows used to measure the fair value of the asset under SFAS
141R and other GAAP. FSP 142-3 is effective for financial statements issued for
fiscal years beginning after December 15, 2008. The measurement provisions
of this standard will apply only to intangible assets of the Company acquired
after the effective date.




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




NOTE
2. ACQUISITIONS





Effective
October 1, 2007, the Company acquired Jack Martin & Associates, Inc. (“JM”),
a marine insurance agency located in Annapolis, Maryland. Pursuant to the
acquisition agreement, the Company paid $3.7 million in cash for all of the
issued and outstanding capital stock of JM. The total fair value of assets
acquired was $484 thousand and the total of liabilities assumed was $433
thousand. Total intangible assets recorded relating to the acquisition of JM
included $1.9 million of goodwill, $1.2 million of intangible assets subject to
amortization, and $0.8 million of intangible assets not subject to amortization.
In addition to the purchase price, the acquisition agreement calls for a
deferred payment to be made on or before February 14, 2011 if the acquired
business meets certain performance criteria through December 31,
2010.





Effective
October 1, 2007, the Company acquired TSGIA, Inc. and its operating
subsidiaries, Tri-State General Insurance Agency, LTD, Tri-State General
Insurance Agency of New Jersey, Inc., Tri-State General Insurance Agency of
Virginia, Inc., and ESFS, Inc. (collectively, “TSGIA”). In accordance with the
purchase agreement, the Company paid $5.85 million for TSGIA. The total fair
value of assets acquired was $3.2 million and the total of liabilities assumed
was $3.0 million. Additionally, the Company assumed $2.5 million in long-term
debt. Total intangible assets recorded relating to the acquisition of TSGIA
included $2.1 million of goodwill, $1.5 million of intangible assets subject to
amortization, and $1.7 million of intangible assets not subject to amortization.
In addition to the purchase price, the acquisition agreement calls for a
deferred payment to be made on or before February 14, 2013 if the acquired
business meets certain performance criteria through December 31,
2012.




The
results of operations of JM and TSGIA subsequent to the acquisition date are
included in the Company’s Consolidated Statements of Income.




52


NOTE
3. CASH AND DUE FROM BANKS
 
 The Board
of Governors of the Federal Reserve System (the “FRB”) requires banks to
maintain certain minimum cash balances consisting of vault cash and deposits in
the appropriate Federal Reserve Bank or in other commercial banks. Such balances
for the Company’s bank subsidiaries averaged approximately $1.4 million and $1.7
million during 2008 and 2007, respectively.




NOTE
4. INVESTMENT SECURITIES





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





Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                Fair(Dollars in thousands)
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueAvailable-for-sale
      securities:December
      31, 2008:Obligations
      of U.S. Treasury
                
                $
                1,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,000Obligations
      of U.S. Government agencies and corporations
                
                
                49,996
                
                
                
                1,451
                
                
                
                -
                
                
                
                51,447Mortgage-backed
      securities
                
                
                22,028
                
                
                
                879
                
                
                
                8
                
                
                
                22,899Federal
      Home Loan Bank stock
                
                
                3,003
                
                
                
                -
                
                
                
                -
                
                
                
                3,003Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                551
                
                
                
                2
                
                
                
                -
                
                
                
                553$
                76,880
                
                
                $
                2,332
                
                
                $
                8
                
                
                $
                79,204December
      31, 2007:Obligations
      of U.S. Government agencies and corporations
                
                $
                67,204
                
                
                $
                624
                
                
                $
                95
                
                
                $
                67,733Mortgage-backed
      securities
                
                
                25,810
                
                
                
                137
                
                
                
                193
                
                
                
                25,754Federal
      Home Loan Bank stock
                
                
                2,984
                
                
                
                -
                
                
                
                -
                
                
                
                2,984Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Federal
      Home Loan Mortgage Corporation cumulative preferred stock
                
                
                389
                
                
                
                -
                
                
                
                61
                
                
                
                328Other
      equity securities
                
                
                35
                
                
                
                1
                
                
                
                -
                
                
                
                36$
                96,724
                
                
                $
                762
                
                
                $
                349
                
                
                $
                97,137Held-to-maturity
      securities:December
      31, 2008:Obligations
      of states and political subdivisions
                
                $
                10,252
                
                
                $
                159
                
                
                $
                21
                
                
                $
                10,390December
      31, 2007:Obligations
      of states and political subdivisions
                
                $
                12,895
                
                
                $
                86
                
                
                $
                58
                
                
                $
                12,923Mortgage-backed
      securities
                
                
                1
                
                
                
                -
                
                
                
                -
                
                
                
                1$
                12,896
                
                
                $
                86
                
                
                $
                58
                
                
                $
                12,924





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 December 31, 2008, are as follows:





Continuous unrealized losses existing for:Less Than 12
                
                
                More Than 12
                
                
                Total Unrealized(Dollars in thousands)
                
                Fair Value
                
                
                Months
                
                
                Months
                
                
                LossesAvailable-for-sale
      securities:Mortgage-backed
      securities
                
                $
                865
                
                
                $
                3
                
                
                $
                5
                
                
                $
                8




53


The
available-for-sale investment portfolio has a fair value of approximately $79.2
million, of which approximately $865 thousand have unrealized losses from their
purchase price. All of these securities are mortgage-backed securities. The
securities representing the unrealized losses in the available-for-sale
portfolio all have modest duration risk, low credit risk, and minimal loss
(approximately 0.01%) when compared to amortized cost. The unrealized losses
that exist are the result of market changes in interest rates since the original
purchase. These factors, coupled with the Company’s intent and ability to hold
these investments for a period of time sufficient to allow for any anticipated
recovery in fair value, substantiates that the unrealized losses in the
available-for-sale portfolio are temporary.


Gross
unrealized losses and fair value by length of time that the individual
held-to-maturity securities have been in a continuous unrealized loss position
at December 31, 2008, are as follows:





Continuous unrealized losses existing for:Less Than 12
                
                
                More Than 12
                
                
                Total Unrealized(Dollars in thousands)
                
                Fair Value
                
                
                Months
                
                
                Months
                
                
                LossesHeld-to-maturity
      securities:Obligations
      of states and political subdivisions
                
                $
                1,071
                
                
                $
                15
                
                
                $
                6
                
                
                $
                21





The
held-to-maturity investment portfolio has a fair value of approximately $10.4
million, of which approximately $1.1 million have unrealized losses from their
purchase price. The securities representing the unrealized losses in the
held-to-maturity portfolio are all municipal securities with modest duration
risk, low credit risk, and minimal losses (approximately 0.20%) when compared to
amortized cost. The unrealized losses that exist are the result of market
changes in interest rates since the original purchase. These factors, coupled
with the Company’s intent and ability to hold these investments for a period of
time sufficient to allow for any anticipated recovery in fair value,
substantiates that the unrealized losses in the held-to-maturity portfolio are
temporary.





The
amortized cost and estimated fair values of investment securities by maturity
date at December 31, 2008, 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
                
                $
                8,818
                
                
                $
                8,934
                
                
                $
                4,357
                
                
                $
                4,385Due
      after one year through five years
                
                
                47,125
                
                
                
                48,621
                
                
                
                4,753
                
                
                
                4,873Due
      after five years through ten years
                
                
                4,990
                
                
                
                5,155
                
                
                
                1,142
                
                
                
                1,132Due
      after ten years
                
                
                12,091
                
                
                
                12,636
                
                
                
                -
                
                
                
                -73,024
                
                
                
                75,346
                
                
                
                10,252
                
                
                
                10,390Equity
      securities
                
                
                3,856
                
                
                
                3,858
                
                
                
                -
                
                
                
                -$
                76,880
                
                
                $
                79,204
                
                
                $
                10,252
                
                
                $
                10,390





The
maturity date for mortgage-backed securities is determined by its expected
maturity. The maturity date for the remaining debt securities is determined
using its contractual maturity date.





The
following table sets forth the amortized cost and estimated fair values of
securities which have been pledged as collateral for obligations to federal,
state and local government agencies, and other purposes as required or permitted
by law, or sold under agreements to repurchase. All pledged securities are in
the available-for-sale investment portfolio.





December 31, 2008
                    
                    
                    December 31, 2007Amortized
                    
                    
                    Estimated
                    
                    
                    Amortized
                    
                    
                    Estimated(Dollars in thousands)
                    
                    Cost
                    
                    
                    Fair Value
                    
                    
                    Cost
                    
                    
                    Fair ValuePledged
      available-for-sale securities
                    
                    $
                    69,124
                    
                    
                    $
                    71,322
                    
                    
                    $
                    88,274
                    
                    
                    $
                    88,805





There
were no obligations of states or political subdivisions whose carrying value, as
to any issuer, exceeded 10% of stockholders’ equity at December 31, 2008, or
2007.





Proceeds
from sales of investment securities were $2 thousand, $3.5 million, and $51
thousand for the years ended December 31, 2008, 2007, and 2006, respectively.
Gross gains from sales of investment securities were $0, $5 thousand, and $3
thousand for the years ended December 31, 2008, 2007, and 2006, respectively.
Gross losses were $15 thousand for the year ended December 31, 2008. There were
no gross losses for the years ended December 31, 2007 and 2006. The investment
securities losses in 2008 resulted from the sale of 10,000 shares of Freddie Mac
preferred stock. The Company also incurred a $371 thousand other than temporary
impairment loss on these securities during 2008.


54


NOTE
5. LOANS AND ALLOWANCE FOR CREDIT LOSSES





The
Company makes residential mortgage, consumer and commercial loans to customers
primarily in the Maryland counties of Talbot, Queen Anne’s, Kent, Caroline and
Dorchester and in Kent County, Delaware. The principal categories of the loan
portfolio at December 31 are summarized as follows:





(Dollars in thousands)
                
                2008
                
                
                2007Real
      estate loans:Construction
      and land development
                
                $
                179,847
                
                
                $
                155,527Secured
      by farmland
                
                
                24,797
                
                
                
                23,741Secured
      by residential properties
                
                
                289,510
                
                
                
                255,688Secured
      by non-farm, non-residential properties
                
                
                279,599
                
                
                
                225,478Loans
      to farmers (loans to finance agricultural production and other
      loans)
                
                
                2,724
                
                
                
                2,779Commercial
      and industrial loans
                
                
                80,107
                
                
                
                82,382Loans
      to individuals for household, family, and other personal
      expenditures
                
                
                22,606
                
                
                
                23,053Obligations
      of states and political subdivisions in the United States,
      tax-exempt
                
                
                7,419
                
                
                
                5,355All
      other loans
                
                
                1,919
                
                
                
                2,347888,528
                
                
                
                776,350Allowance
      for credit losses
                
                
                (9,320
                )
                
                
                (7,551
                )$
                879,208
                
                
                $
                768,799





Loans are
net of unearned income of $504 thousand at year-end 2008 and $673 thousand at
year-end 2007.





In the
normal course of banking business, loans are made to officers and directors and
their affiliated interests. These loans are made on substantially the same terms
and conditions as those prevailing at the time for comparable transactions with
outsiders and are not considered to involve more than the normal risk of
collectibility. As of December 31, 2008, and 2007, such loans outstanding, both
direct and indirect (including guarantees), to directors, their associates and
policy-making officers, totaled approximately $9.5 million and $11.0 million,
respectively. During 2008 and 2007, loan additions were approximately $913
thousand and $1.1 million, respectively, and loan repayments were approximately
$2.4 million and $2.3 million, respectively.





Activity
in the allowance for credit losses is summarized as follows:





(Dollars in thousands)
                
                2008
                
                
                2007
                
                
                2006Balance
      beginning of year:
                
                $
                7,551
                
                
                $
                6,300
                
                
                $
                5,236Loans
      charged off:Real
      estate – construction
                
                
                (536
                )
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                (316
                )
                
                
                (137
                )
                
                
                -Real
      estate – commercial
                
                
                (238
                )
                
                
                -
                
                
                
                (2
                )Commercial
                
                
                (447
                )
                
                
                (276
                )
                
                
                (539
                )Consumer
                
                
                (276
                )
                
                
                (301
                )
                
                
                (137
                )(1,813
                )
                
                
                (714
                )
                
                
                (678
                )Recoveries:Real
      estate – construction
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                19
                
                
                
                -
                
                
                
                -Real
      estate – commercial
                
                
                -
                
                
                
                -
                
                
                
                46Commercial
                
                
                136
                
                
                
                165
                
                
                
                123Consumer
                
                
                90
                
                
                
                76
                
                
                
                80245
                
                
                
                241
                
                
                
                249Net
      loans charged off
                
                
                (1,568
                )
                
                
                (473
                )
                
                
                (429
                )Provision
      for credit losses
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493Balance,
      end of year
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300


55





Information
with respect to impaired loans and the related valuation allowance as of
December 31 is as follows:





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006Impaired
      loans with a valuation allowance
                
                $
                2,550
                
                
                $
                3,413
                
                
                $
                7,658Impaired
      loans with no valuation allowance
                
                
                5,565
                
                
                
                127
                
                
                
                -Total
      impaired loans
                
                $
                8,115
                
                
                $
                3,540
                
                
                $
                7,658Allowance
      for credit losses applicable to impaired loans
                
                $
                341
                
                
                $
                819
                
                
                $
                883Allowance
      for credit losses applicable to other than impaired loans
                
                
                8,979
                
                
                
                6,732
                
                
                
                5,417Total
      allowance for credit losses
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300Average
      recorded investment in impaired loans
                
                $
                5,477
                
                
                $
                3,958
                
                
                $
                1,857





Gross
interest income of $476 thousand and $404 thousand would have been recorded in
2008 and 2007, respectively, if nonaccrual loans had been current and performing
in accordance with their original terms.  Interest actually recorded
on such loans was $193 thousand and $142 thousand for 2008 and 2007,
respectively.





NOTE
6. PREMISES AND EQUIPMENT





A summary
of premises and equipment at December 31 is as follows:





(Dollars
      in thousands)
                    
                    2008
                    
                    
                    2007Land
                    
                    $
                    4,337
                    
                    
                    $
                    4,395Buildings
      and land improvements
                    
                    
                    11,202
                    
                    
                    
                    12,322Furniture
      and equipment
                    
                    
                    7,195
                    
                    
                    
                    7,21222,734
                    
                    
                    
                    23,929Accumulated
      depreciation
                    
                    
                    (8,879
                    )
                    
                    
                    (8,312
                    )$
                    13,855
                    
                    
                    $
                    15,617





Depreciation
expense totaled $1.1 million for each of the three years in the period ended
December 31, 2008.  The decrease in premises and equipment was
primarily from the sale of a bank branch.





On April
17, 2008, the Company entered into a sale-leaseback agreement with Milford Plaza
Enterprises, LLC (“Purchaser”).  Under the agreement, the Company
terminated its ground lease with the Purchaser and conveyed to the Purchaser
title to the Company’s improvements to the property, generally consisting of the
Company’s branch banking facility in Milford, Delaware.  The Company
received $1.3 million for this sale and an immaterial loss was recorded on the
transaction.  The Company has leased back the facility for an initial
period of 12 years.  Monthly rental expense under the agreement is
approximately $11 thousand.





The
Company leases facilities under operating leases.  Rental expense for
the years ended December 31, 2008, 2007 and 2006 was $607 thousand, $380
thousand and $304 thousand, respectively.  The increase in 2008 was
mainly due to the rent on the property in the sales-leaseback transaction
discussed above and rent incurred by the insurance entities acquired in the
fourth quarter of 2007.  Future minimum annual rental payments are
approximately as follows (dollars in thousands):





2009
                          
                          $
                          7212010
                          
                          
                          5422011
                          
                          
                          4782012
                          
                          
                          3862013
                          
                          
                          299Thereafter
                          
                          
                          2,098Total
      minimum lease payments
                          
                          $
                          4,524




56




NOTE
7.  INVESTMENT IN UNCONSOLIDATED SUBSIDIARY





During
2008, the Company sold its investment in 20.0% of the outstanding common stock
of the Delmarva Data Bank Processing Center, Inc. (“Delmarva
Data”).  The Company recorded a $337 thousand loss on the
sale.





December
      31,(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Balance,
      beginning of year
                  
                  $
                  937
                  
                  
                  $
                  937
                  
                  
                  $
                  909Equity
      in net income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  28Sale
      of investment
                  
                  
                  (937
                  )
                  
                  
                  -
                  
                  
                  
                  -Balance,
      end of year
                  
                  $
                  -
                  
                  
                  $
                  937
                  
                  
                  $
                  937





Data
processing and other expenses paid to Delmarva Data totaled approximately $1.9
million, $2.0 million and $1.9 million for the years ended December 31, 2008,
2007 and 2006, respectively.





NOTE
8.  GOODWILL AND OTHER INTANGIBLE ASSETS





Goodwill
totaled $16.0 million at both December 31, 2008 and December 31,
2007.  The Community banking segment had $4.1 million in goodwill and
the Insurance segment had $11.9 million in goodwill at December 31, 2008,
unchanged from December 31, 2007.  The Insurance segment increased its
goodwill by $4.0 million during 2007 due to the acquisition of two insurance
companies, JM and TSGIA.





The
significant components of goodwill and acquired intangible assets are as
follows:





December
      31, 2008
                                                                    
                                                                    
                                                                    December
      31, 2007Weighted
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    WeightedGross
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    Net
                                                                    
                                                                    
                                                                    Average
                                                                    
                                                                    
                                                                    Gross
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    Net
                                                                    
                                                                    
                                                                    AverageCarrying
                                                                    
                                                                    
                                                                    Accumulated
                                                                    
                                                                    
                                                                    Carrying
                                                                    
                                                                    
                                                                    Remaining
                                                                    
                                                                    
                                                                    Carrying
                                                                    
                                                                    
                                                                    Accumulated
                                                                    
                                                                    
                                                                    Carrying
                                                                    
                                                                    
                                                                    Remaining(Dollars
      in thousands)
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    Amortization
                                                                    
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    Life
                                                                    
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    Amortization
                                                                    
                                                                    
                                                                    Amount
                                                                    
                                                                    
                                                                    LifeGoodwill
                                                                    
                                                                    $
                                                                    16,621
                                                                    
                                                                    
                                                                    $
                                                                    667
                                                                    
                                                                    
                                                                    $
                                                                    15,954
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    16,621
                                                                    
                                                                    
                                                                    $
                                                                    667
                                                                    
                                                                    
                                                                    $
                                                                    15,954
                                                                    
                                                                    
                                                                    
                                                                    -Other
      intangible assetsAmortized
      other intangible assetsEmployment
      agreements
                                                                    
                                                                    $
                                                                    1,730
                                                                    
                                                                    
                                                                    $
                                                                    312
                                                                    
                                                                    
                                                                    $
                                                                    1,418
                                                                    
                                                                    
                                                                    
                                                                    5.7
                                                                    
                                                                    
                                                                    $
                                                                    1,730
                                                                    
                                                                    
                                                                    $
                                                                    62
                                                                    
                                                                    
                                                                    $
                                                                    1,668
                                                                    
                                                                    
                                                                    
                                                                    6.7Insurance
      expirations
                                                                    
                                                                    
                                                                    1,270
                                                                    
                                                                    
                                                                    
                                                                    555
                                                                    
                                                                    
                                                                    
                                                                    715
                                                                    
                                                                    
                                                                    
                                                                    8.5
                                                                    
                                                                    
                                                                    
                                                                    1,270
                                                                    
                                                                    
                                                                    
                                                                    471
                                                                    
                                                                    
                                                                    
                                                                    799
                                                                    
                                                                    
                                                                    
                                                                    9.5Core
      deposit intangible
                                                                    
                                                                    
                                                                    968
                                                                    
                                                                    
                                                                    
                                                                    575
                                                                    
                                                                    
                                                                    
                                                                    393
                                                                    
                                                                    
                                                                    
                                                                    3.3
                                                                    
                                                                    
                                                                    
                                                                    968
                                                                    
                                                                    
                                                                    
                                                                    454
                                                                    
                                                                    
                                                                    
                                                                    514
                                                                    
                                                                    
                                                                    
                                                                    4.3Customer
      relationships
                                                                    
                                                                    
                                                                    960
                                                                    
                                                                    
                                                                    
                                                                    75
                                                                    
                                                                    
                                                                    
                                                                    885
                                                                    
                                                                    
                                                                    
                                                                    14.7
                                                                    
                                                                    
                                                                    
                                                                    960
                                                                    
                                                                    
                                                                    
                                                                    15
                                                                    
                                                                    
                                                                    
                                                                    945
                                                                    
                                                                    
                                                                    
                                                                    15.7Unidentifiable
      intangibleresulting
      from branchacquisitions
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    104
                                                                    
                                                                    
                                                                    
                                                                    104
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -Other
      identifiableintangibles
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    621
                                                                    
                                                                    
                                                                    
                                                                    621
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -4,928
                                                                    
                                                                    
                                                                    
                                                                    1,517
                                                                    
                                                                    
                                                                    
                                                                    3,411
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    5,653
                                                                    
                                                                    
                                                                    
                                                                    1,727
                                                                    
                                                                    
                                                                    
                                                                    3,926Unamortized
      other intangible assetsCarrier
      relationships
                                                                    
                                                                    
                                                                    1,300
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,300
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,300
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,300
                                                                    
                                                                    
                                                                    
                                                                    -Trade
      name
                                                                    
                                                                    
                                                                    1,210
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,210
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,210
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    1,210
                                                                    
                                                                    
                                                                    
                                                                    -2,510
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    2,510
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    2,510
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    2,510Total
      other intangible assets
                                                                    
                                                                    $
                                                                    7,438
                                                                    
                                                                    
                                                                    $
                                                                    1,517
                                                                    
                                                                    
                                                                    $
                                                                    5,921
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    
                                                                    $
                                                                    8,163
                                                                    
                                                                    
                                                                    $
                                                                    1,727
                                                                    
                                                                    
                                                                    $
                                                                    6,436





The
current period and estimated future amortization expense for amortized other
intangible assets is as follows:





Amortization(Dollars
      in thousands)
                  
                  
                  ExpenseYear
      ended December 31, 2008
                  
                  
                  $
                  515Estimate
      for years ended December 31,
                  2009
                  
                  
                  5152010
                  
                  
                  5152011
                  
                  
                  5152012
                  
                  
                  4022013
                  
                  
                  306





57





Under the
provisions of SFAS No. 142, goodwill was subjected to an annual assessment for
impairment during 2008.  As a result of annual assessment reviews, the
Company determined that there was no impairment of goodwill.  The
Company will continue to review goodwill on an annual basis for impairment and
as events occur or circumstances change.





NOTE
9.  DEPOSITS





The
approximate amount of certificates of deposit of $100,000 or more at December
31, 2008 and 2007 was $235.2 million and $161.6 million,
respectively.





The
approximate maturities of time deposits at December 31 are as
follows:





(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007Due
      in one year or less
                  
                  $
                  328,367
                  
                  
                  $
                  277,952Due
      in one to three years
                  
                  
                  96,518
                  
                  
                  
                  71,350Due
      in three to five years
                  
                  
                  41,574
                  
                  
                  
                  26,993$
                  466,459
                  
                  
                  $
                  376,295





NOTE
10.  SHORT-TERM BORROWINGS





The
following table summarizes certain information for short-term borrowings for the
years ended December 31:





2008
                
                
                2007(Dollars
      in thousands)
                
                Amount
                
                
                Rate
                
                
                Amount
                
                
                RateAverage
      for the Year:Retail
      repurchase agreements
                
                $
                24,229
                
                
                
                1.48
                %
                
                $
                25,785
                
                
                
                3.60
                %Federal
      Home Loan Bank advances
                
                
                22,219
                
                
                
                3.39
                
                
                
                7,000
                
                
                
                4.50Other
      short-term borrowings
                
                
                1,317
                
                
                
                2.69
                
                
                
                353
                
                
                
                5.51Total
                
                $
                47,765
                
                
                
                2.40
                
                
                $
                33,138
                
                
                
                3.81At
      Year End:Retail
      repurchase agreements
                
                $
                24,469
                
                
                
                0.45
                %
                
                $
                27,494
                
                
                
                3.27
                %Federal
      Home Loan Bank advances
                
                
                24,050
                
                
                
                0.51
                
                
                
                20,000
                
                
                
                4.65Other
      short-term borrowings
                
                
                4,450
                
                
                
                0.45
                
                
                
                200
                
                
                
                4.92Total
                
                $
                52,969
                
                
                
                0.49
                
                
                $
                47,694
                
                
                
                3.86Maximum
      Month-End BalanceRetail
      repurchase agreements
                
                $
                33,094
                
                
                
                
                
                
                $
                34,536Federal
      Home Loan Bank advances
                
                
                31,500
                
                
                
                
                
                
                
                20,000Other
      short-term borrowings
                
                
                8,500
                
                
                
                
                
                
                
                2,500





Securities
sold under agreements to repurchase are securities sold to customers, at the
customers’ request, under a “roll-over” contract that matures in one business
day.  The underlying securities sold are U.S. Government agency
securities, which are segregated in the Company’s custodial accounts from other
investment securities.





The
Company may periodically borrow from a correspondent federal funds line of
credit arrangement, under a secured reverse repurchase agreement, or from the
Federal Home Loan Bank to meet short-term liquidity needs.




58




NOTE
11.  LONG-TERM DEBT





As of
December 31, the Company had the following long-term debt:





(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007Federal
      Home Loan Bank (FHLB) 5.69% Advance due in 2008
                  
                  $
                  -
                  
                  
                  $
                  7,000FHLB
      4.17%Advance due in 2009
                  
                  
                  3,000
                  
                  
                  
                  3,000FHLB
      3.09% Advance due in 2010
                  
                  
                  3,000
                  
                  
                  
                  -Acquisition-related
      debt, 4.08% interest, amortizing over five years
                  
                  
                  1,947
                  
                  
                  
                  2,485$
                  7,947
                  
                  
                  $
                  12,485





The
Company has pledged its real estate mortgage loan portfolio under a blanket
floating lien as collateral for the FHLB advances.





The
acquisition-related debt was incurred as part of the purchase price of TSGIA and
is payable to the seller thereof, who remains the President of that
subsidiary.





NOTE
12.  BENEFIT PLANS





401(k)
and Profit Sharing Plan





The
Company has a 401(k) and profit sharing plan covering substantially all
full-time employees.  The plan calls for matching contributions by the
Company, and the Company makes discretionary contributions based on profits.
Company contributions to this plan included in expense totaled $1.4 million,
$1.1 million, and $1.0 million for 2008, 2007, and 2006,
respectively.





TSGIA had
a separate 401(k) plan covering substantially all of its full-time employees in
2007.  The Company’s total expense under this plan was $11 thousand
for 2007.





NOTE
13.  STOCK-BASED COMPENSATION





At
December 31, 2008, the Company had three equity compensation
plans:  (i) the Shore Bancshares, Inc. 2006 Stock and Incentive
Compensation Plan (“2006 Equity Plan”); (ii) the Shore Bancshares, Inc. Employee
Stock Purchase Plan (“ESPP”); and (iii) the Shore Bancshares, Inc. 1998 Stock
Option Plan (the “1998 Option Plan”).  The ability of the Company to
grant options under the 1998 Option Plan terminated by its terms on March 3,
2008, but stock options granted under the 1998 Option Plan were outstanding at
December 31, 2008.





Under the
2006 Equity Plan, stock-based awards may be granted periodically to directors,
executive officers, and key employees at the discretion of the Compensation
Committee of the Company’s Board.  Stock-based awards granted to date
under the 2006 Equity Plan are generally time-based, vesting on each anniversary
of the grant date over a three to five year period of time and, in the case of
stock options, expiring 10 years from the grant date.  The 2006 Equity
Plan originally reserved 600,000 shares of common stock for grant, and 581,972
shares remained available for grant at December 31, 2008.





Under the
ESPP, employees are allowed to purchase shares of the Company’s common stock at
85% of the fair market value on the date of grant.  ESPP grants are
100% vested at date of grant and have a 27-month term.  As amended,
the plan reserved 67,500 shares of common stock for issuance under the ESPP and
29,204 shares remained available for grant at December 31, 2008.





The
following table summarizes restricted stock award activity for the Company under
the 2006 Equity Plan for the two years ended December 31, 2008:





Year
      Ended December 31, 2008
                
                
                Year
      Ended December 31, 2007Number
                
                
                Weighted Average Grant
                
                
                Number
                
                
                Weighted
      Average
                  Grantof
      Shares
                
                
                Date
      Fair Value
                
                
                of
      Shares
                
                
                Date
      Fair ValueNonvested
      at beginning of year
                
                
                3,845
                
                
                $
                25.31
                
                
                
                -
                
                
                $
                -Granted
                
                
                13,783
                
                
                
                21.93
                
                
                
                4,245
                
                
                
                25.28Vested
                
                
                (769
                )
                
                
                25.31
                
                
                
                (400
                )
                
                
                25.00Cancelled
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Nonvested
      at end of year
                
                
                16,859
                
                
                
                22.55
                
                
                
                3,845
                
                
                
                25.31





59





The total
fair value of restricted stock awards vested was $16 thousand in 2008 and $10
thousand in 2007.





The
following is a summary of stock option activity for the 1998 Option Plan and the
ESPP for 2008 and 2007:





Year
      Ended December 31, 2008
                    
                    
                    Year
      Ended December 31, 2007Number
                    
                    
                    Weighted Average
                    
                    
                    Number
                    
                    
                    Weighted Averageof
      Shares
                    
                    
                    Exercise Price
                    
                    
                    of
      Shares
                    
                    
                    Exercise
      PriceOutstanding
      at beginning of year
                    
                    
                    33,797
                    
                    
                    $
                    15.67
                    
                    
                    
                    37,515
                    
                    
                    $
                    15.82Granted
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Exercised
                    
                    
                    (13,181
                    )
                    
                    
                    15.46
                    
                    
                    
                    (3,444
                    )
                    
                    
                    17.07Expired/Cancelled
                    
                    
                    (2,066
                    )
                    
                    
                    18.47
                    
                    
                    
                    (274
                    )
                    
                    
                    18.47Outstanding
      at end of year
                    
                    
                    18,550
                    
                    
                    
                    15.52
                    
                    
                    
                    33,797
                    
                    
                    
                    15.67




The
following summarizes information about stock options outstanding at December 31,
2008:





Options
      Outstanding and ExercisableOptions
      Outstanding
                                    
                                    
                                    
                                    
                                    
                                    Weighted
      AverageRemainingNumber
                                    
                                    
                                    Exercise
      Price
                                    
                                    
                                    Number
                                    
                                    
                                    Contract
      Life (in years)5,000
                                    
                                    
                                    $
                                    21.33
                                    
                                    
                                    
                                    5,000
                                    
                                    
                                    
                                    0.053,255
                                    
                                    
                                    
                                    14.00
                                    
                                    
                                    
                                    3,255
                                    
                                    
                                    
                                    1.0510,295
                                    
                                    
                                    
                                    13.17
                                    
                                    
                                    
                                    10,295
                                    
                                    
                                    
                                    3.2818,550
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    18,550





The fair
value of stock options issued is measured on the date of grant and recognized
over the vesting period.  The Company estimates the fair value of
stock options using the Black-Scholes option-pricing model with the following
weighted average assumptions for options granted pursuant to the ESPP during
2006; there were no options granted in 2008 and 2007:





2006Dividend
      yield
                    
                    
                    2.40
                    %Expected
      volatility
                    
                    
                    23.57
                    %Risk
      free interest rate
                    
                    
                    4.53
                    %Expected
      lives (in years)
                    
                    
                    2.25





The total
intrinsic value of outstanding stock options and outstanding exercisable stock
options was $157 thousand at December 31, 2008.  The total intrinsic
value of stock options exercised during the years ended December 31, 2008, 2007,
and 2006 was $80 thousand, $32 thousand and $814 thousand,
respectively.  The total fair value of stock options vested was $0 for
2008 and $30 thousand for both 2007 and 2006.





Stock-based
compensation expense totaled $91 thousand, $63 thousand and $48 thousand in
2008, 2007, and 2006, respectively.  Stock-based compensation expense
is recognized ratably over the requisite service period for all
awards.  The total income tax benefit recognized in the accompanying
consolidated statements of income related to stock-based compensation was $4
thousand, $3 thousand, and $279 thousand in 2008, 2007, and 2006,
respectively.  Unrecognized stock-based compensation expense related
to stock-based awards totaled $300 thousand at December 31, 2008.  At
such date, the weighted-average period over which this unrecognized expense was
expected to be recognized was 3.5 years.





NOTE
14.  DEFERRED COMPENSATION





During
2006, the Company adopted the Shore Bancshares, Inc. Executive Deferred
Compensation Plan (the “Plan”) for members of management and highly compensated
employees of the Company and its subsidiaries.  The Plan permits a
participant to elect, each year, to defer receipt of up to 100% of his or her
salary and bonus to be earned in the following year. The Plan also permits the
participant to defer the receipt of performance-based compensation not later
than six months before the end of the period for which it is to be earned. The
deferred amounts will be credited to an account maintained on behalf of the
participant and will be invested at the discretion of each participant in
certain deemed investment options selected from time to time by the Compensation
Committee of the Company’s Board.   The Company may also make
matching, mandatory and discretionary contributions for certain
participants.  A participant is fully vested at all times in the
amounts that he or she elects to defer.  Any contributions by the
Company will vest over a five-year period.  The Company made
contributions to the Plan totaling $84 thousand, $167 thousand, and $0 for 2008,
2007, and 2006, respectively.  Elective deferrals were made by one
plan participant during 2007 and 2006.





60





The
Company has a supplemental deferred compensation plan to provide retirement
benefits to its President and Chief Executive Officer.  The
participant is 100% vested in amounts credited to his account.  No
contributions were made to this plan in 2008 or 2007.  Contributions
to the plan were $20 thousand in 2006.





Centreville
National Bank has agreements with certain of its directors under which they have
deferred part of their fees and compensation.  The amounts deferred
are invested in insurance policies, owned by the Company, on the lives of the
respective individuals.  Amounts available under the policies are to
be paid to the individuals as retirement benefits over future
years.   The cash surrender value and the accrued benefit
obligation included in other assets and other liabilities at December 31 are as
follows:





(Dollars
      in thousands)
                      
                      2008
                      
                      
                      2007Cash
      surrender value
                      
                      $
                      2,276
                      
                      
                      $
                      2,204Accrued
      benefit obligation
                      
                      
                      1,252
                      
                      
                      
                      902





NOTE
15.  INCOME TAXES





Income
taxes included in the balance sheets as of December 31 are as
follows:





(Dollars
      in thousands)
                      
                      2008
                      
                      
                      2007Federal
      income taxes currently receivable
                      
                      $
                      1,180
                      
                      
                      $
                      66State
      income taxes currently receivable
                      
                      
                      143
                      
                      
                      
                      66Deferred
      income tax benefit
                      
                      
                      1,579
                      
                      
                      
                      1,847





Components
of income tax expense for each of the three years ended December 31 are as
follows:





(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006Currently
      payable:Federal
                
                $
                6,120
                
                
                $
                7,162
                
                
                $
                7,367State
                
                
                1,470
                
                
                
                1,217
                
                
                
                1,2117,590
                
                
                
                8,379
                
                
                
                8,578Deferred
      income tax benefit:Federal
                
                
                (334
                )
                
                
                (255
                )
                
                
                (351
                )State
                
                
                (164
                )
                
                
                (122
                )
                
                
                (73
                )(498
                )
                
                
                (377
                )
                
                
                (424
                )$
                7,092
                
                
                $
                8,002
                
                
                $
                8,154





A
reconciliation of tax computed at the statutory federal tax rate of 35% to the
actual tax expense for the three years ended December 31 follows:





(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Tax
      at federal statutory rate
                  
                  
                  35.0
                  %
                  
                  
                  35.0
                  %
                  
                  
                  35.0
                  %Tax
      effect of:Tax-exempt
      income
                  
                  
                  (1.2
                  )
                  
                  
                  (1.0
                  )
                  
                  
                  (0.9
                  )Non-deductible
      expenses
                  
                  
                  0.1
                  
                  
                  
                  0.2
                  
                  
                  
                  0.1State
      income taxes, net of federal benefit
                  
                  
                  4.6
                  
                  
                  
                  3.4
                  
                  
                  
                  3.5Other
                  
                  
                  (0.3
                  )
                  
                  
                  (0.3
                  )
                  
                  
                  (0.1
                  )Income
      tax expense
                  
                  
                  38.2
                  %
                  
                  
                  37.3
                  %
                  
                  
                  37.6
                  %





61





Significant
components of the Company’s deferred tax assets and liabilities as of December
31 are as follows:





(Dollars
      in thousands)
                  
                  2008
                  
                  
                  2007Deferred
      tax assets:Allowance
      for credit losses
                  
                  $
                  3,688
                  
                  
                  $
                  2,997Provision
      for off-balance sheet commitments
                  
                  
                  171
                  
                  
                  
                  157Net
      operating loss carry forward
                  
                  
                  115
                  
                  
                  
                  41Deferred
      gain on sale leaseback
                  
                  
                  52
                  
                  
                  
                  55Recognized
      loss on impaired securities
                  
                  
                  -
                  
                  
                  
                  45Deferred
      income
                  
                  
                  271
                  
                  
                  
                  99Accrued
      employee benefits
                  
                  
                  710
                  
                  
                  
                  460Other
                  
                  
                  8
                  
                  
                  
                  18Total
      deferred tax assets
                  
                  
                  5,015
                  
                  
                  
                  3,872Deferred
      tax liabilities:Depreciation
                  
                  
                  389
                  
                  
                  
                  389Purchase
      accounting adjustments
                  
                  
                  1,161
                  
                  
                  
                  959Federal
      Home Loan Bank stock dividend
                  
                  
                  29
                  
                  
                  
                  29Undistributed
      income of unconsolidated subsidiary
                  
                  
                  -
                  
                  
                  
                  76Deferred
      capital gain on branch sale
                  
                  
                  493
                  
                  
                  
                  -Deferred
      loan costs
                  
                  
                  377
                  
                  
                  
                  332Unrealized
      gains on available-for-sale securities
                  
                  
                  932
                  
                  
                  
                  166Other
                  
                  
                  55
                  
                  
                  
                  74Total
      deferred tax liabilities
                  
                  
                  3,436
                  
                  
                  
                  2,025Net
      deferred tax assets
                  
                  $
                  1,579
                  
                  
                  $
                  1,847





NOTE
16.   EARNINGS PER COMMON SHARE





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





(In
      thousands, except per share data)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Net
      Income
                  
                  $
                  11,470
                  
                  
                  $
                  13,450
                  
                  
                  $
                  13,554Weighted
      average shares outstanding – basic
                  
                  
                  8,384
                  
                  
                  
                  8,380
                  
                  
                  
                  8,366Dilutive
      effect of stock-based awards
                  
                  
                  7
                  
                  
                  
                  14
                  
                  
                  
                  27Weighted
      average shares outstanding – diluted
                  
                  
                  8,391
                  
                  
                  
                  8,394
                  
                  
                  
                  8,393Earnings
      per common share – Basic
                  
                  $
                  1.37
                  
                  
                  $
                  1.61
                  
                  
                  $
                  1.62Earnings
      per common share – Diluted
                  
                  $
                  1.37
                  
                  
                  $
                  1.60
                  
                  
                  $
                  1.61





There
were 3,284 antidilutive stock-based awards excluded from the earnings per share
calculation for 2008.  For the years ended December 31, 2007 and 2006,
there were no antidilutive stock-based awards to exclude from the earnings per
share calculation.





NOTE
17.    REGULATORY CAPITAL REQUIREMENTS





The
Company and each of the Banks are subject to various regulatory capital
requirements administered by the federal banking agencies.  Failure to
meet minimum capital requirements can initiate certain mandatory - and possibly
additional discretionary - actions by regulators that, if undertaken, could have
a direct material effect on the Company’s financial statements.  Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Banks must meet specific capital guidelines that involve
quantitative measures of the Banks’ assets, liabilities, and certain off-balance
sheet items as calculated under regulatory accounting practices.  The
Banks’ capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.





62





Quantitative
measures established by regulation to ensure capital adequacy require the Banks
to maintain amounts and ratios (set forth in the table below) of Tier 1 and
total capital (as defined in the regulations) to risk-weighted assets (as
defined), and of Tier 1 capital (as defined) to average assets (leverage
ratio).  Management believes, as of December 31, 2008, that the
Company and the Banks met all capital adequacy requirements to which they are
subject.





As of
December 31, 2008 and 2007, the most recent notification from the Federal
Deposit Insurance Corporation and the Office of the Comptroller of the Currency
categorized the Banks as well capitalized under the regulatory framework for
prompt corrective action.  To be categorized as well capitalized, the
Banks must maintain minimum Tier 1 risk-based and total risk-based capital
ratios, and Tier 1 leverage ratios.  Management knows of no trends or
demands, commitments, events or uncertainties that are likely to have a material
adverse impact on the ability of the Company or any of the Banks to remain in
the well capitalized category.





The
minimum ratios for capital adequacy purposes are 4.00%, 8.00% and 4.00% for the
Tier 1 risk-based capital, total risk-based capital and leverage ratios,
respectively.  To be categorized as well capitalized, a bank must
maintain minimum ratios of 6.00%, 10.00% and 5.00% for its Tier 1 risk-based
capital, total risk-based capital and leverage ratios,
respectively.  Shore Bancshares, Inc., as a financial holding company,
is subject to the well-capitalized requirement.





Capital
amounts and ratios for Shore Bancshares, Inc., Talbot Bank, Centreville National
Bank and Felton Bank as of December 31, 2008 and 2007 are presented
below:





December 31, 2008
                (Dollars in thousands)
              
              Tier
      1
                Capital
              
              
              Total
                Risk-
                Based
                Capital
              
              
              Net
                Risk-
                Weighted
                Assets
              
              
              Adjusted
                Average
                Total
      Assets
              
              
              Tier
      1
                Risk-Based
                Capital
                Ratio
              
              
              Total
                Risk-Based
                Capital
                Ratio
              
              
              Tier
      1
                Leverage
                RatioCompany
              
              $
              104,117
              
              
              $
              113,872
              
              
              $
              894,024
              
              
              $
              1,013,815
              
              
              
              11.65
              %
              
              
              12.74
              %
              
              
              10.27
              %Talbot
      Bank
              
              
              64,302
              
              
              
              70,101
              
              
              
              556,417
              
              
              
              605,533
              
              
              
              11.56
              
              
              
              12.60
              
              
              
              10.62Centreville National Bank
              
              
              30,817
              
              
              
              33,327
              
              
              
              257,864
              
              
              
              314,232
              
              
              
              11.95
              
              
              
              12.92
              
              
              
              9.81Felton
      Bank
              
              
              7,182
              
              
              
              8,161
              
              
              
              79,085
              
              
              
              89,802
              
              
              
              9.08
              
              
              
              10.32
              
              
              
              8.00





December 31, 2007
                  (Dollars in thousands)
                
                Tier
      1
                  Capital
                
                
                Total
                  Risk-
                  Based
                  Capital
                
                
                Net
                  Risk-
                  Weighted
                  Assets
                
                
                Adjusted
                  Average
                  Total
      Assets
                
                
                Tier
      1
                  Risk-Based
                  Capital
                  Ratio
                
                
                Total
                  Risk-Based
                  Capital
                  Ratio
                
                
                Tier
      1
                  Leverage
                  RatioCompany
                
                $
                97,744
                
                
                $
                105,694
                
                
                $
                804,240
                
                
                $
                930,619
                
                
                
                12.15
                %
                
                
                13.14
                %
                
                
                10.50
                %Talbot
      Bank
                
                
                59,298
                
                
                
                64,209
                
                
                
                473,288
                
                
                
                532,486
                
                
                
                12.53
                
                
                
                13.57
                
                
                
                11.14Centreville National Bank
                
                
                29,575
                
                
                
                31,604
                
                
                
                249,569
                
                
                
                308,789
                
                
                
                11.85
                
                
                
                12.66
                
                
                
                9.58Felton
      Bank
                
                
                7,024
                
                
                
                7,988
                
                
                
                77,107
                
                
                
                90,647
                
                
                
                9.11
                
                
                
                10.36
                
                
                
                7.75





Federal
and state laws and regulations applicable to banks and their holding companies
impose certain restrictions on dividend payments by the Banks, as well as
restricting extensions of credit and transfers of assets between the Banks and
the Company.  The Banks paid dividends of $5.0 million to the Company
during 2008.  At December 31, 2008, the Banks could have paid
dividends to the Company of approximately $10.5 million without the prior
consent and approval of the regulatory agencies.  The Company had no
outstanding receivables from subsidiaries at December 31, 2008 or
2007.





NOTE
18.  LINES OF CREDIT





The Banks
had $57.5 million in unsecured federal funds lines of credit and a reverse
repurchase agreement available on a short-term basis from correspondent banks at
December 31, 2008.  The comparable amount was $20.5 million at
December 31, 2007.  In addition, the Banks had credit availability of
approximately $62.1 million and $86.9 million from the Federal Home Loan Bank at
December 31, 2008 and 2007, respectively. The Banks have pledged as collateral,
under a blanket lien, all qualifying residential loans under borrowing
agreements with the Federal Home Loan Bank.  At December 31, 2008 and
2007, the Federal Home Loan Bank had issued letters of credit in the amounts of
$65.0 million and $35.0 million, respectively, on behalf of the Banks to local government entities as collateral for their
deposits.  The Banks had short-term borrowings from the Federal Home
Loan Bank at December 31, 2008 and 2007 of $24.1 million and $20.0 million,
respectively.




63




NOTE
19.    DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL
INSTRUMENTS





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





Cash and Cash
Equivalents


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





Investment
Securities


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





Loan
Receivables


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





Financial
Liabilities


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





Commitments to Extend Credit
and Standby Letters of Credit


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





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





2008
                  
                  
                  2007Estimated
                  
                  
                  
                  
                  
                  EstimatedCarrying
                  
                  
                  Fair
                  
                  
                  Carrying
                  
                  
                  Fair(Dollars
      in thousands)
                  
                  Amount
                  
                  
                  Value
                  
                  
                  Amount
                  
                  
                  ValueFinancial
      assets:Cash
      and cash equivalents
                  
                  $
                  27,294
                  
                  
                  $
                  27,294
                  
                  
                  $
                  26,880
                  
                  
                  $
                  26,797Investment
      securities
                  
                  
                  89,456
                  
                  
                  
                  89,594
                  
                  
                  
                  110,033
                  
                  
                  
                  110,060Loans
                  
                  
                  888,528
                  
                  
                  
                  914,695
                  
                  
                  
                  776,350
                  
                  
                  
                  789,247Less:  allowance
      for loan losses
                  
                  
                  (9,320
                  )
                  
                  -
                  
                  
                  
                  (7,551
                  )
                  
                  
                  -$
                  995,958
                  
                  
                  $
                  1,031,583
                  
                  
                  $
                  905,712
                  
                  
                  $
                  926,104Financial
      liabilities:Deposits
                  
                  $
                  845,371
                  
                  
                  $
                  861,951
                  
                  
                  $
                  765,895
                  
                  
                  $
                  771,697Short-term
      borrowings
                  
                  
                  52,969
                  
                  
                  
                  52,969
                  
                  
                  
                  47,694
                  
                  
                  
                  47,703Long-term
      debt
                  
                  
                  7,947
                  
                  
                  
                  8,060
                  
                  
                  
                  12,485
                  
                  
                  
                  12,657$
                  906,287
                  
                  
                  $
                  922,980
                  
                  
                  $
                  826,074
                  
                  
                  $
                  832,057





64





2008
                    
                    
                    2007Estimated
                    
                    
                    
                    
                    
                    EstimatedCarrying
                    
                    
                    Fair
                    
                    
                    Carrying
                    
                    
                    Fair(Dollars
      in thousands)
                    
                    Amount
                    
                    
                    Value
                    
                    
                    Amount
                    
                    
                    ValueUnrecognized
      financial instruments:Commitments
      to extend credit
                    
                    $
                    211,423
                    
                    
                    $
                    -
                    
                    
                    $
                    246,295
                    
                    
                    $
                    -Standby
      letters of credit
                    
                    
                    12,508
                    
                    
                    
                    -
                    
                    
                    
                    18,276
                    
                    
                    
                    -$
                    223,931
                    
                    
                    $
                    -
                    
                    
                    $
                    264,571
                    
                    
                    $
                    -





NOTE
20.FAIR VALUE MEASUREMENTS




Effective
January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements”
which provides a framework for measuring and disclosing fair value under GAAP.
SFAS 157 requires disclosures about the fair value of assets and liabilities
recognized in the balance sheet in periods subsequent to initial recognition,
whether the measurements are made on a recurring basis or on a nonrecurring
basis.




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




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




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




65




Loans





The
Company does not record loans at fair value on a recurring basis, however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established. Loans for which it is probable that payment of interest and
principle will not be made in accordance with the contractual terms of the loan
are considered impaired. Once a loan is identified as individually impaired,
management measures impairment in accordance with SFAS 114, “Accounting by
Creditors for Impairment of a Loan.” The fair 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. 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. At December 31, 2008, substantially all of
the impaired loans were evaluated based upon the fair value of the collateral.
In accordance with SFAS 157, impaired loans that have an allowance established
based on the fair value of collateral require classification in the fair value
hierarchy. When the fair value of the collateral is based on an observable
market price or a current appraised value, the Company records the loan as
nonrecurring Level 2. When an appraised value is not available or management
determines the fair value of the collateral is further impaired below the
appraised value and there is no observable market price, the Company records the
loan as nonrecurring Level 3.





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 December 31, 2008.





SignificantOther
                                    
                                    
                                    SignficantQuoted
                                    
                                    
                                    Observable
                                    
                                    
                                    UnobservablePrices
                                    
                                    
                                    Inputs
                                    
                                    
                                    Inputs(Dollars
      in thousands)
                                    
                                    Fair
      Value
                                    
                                    
                                    (Level
      1)
                                    
                                    
                                    (Level
      2)
                                    
                                    
                                    (Level
      3)Securities
      available for sale
                                    
                                    $
                                    79,204
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    79,204
                                    
                                    
                                    $
                                    -





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 December 31, 2008.





SignificantOther
                    
                    
                    SignficantQuoted
                    
                    
                    Observable
                    
                    
                    UnobservablePrices
                    
                    
                    Inputs
                    
                    
                    Inputs(Dollars
      in thousands)
                    
                    Fair
      Value
                    
                    
                    (Level
      1)
                    
                    
                    (Level
      2)
                    
                    
                    (Level
      3)Impaired
      loans
                    
                    $
                    7,774
                    
                    
                    $
                    -
                    
                    
                    $
                    
                    
                    
                    $
                    7,774





Impaired
loans had a carrying amount of $8.1 million with a valuation allowance of $341
thousand at December 31, 2008.





NOTE
21.   FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK





In the
normal course of business, to meet the financing needs of its customers, the
Banks are parties to financial instruments with off-balance sheet
risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  The Banks’ exposure to credit
loss in the event of nonperformance by the other party to these financial
instruments is represented by the contractual amount of the
instruments.  The Banks use the same credit policies in making
commitments and conditional obligations as they do for on-balance sheet
instruments.  The Banks generally require collateral or other security
to support the financial instruments with credit risk.  The amount of
collateral or other security is determined based on management’s credit
evaluation of the counterparty. The Banks evaluate each customer’s
creditworthiness on a case-by-case basis.





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Letters of
credit are conditional commitments issued by the Company to guarantee the
performance of a customer to a third party.  Letters of credit and
other commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee.  Because many of the letters
of credit and commitments are expected to expire without being drawn upon, the
total commitment amount does not necessarily represent future cash
requirements.





66





Commitments
outstanding as of December 31 are as follows:





(Dollars
      in thousands)
                      
                      2008
                      
                      
                      2007Commitments
      to extend credit
                      
                      $
                      211,423
                      
                      
                      $
                      246,295Letters
      of credit
                      
                      
                      12,508
                      
                      
                      
                      18,276$
                      223,931
                      
                      
                      $
                      264,571





NOTE
22.  CONTINGENCIES





In the
normal course of business, the Company and its subsidiaries may become involved
in litigation arising from banking, financial, and other
activities.  Management, after consultation with legal counsel, does
not anticipate that the future liability, if any, arising out of current
proceedings will have a material effect on the Company’s financial condition,
operating results, or liquidity.





NOTE
23.    PARENT COMPANY FINANCIAL INFORMATION





Condensed
financial information for Shore Bancshares, Inc. (Parent Company Only) is as
follows:





Condensed
      Balance SheetsDecember
      31,(Dollars
      in thousands)
                
                2008
                
                
                2007AssetsCash
                
                $
                1,936
                
                
                $
                1,441Investment
      in subsidiaries
                
                
                125,642
                
                
                
                118,995Income
      taxes receivable
                
                
                314
                
                
                
                577Premises
      and equipment, net
                
                
                2,885
                
                
                
                2,997Other
      assets
                
                
                604
                
                
                
                172Total
      assets
                
                $
                131,381
                
                
                $
                124,182LiabilitiesAccounts
      payable
                
                $
                1,083
                
                
                $
                640Deferred
      tax liability
                
                
                966
                
                
                
                822Long-term
      debt
                
                
                1,947
                
                
                
                2,485Total
      liabilities
                
                
                3,996
                
                
                
                3,947Stockholders’
      equityCommon
      stock
                
                
                84
                
                
                
                84Additional
      paid in capital
                
                
                29,768
                
                
                
                29,539Retained
      earnings
                
                
                96,140
                
                
                
                90,365Accumulated
      other comprehensive income
                
                
                1,393
                
                
                
                247Total
      stockholders’ equity
                
                
                127,385
                
                
                
                120,235Total
      liabilities and stockholders’ equity
                
                $
                131,381
                
                
                $
                124,182





67





Condensed
      Statements of IncomeFor
      the Years Ended December 31,(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006IncomeDividends
      from subsidiaries
                
                $
                6,131
                
                
                $
                11,234
                
                
                $
                5,115Management
      and other fees from subsidiaries
                
                
                5,285
                
                
                
                5,078
                
                
                
                3,982Rental
      income
                
                
                76
                
                
                
                76
                
                
                
                108Interest
      income
                
                
                20
                
                
                
                14
                
                
                
                10Total
      income
                
                
                11,512
                
                
                
                16,402
                
                
                
                9,215ExpensesSalaries
      and employee benefits
                
                
                4,111
                
                
                
                3,675
                
                
                
                3,034Occupancy
      and equipment expense
                
                
                367
                
                
                
                333
                
                
                
                257Other
      operating expenses
                
                
                1,389
                
                
                
                1,346
                
                
                
                1,195Total
      expenses
                
                
                5,867
                
                
                
                5,354
                
                
                
                4,486Income
      before income tax expense and equity in undistributed net income of
      subsidiaries
                
                
                5,645
                
                
                
                11,048
                
                
                
                4,729Income
      tax (benefit) expense
                
                
                (86
                )
                
                
                109
                
                
                
                331Income
      before equity in undistributed net income of subsidiaries
                
                
                5,731
                
                
                
                10,939
                
                
                
                4,398Equity
      in undistributed net income of subsidiaries
                
                
                5,739
                
                
                
                2,511
                
                
                
                9,156Net
      income
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554





68





Condensed
      Statements of Cash FlowFor
      the Years Ended December 31,(Dollars
      in thousands)
                
                2008
                
                
                2007
                
                
                2006Cash
      flows from operating activities:Net
      income
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554Adjustments
      to reconcile net income to cash provided by operating
      activities:Equity
      in undistributed net income of subsidiaries
                
                
                (5,739
                )
                
                
                (2,511
                )
                
                
                (9,156
                )Depreciation
                
                
                233
                
                
                
                166
                
                
                
                125Loss
      on disposals of premises and equipment
                
                
                1
                
                
                
                2
                
                
                
                -Stock-based
      compensation expense
                
                
                91
                
                
                
                63
                
                
                
                48Excess
      tax benefits from stock-based arrangements
                
                
                (4
                )
                
                
                (3
                )
                
                
                (279
                )Net
      (increase) decrease in other assets
                
                
                (169
                )
                
                
                (267
                )
                
                
                186Net
      increase in other liabilities
                
                
                592
                
                
                
                553
                
                
                
                186Net
      cash provided by operating activities
                
                
                6,475
                
                
                
                11,453
                
                
                
                4,664Cash
      flows from investing activities:Acquisition
                
                
                -
                
                
                
                (8,001
                )
                
                
                -Purchase
      of premises and equipment
                
                
                (122
                )
                
                
                (135
                )
                
                
                (281
                )Investment
      in subsidiaries
                
                
                (85
                )
                
                
                -
                
                
                
                -Net
      cash used by investing activities
                
                
                (207
                )
                
                
                (8,136
                )
                
                
                (281
                )Cash
      flows from financing activities:Proceeds
      from long-term debt
                
                
                -
                
                
                
                2,485
                
                
                
                -Repayment
      of long-term debt
                
                
                (538
                )
                
                
                -
                
                
                
                -Excess
      tax benefits from stock-based arrangements
                
                
                4
                
                
                
                3
                
                
                
                279Proceeds
      from issuance of common stock
                
                
                138
                
                
                
                54
                
                
                
                654Stock
      repurchased and retired
                
                
                -
                
                
                
                (266
                )
                
                
                -Dividends
      paid
                
                
                (5,377
                )
                
                
                (5,364
                )
                
                
                (4,917
                )Net
      cash used by financing activities
                
                
                (5,773
                )
                
                
                (3,088
                )
                
                
                (3,984
                )Net
      increase in cash and cash equivalents
                
                
                495
                
                
                
                229
                
                
                
                399Cash
      and cash equivalents at beginning of year
                
                
                1,441
                
                
                
                1,212
                
                
                
                813Cash
      and cash equivalents at end of year
                
                $
                1,936
                
                
                $
                1,441
                
                
                $
                1,212




69




NOTE
24.  QUARTERLY FINANCIAL RESULTS (unaudited)





A summary
of selected consolidated quarterly financial data for the two years ended
December 31, 2008, is reported as follows:





First
                            
                            
                            Second
                            
                            
                            Third
                            
                            
                            Fourth(In
      thousands, except per share data)
                            
                            Quarter
                            
                            
                            Quarter
                            
                            
                            Quarter
                            
                            
                            Quarter2008Interest
      income
                            
                            $
                            15,923
                            
                            
                            $
                            15,127
                            
                            
                            $
                            15,298
                            
                            
                            $
                            15,126Net
      interest income
                            
                            
                            10,030
                            
                            
                            
                            9,632
                            
                            
                            
                            9,909
                            
                            
                            
                            10,348Provision
      for credit losses
                            
                            
                            462
                            
                            
                            
                            615
                            
                            
                            
                            875
                            
                            
                            
                            1,385Income
      before income taxes
                            
                            
                            5,479
                            
                            
                            
                            4,482
                            
                            
                            
                            4,851
                            
                            
                            
                            3,750Net
      income
                            
                            
                            3,372
                            
                            
                            
                            2,766
                            
                            
                            
                            3,071
                            
                            
                            
                            2,261Basic
      earnings per common share
                            
                            $
                            0.40
                            
                            
                            $
                            0.33
                            
                            
                            $
                            0.37
                            
                            
                            $
                            0.27Diluted
      earnings per common share
                            
                            $
                            0.40
                            
                            
                            $
                            0.33
                            
                            
                            $
                            0.37
                            
                            
                            $
                            0.272007Interest
      income
                            
                            $
                            15,890
                            
                            
                            $
                            16,255
                            
                            
                            $
                            16,543
                            
                            
                            $
                            16,453Net
      interest income
                            
                            
                            9,905
                            
                            
                            
                            10,242
                            
                            
                            
                            10,463
                            
                            
                            
                            10,426Provision
      for credit losses
                            
                            
                            242
                            
                            
                            
                            413
                            
                            
                            
                            604
                            
                            
                            
                            465Income
      before income taxes
                            
                            
                            5,420
                            
                            
                            
                            5,343
                            
                            
                            
                            5,315
                            
                            
                            
                            5,374Net
      income
                            
                            
                            3,403
                            
                            
                            
                            3,356
                            
                            
                            
                            3,351
                            
                            
                            
                            3,340Basic
      earnings per common share
                            
                            $
                            0.41
                            
                            
                            $
                            0.40
                            
                            
                            $
                            0.40
                            
                            
                            $
                            0.40Diluted
      earnings per common share
                            
                            $
                            0.41
                            
                            
                            $
                            0.40
                            
                            
                            $
                            0.40
                            
                            
                            $
                            0.40





Earnings
per share are based upon quarterly results and may not be additive to the annual
earnings per share amounts.





NOTE
25.  SEGMENT REPORTING





The
Company operates two primary business segments:  Community Banking and
Insurance Products and Services.  The Community Banking business
provides services to consumers and small businesses on the Eastern Shore of
Maryland and in Delaware through its 18-branch network. Community banking
activities include small business services, retail brokerage, trust services 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.




70




Selected
financial information by business segments is included in the following
table:





Community
                          
                          
                          Insurance
      Products
                          
                          
                          Parent(Dollars
      in thousands)
                          
                          Banking
                          
                          
                          and
      Services
                          
                          
                          Company
                          
                          
                          Total2008Interest
      income
                          
                          $
                          61,400
                          
                          
                          $
                          74
                          
                          
                          $
                          -
                          
                          
                          $
                          61,474Interest
      expense
                          
                          
                          (21,434
                          )
                          
                          
                          -
                          
                          
                          
                          (121
                          )
                          
                          
                          (21,555
                          )Provision
      for credit losses
                          
                          
                          (3,337
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (3,337
                          )Noninterest
      income
                          
                          
                          7,644
                          
                          
                          
                          12,707
                          
                          
                          
                          (1
                          )
                          
                          
                          20,350Noninterest
      expense
                          
                          
                          (20,864
                          )
                          
                          
                          (11,967
                          )
                          
                          
                          (5,539
                          )
                          
                          
                          (38,370
                          )Net
      intersegment (expense) income
                          
                          
                          (4,763
                          )
                          
                          
                          (412
                          )
                          
                          
                          5,175
                          
                          
                          
                          -Income
      (loss) before taxes
                          
                          
                          18,646
                          
                          
                          
                          402
                          
                          
                          
                          (486
                          )
                          
                          
                          18,562Income
      tax (expense) benefit
                          
                          
                          (7,124
                          )
                          
                          
                          (154
                          )
                          
                          
                          186
                          
                          
                          
                          (7,092
                          )Net
      income (loss)
                          
                          $
                          11,522
                          
                          
                          $
                          248
                          
                          
                          $
                          (300
                          )
                          
                          $
                          11,470Total
      assets
                          
                          $
                          1,021,715
                          
                          
                          $
                          20,146
                          
                          
                          $
                          2,780
                          
                          
                          $
                          1,044,6412007Interest
      income
                          
                          $
                          61,133
                          
                          
                          $
                          8
                          
                          
                          $
                          -
                          
                          
                          $
                          65,141Interest
      expense
                          
                          
                          (24,105
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (24,105
                          )Provision
      for credit losses
                          
                          
                          (1,724
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (1,724
                          )Noninterest
      income
                          
                          
                          6,775
                          
                          
                          
                          7,906
                          
                          
                          
                          (2
                          )
                          
                          
                          14,679Noninterest
      expense
                          
                          
                          (20,205
                          )
                          
                          
                          (7,124
                          )
                          
                          
                          (5,210
                          )
                          
                          
                          (32,539
                          )Net
      intersegment (expense) income
                          
                          
                          (4,646
                          )
                          
                          
                          (381
                          )
                          
                          
                          5,027
                          
                          
                          
                          -Income
      (loss) before taxes
                          
                          
                          21,228
                          
                          
                          
                          409
                          
                          
                          
                          (185
                          )
                          
                          
                          21,452Income
      tax (expense) benefit
                          
                          
                          (7,918
                          )
                          
                          
                          (153
                          )
                          
                          
                          69
                          
                          
                          
                          (8,002
                          )Net
      income (loss)
                          
                          $
                          13,310
                          
                          
                          $
                          256
                          
                          
                          $
                          (116
                          )
                          
                          $
                          13,450Total
      assets
                          
                          $
                          933,583
                          
                          
                          $
                          20,405
                          
                          
                          $
                          2,923
                          
                          
                          $
                          956,9112006Interest
      income
                          
                          $
                          57,971
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          57,971Interest
      expense
                          
                          
                          (19,074
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (19,074
                          )Provision
      for credit losses
                          
                          
                          (1,493
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (1,493
                          )Noninterest
      income
                          
                          
                          5,994
                          
                          
                          
                          6,812
                          
                          
                          
                          33
                          
                          
                          
                          12,839Noninterest
      expense
                          
                          
                          (18,592
                          )
                          
                          
                          (5,561
                          )
                          
                          
                          (4,382
                          )
                          
                          
                          (28,535
                          )Net
      intersegment (expense) income
                          
                          
                          (3,673
                          )
                          
                          
                          (291
                          )
                          
                          
                          3,964
                          
                          
                          
                          -Income
      (loss) before taxes
                          
                          
                          21,133
                          
                          
                          
                          960
                          
                          
                          
                          (385
                          )
                          
                          
                          21,708Income
      tax (expense) benefit
                          
                          
                          (7,939
                          )
                          
                          
                          (360
                          )
                          
                          
                          145
                          
                          
                          
                          (8,154
                          )Net
      income (loss)
                          
                          $
                          13,194
                          
                          
                          $
                          600
                          
                          
                          $
                          (240
                          )
                          
                          $
                          13,554Total
      assets
                          
                          $
                          932,616
                          
                          
                          $
                          9,777
                          
                          
                          $
                          3,256
                          
                          
                          $
                          945,649





NOTE
26.  SUBSEQUENT EVENT





On
January 9, 2009, pursuant to the U.S. Department of Treasury’s TARP Capital
Purchase Program, the Corporation issued the following securities to the initial
selling security holder for an aggregate consideration of
$25,000,000:  (i) 25,000 shares of Fixed Rate Cumulative Perpetual
Preferred Stock, Series A, par value $.01 per share (the “Series A Preferred
Stock”); and (ii) an immediately exercisable warrant to purchase 172,970 shares
of common stock, par value $.01 per share, for an exercise price of $21.68 per
share.  The proceeds from this transaction count as Tier 1 capital and
the warrant qualifies as tangible common equity.  The Series A
Preferred Stock pay a cumulative preferred dividend of 5% per annum per $1,000
of liquidation amount from January 9, 2009 to February 15, 2014, and a
cumulative preferred dividend of 9% per annum per $1,000 of liquidation amount
on and after February 16, 2014.  The operative documents relating to
this transaction have been filed with the U.S. Securities and Exchange
Commission and are referenced as Exhibits 3.1(ii) and 4.1 through 4.4 to this
annual report.




71




Item
9.         Changes in and
Disagreements with Accountants on Accounting and Financial
Disclosure.





None.





Item
9A.      Controls and Procedures.





The
Company maintains disclosure controls and procedures that are designed to ensure
that information required to be disclosed in the Company’s reports filed under
the Exchange Act with the SEC, such as this annual 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
the Company’s management, including the President and 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, control 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 December 31,
2008, was carried out under the supervision and with the participation of the
Company’s management, including the CEO and the PAO.  Based on that
evaluation, the Company’s management, including the CEO and the PAO, has
concluded that the Company’s disclosure controls and procedures are, in fact,
effective at the reasonable assurance level.





During
the fourth quarter of 2008, there was no change in the Company’s internal
control over financial reporting that has materially affected, or is reasonably
likely to materially affect, the Company’s internal control over financial
reporting.





As
required by Section 404 of the Sarbanes-Oxley Act of 2002, management has
performed an evaluation and testing of the Company’s internal control over
financial reporting as of December 31, 2008.  Management’s report on
the Company’s internal control over financial reporting and the related
attestation report of the Company’s independent registered public accounting
firm are included in Item 8 of Part II of this annual report, and each such
report is incorporated into this Item 9A by reference thereto.





Item
9B.      Other Information





None.





PART
III





Item
10.       Directors, Executive Officers and
Corporate Governance.





The
Company has adopted a Code of Ethics that applies to all of its directors,
officers, and employees, including its principal executive officer, principal
financial officer, principal accounting officer, or controller, or persons
performing similar functions.  A written copy of the Company’s Code of
Ethics will be provided to stockholders, free of charge, upon request
to:  W. David Morse, Secretary, Shore Bancshares, Inc., 18 E. Dover
Street, Easton, Maryland 21601 or (410) 822-1400.





All other
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2009
Annual Meeting of Stockholders.





Item
11.       Executive
Compensation.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2009
Annual Meeting of Stockholders.




72


Item
12.       Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters.
 
 The
information provided in Item 5 of Part II of this report under the heading
“EQUITY COMPENSATION PLAN INFORMATION” is incorporated herein by
reference.  All other information required by this item is
incorporated herein by reference to the Company’s definitive proxy statement to
be filed in connection with the 2009 Annual Meeting of
Stockholders.




Item
13.       Certain Relationships and Related
Transactions, and Director Independence.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2009
Annual Meeting of Stockholders.





Item
14.       Principal Accountant Fees and
Services.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2009
Annual Meeting of Stockholders.





PART
IV





Item
15.       Exhibits and Financial Statement
Schedules.





(a)(1), (2) and (c) Financial
statements and schedules:





Report of Independent Registered Public
Accounting Firm


Consolidated Balance Sheets at December
31, 2008 and 2007


Consolidated Statements of Income —
Years Ended December 31, 2008, 2007, and 2006


Consolidated Statements of Changes in
Stockholders’ Equity — Years Ended December 31, 2008, 2007 and2006


Consolidated Statements of Cash Flows —
Years Ended December 31, 2008, 2007 and 2006


Notes to Consolidated Financial
Statements for the years ended December 31, 2008, 2007 and 2006





(a)(3) and (b) Exhibits required to be
filed by Item 601 of Regulation S-K:





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




73




SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





Shore
      Bancshares, Inc.Date:
                              March
      13, 2009
                              
                              By:
                              /s/
      W. Moorhead VermilyeW.
      Moorhead VermilyePresident
      and
CEO





Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.





/s/
      Herbert L. Andrew, III
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March
      13, 2009Herbert
      L. Andrew, IIIDirector
                                                                                            
                                                                                            March 13, 2009Blenda
      W. Armistead/s/ Lloyd L. Beatty, Jr.
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009Lloyd
      L. Beatty, Jr./s/ Paul M. Bowman
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009Paul
      M. Bowman/s/ William W. Duncan
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009William
      W. Duncan/s/ Richard C. Granville
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009Richard
      C. GranvilleDirector
                                                                                            
                                                                                            March 13, 2009W.
      Edwin Kee/s/ Neil R. LeCompte
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009Neil
      R. LeCompte/s/ Jerry F. Pierson
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March 13, 2009Jerry
      F. Pierson/s/
      Christopher F. Spurry
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March
      13, 2009Christopher
      F. Spurry/s/
      F. Winfield Trice, Jr.
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March
      13, 2009F.
      Winfield Trice, Jr./s/
      W. Moorhead Vermilye
                                                                                            
                                                                                            Director
                                                                                            
                                                                                            March
      13, 2009W.
      Moorhead Vermilye
                                                                                            
                                                                                            President/CEO/s/ Susan E. Leaverton
                                                                                            
                                                                                            Treasurer/
                                                                                            
                                                                                            March 13, 2009Susan
      E. Leaverton
                                                                                            
                                                                                            Principal
      Accounting Officer




74




EXHIBIT
LIST





Exhibit
      No.
                                                                                              
                                                                                              Description3.1(i)
                                                                                              
                                                                                              Amended
      and Restated Articles of Incorporation (incorporated by reference to
      Exhibit 3.1 of the Company’s Form 8-K filed on December 14,
      2000).3.1(ii)
                                                                                              
                                                                                              Articles
      Supplementary relating to the Fixed Rate Cumulative Perpetual Preferred
      Stock, Series A (incorporated by reference Exhibit 4.1 of the Company’s
      Form 8-K filed on January 13, 2009)3.2(i)
                                                                                              
                                                                                              Amended
      and Restated By-Laws (filed herewith).3.2(ii)
                                                                                              
                                                                                              First
      Amendment to Amended and Restated By-Laws (filed
  herewith).4.1
                                                                                              
                                                                                              Letter
      Agreement, including the related Securities Purchase Agreement – Standard
      Terms, dated January 9, 2009 by and between the Company and the U.S.
      Department of Treasury (incorporated by reference to Exhibit 10.1 of the
      Company’s Form 8-K filed on January 13, 2009)4.2
                                                                                              
                                                                                              Form
      of Stock Certificate for the Series A Preferred Stock (incorporated by
      reference to Exhibit 4.2 of the Company’s Registration Statement on Form
      S-3, File No. 333-157141)4.3
                                                                                              
                                                                                              Common
      Stock Purchase Warrant dated January 9, 2009 issued to the U.S. Department
      of Treasury (incorporated by reference to Exhibit 4.2 of the Company’s
      Form 8-K filed on January 13, 2009)10.1
                                                                                              
                                                                                              Form
      of Employment Agreement with W. Moorhead Vermilye (incorporated by
      reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed
      on July 31, 2000).10.2
                                                                                              
                                                                                              Employment
      Termination Agreement among Centreville National Bank, the Company, and
      Daniel T. Cannon dated December 7, 2006 (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on December 12,
      2006).10.3
                                                                                              
                                                                                              Employment
      Agreement with Thomas H. Evans, as amended on November 3, 2005
      (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed
      on November 9, 2005).10.4
                                                                                              
                                                                                              Summary
      of Compensation Arrangement for Lloyd L. Beatty, Jr. (incorporated by
      reference to Exhibit 10.1 of the Company’s Form 8-K filed on August 1,
      2006).10.5
                                                                                              
                                                                                              Amended
      Summary of Compensation Arrangement for William W. Duncan, Jr.
      (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed
      on February 14, 2007, as amended by Form 8-K/A filed on May 3,
      2007).10.6
                                                                                              
                                                                                              Summary
      of Compensation Arrangement between Centreville National Bank and F.
      Winfield Trice, Jr. (incorporated by reference to Exhibit 10.1 of the
      Company’s Form 8-K filed on August 13, 2007).10.7
                                                                                              
                                                                                              Employment
      Agreement between The Avon-Dixon Agency, LLC and Mark M. Freestate
      (incorporated by reference to Exhibit 10.6 of the Company’s Annual Report
      on Form 10-K for the year ended December 31, 2006).10.8
                                                                                              
                                                                                              Shore
      Bancshares, Inc. Management Incentive Plan (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on April 3,
      2007).10.9
                                                                                              
                                                                                              Revised
      Schedule A to the Shore Bancshares, Inc. Management Incentive Plan
      (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed
      on August 13, 2007).10.10
                                                                                              
                                                                                              Shore
      Bancshares, Inc. Amended and Restated Executive Deferred Compensation Plan
      (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed
      on February 14, 2007)10.11
                                                                                              
                                                                                              Deferral
      Election, Investment Designation, and Beneficiary Designation Forms under
      the Shore Bancshares, Inc. Amended and Restated Executive Deferred
      Compensation Plan (incorporated herein by reference to Exhibit 10.1 to the
      Company’s Form 8-K filed on October 2,
2006).




75





10.12
            
            Form
      of Centreville National Bank of Maryland Director Indexed Fee Continuation
      Plan Agreement with Messrs. Cannon, Freestate and Pierson (incorporated by
      reference to Exhibit 10.2 to the Company’s Form 8-K filed on December 12,
      2006).10.13
            
            Form
      of Amended and Restated Director Indexed Fee Continuation Plan Agreement
      between Centreville National Bank and Messrs. Cannon, Freestate and
      Pierson (incorporated by reference to Exhibit 10.2 of the Company’s
      Current Report on Form 8-K filed on January 7, 2009).10.14
            
            Form
      of Centreville National Bank Life Insurance Endorsement Split Dollar Plan
      Agreement with Messrs. Cannon, Freestate and Pierson (incorporated by
      reference to Exhibit 10.3 to the Company’s Form 8-K filed on December 12,
      2006).10.15
            
            Form
      of Executive Supplemental Retirement Plan Agreement between The
      Centreville National Bank of Maryland and Daniel T. Cannon (incorporated
      by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form
      10-Q for the period ended September 30, 2003).10.16
            
            Form
      of Life Insurance Endorsement Method Split Dollar Plan Agreement between
      The Centreville National Bank of Maryland and Daniel T. Cannon
      (incorporated by reference to Exhibit 10.5 of the Company's Quarterly
      Report on Form 10-Q for the period ended September 30,
    2003).10.17
            
            Talbot
      Bank of Easton, Maryland Supplemental Deferred Compensation Plan
      (incorporated by reference to Exhibit 10.7 of the Company’s Quarterly
      Report on Form 10-Q for the period ended September 30,
    2005).10.18
            
            First
      Amendment to The Talbot Bank of Easton, Maryland Supplemental Deferred
      Compensation Plan for the benefit of W. Moorhead Vermilye (incorporated by
      reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K
      filed on January 7, 2009).10.19
            
            Talbot
      Bank of Easton, Maryland Supplemental Deferred Compensation Plan Trust
      Agreement (incorporated by reference to Exhibit 10.7 of the Company’s
      Quarterly Report on Form 10-Q for the period ended September 30,
      2005).10.20
            
            1998
      Employee Stock Purchase Plan, as amended (incorporated by reference to
      Appendix A of the Company’s definitive Proxy Statement on Schedule 14A for
      the 2003 Annual Meeting of Stockholders filed on March 31,
      2003).10.21
            
            1998
      Stock Option Plan (incorporated by reference to Exhibit 10 of the
      Company’s Registration Statement on Form S-8 filed with the SEC on
      September 25, 1998 (Registration No. 333-64319)).10.22
            
            Talbot
      Bancshares, Inc. Employee Stock Option Plan (incorporated by reference to
      Exhibit 10 of the Company’s Registration Statement on Form S-8 filed May
      4, 2001 (Registration No. 333-60214)).10.23
            
            Shore
      Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (incorporated
      by reference to Appendix A of the Company’s 2006 definitive proxy
      statement filed on March 24, 2006).10.24
            
            Form
      of Restricted Stock Award Agreement under the 2006 Stock and Incentive
      Compensation Plan (incorporated by reference to Exhibit 10.1 to the
      Company’s Form 8-K filed on April 11, 2007).10.25
            
            Changes
      to Director Compensation Arrangements (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on February 6,
      2006).21
            
            Subsidiaries
      of the Company (included in the “BUSINESS—General” section of Item 1 of
      Part I of this Annual Report on Form 10-K).23
            
            Consent
      of Stegman & Company (filed
herewith).




76


31.1
                
                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).




77