Shore Bancshares - 10-Q quarterly report FY

For the Quarterly Period Ended June 30, 2009

For the transition period from ________ to ________

Commission file number 0-22345

(Exact name of registrant as specified in its charter)

Registrant’s Telephone Number, Including Area Code

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

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

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

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

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

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

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except per share amounts)

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Six Months Ended June 30, 2009 and 2008

(Dollars in thousands, except per share amounts)

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

See accompanying notes to Consolidated Financial Statements.

Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

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

(Unaudited)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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:

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

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.

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

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

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 June 30, 2009 and December 31, 2008 are as follows:

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

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

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

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

Investment securities available for sale 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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