Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with GAAP and follow general practices within the banking industry. 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.

Significant accounting policies followed by the Company are presented in Note 1 to the Company's 2007 consolidated financial statements which can be found on the Company's Form 10-KSB. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, 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 identified the determination of 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.

The allowance for credit losses represents management's estimate of probable credit losses inherent in the loan portfolio. 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 sheet.

Allowance for Credit Losses Methodology

The allowance for credit losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans, actual loss experience, current economic events in specific industries and geographic areas including unemployment levels and other pertinent factors including regulatory guidance and general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience and consideration of economic trends, all of which may be susceptible to significant change. Credit 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 consists of a specific component and a nonspecific component. The components of the allowance for credit losses represent an estimation done pursuant to either SFAS No. 5 "Accounting for Contingencies," or SFAS No. 114 "Accounting by Creditors for Impairment of a Loan." The specific component of the allowance for credit losses reflects expected losses resulting from analysis developed through credit allocations for individual loans and historical loss experience for each loan category. The credit allocations are based on a regular analysis of all loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The historical

loan loss element is determined statistically using a loss migration analysis that examines loss experience and the related internal gradings of loans charged off. The calculation of the allowance is based, in part, upon historical loss factors, as adjusted, for the major loan categories based upon adjusted historical loss experience over the prior eight quarters. The factors used to adjust the historical loss experience address various risk characteristics of the Bank's loan portfolio including (1) trends in delinquencies and other nonperforming loans, (2) results of independent loan reviews, (3) changes in the categories of loans comprising the loan portfolio, (4) concentrations of loans to specific industry segments, (5) changes in economic conditions on both a local and national level, (6) changes in the Bank's credit administration and loan portfolio management processes, (7) changes in the experience, ability and depth of lending management and staff, (8) the effect of the rapid escalation in real estate prices in 2003 through 2005 and subsequent decline of local real estate values on the level of potential credit losses in the Bank's portfolio and (9) the impact of unresolved collateral and documentation exceptions on the potential credit losses in the Bank's portfolio.

The nonspecific portion of the allowance is determined based on management's assessment of general economic conditions, as well as economic factors in the individual markets in which the Bank operates including the strength and timing of economic cycles and concerns over the effects of a prolonged economic downturn in the current cycle. This determination inherently involves a higher risk of uncertainty and considers current risk factors that may not have yet manifested themselves in the historical loss factors used by the Bank to determine the specific component of the allowance. During the quarter ended June 30, 2008, management increased the factors relating to the concentrations of loans and changes in the local economic conditions as they pertain to the Company's boat loan portfolio. The impact was to increase the existing allowance for credit losses related to the consumer loan portfolio that includes boat loans by $38,000. No changes were made to the qualitative factors in the third quarter 2008. In addition to providing for portfolio growth management during the third quarter downgraded the credit quality of several real estate backed loans and increased the provision to $931,000 for the quarter ended September 30, 2008 compared to $133,000 in provision for the quarter ended September 30, 2007.

Activity in the allowance for credit losses for the nine months ended September 30, 2008 and 2007 is shown below:

                                                               For the Nine Months
 (Dollars in thousands)                                        Ended September 30,
                                                                2008          2007
 Total loans outstanding-at September 30                     $  260,368     $ 240,368

 Average loans outstanding year-to-date                      $  249,962     $ 230,175

 Allowance for credit losses at beginning of period          $    2,283     $   1,976

 Provision charged to expense                                     1,419           153

 Chargeoffs:
 Commercial loans                                                   156            -
 Real estate and construction                                        42
 Consumer and other loans                                            -             21

 Total                                                              198            21

 Recoveries:
 Consumer and other loans                                            17            20

 Total                                                               17            20

 Net chargeoffs                                                     181             1

 Allowance for credit losses at end of year                  $    3,521     $   2,128

 Allowance for credit losses as a percent of total loans           1.35 %        0.89 %
 Net chargeoffs (recoveries) as a percent of average loans         0.07 %        0.00 %

The Company's nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, loans with repossessed collateral and other real estate owned, totaled $5.5 million at September 30, 2008, compared to $1.1 million at December 31, 2007. The percentage of nonperforming loans to total loans was 2.13% at September 30, 2008, compared to 0.44% at December 31, 2007.

Total assets at September 30, 2008 were $375.9 million, an increase of $14.0 million or 3.9% from total assets at December 31, 2007 of $361.9 million. The increase in total assets was due to taking advantage of favorable Federal Home Loan Bank advance rates by increasing outstanding long-term borrowings by $20.0 million or 100.0%. The excess liquidity derived from the advances was invested in short-term certificates of deposit and federal funds sold. Investment securities available for sale decreased to $78.3 million from $83.1 million, a decrease of $4.8 million or 5.8% due to not replacing called securities.

Loans net of the allowance for credit losses at September 30, 2008 were $256.8 million, an increase of $12.9 million or 5.3% from $243.9 million at December 31, 2007. The increase resulted from net additions to commercial loans of $4.8 million and $11.9 million in net additions to real estate loans, offset by a decrease of $2.6 million in consumer loans and an increase in the allowance for credit losses of $1.2 million.

The allowance for credit losses increased $1.2 million to $3.5 million at September 30, 2008 compared to $2.3 million at December 31, 2007. The increase in the allowance is attributed to the addition of a provision for credit losses of $1.4 million. The Company

recorded charge-offs of $198,000 for the nine months ended September 30, 2008 and received recoveries of $17,000 for same period ended September 30, 2008. Management makes periodic provisions to the allowance for credit losses to maintain the allowance at an acceptable level commensurate with management's assessment of the credit risk inherent in the loan portfolio as of the balance sheet date. At September 30, 2008 and December 31, 2007, the allowance for credit losses to total loans was 1.35% and 0.93%, respectively. Nonperforming assets as of September 30, 2008 and December 31, 2007 were $5.5 million and $1.1 million, respectively.

Management recorded provision expense during the nine months ended September 30, 2008 of $1.4 million to replenish the reserve for charge-offs taken during the nine month period ended September 30, 2008 and to provide for the downgrade of several real estate loans, including one real estate loan classified as nonperforming due to the accidental death of the borrower.

Deposits of $288.0 million at September 30, 2008 represent a decrease of $3.6 million or 1.2% from December 31, 2007 deposits of $291.6 million. The decrease was primarily the result of allowing $8.0 million in high-cost, brokered certificates of deposit to runoff without replacement. Money market account balances decreased $38.1 million or 44.6% as balances shifted to the Company's "Superior Savings" product. As a result savings deposits increased $42.1 million or 94.3%. Certificates of deposit, excluding the $8.0 million in brokered certificates of deposit that matured, increased $1.0 million or 1.3%.

Long-term borrowings consisting of Federal Home Loan Bank ("FHLB") borrowings totaled $40.0 million at September 30, 2008 compared to $20.0 million at December 31, 2007. All $40.0 million in borrowings were made under the FHLB of Atlanta's convertible advance program with an average remaining life of 4.13 years to maturity and 0.50 years to the first call date. The borrowings have a weighted average interest rate of 3.06%.

On March 26, 2003, Annapolis Bancorp Statutory Trust I ("Statutory Trust I"), a Connecticut business trust formed, funded and wholly owned by the Company, issued $5,000,000 of variable-rate capital securities to institutional investors. The current rate on these securities is 6.63%. The capital securities are scheduled to mature on March 26, 2033. The capital securities are callable beginning March 26, 2008 and quarterly thereafter.

Comparison of Operating Results for the Nine Months Ended September 30, 2008 and 2007

General. Net income for the nine months ended September 30, 2008 totaled $1.3 million, or $0.33 per basic and $0.32 per diluted share, compared to $1.9 million, or $0.46 per basic and $0.45 per diluted share, for the nine months ended September 30, 2007. Net interest income improved by $954,000 or 10.8% for the nine months ended September 30, 2008 compared to the same period in 2007. Offsetting the improvement in net interest income was an increase in the provision for credit losses of $1.3 million for the nine months ended September 30, 2008 compared to the same period in 2007.

Interest Income. Total interest income decreased $251,000 or 1.5% for the nine months ended September 30, 2008 compared to the same period in 2007 as a result of a

decrease in loan yields. The yield on the loan portfolio decreased to 6.91% for the nine months ended September 30, 2008 from 7.68% for the nine months ended September 30, 2007. The yield on investment securities improved to 5.06% from 4.69% for the nine months ended September 30, 2008 compared to the same period in 2007. The combined yield on federal funds sold and other overnight investments and interest-bearing deposits with banks decreased to 2.74% from 5.24% for the nine months ended September 30, 2008 compared to the same period in 2007 as the Federal Reserve cut the federal funds target rate 275 basis points from September 30, 2007 until September 30, 2008.

Interest Expense. Total interest expense decreased by $1.2 million or 15.2% for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007. The decrease was due to reducing the Company's portfolio of higher paying certificates of deposit, which paid an average of 4.22%, and replacing the certificates with the Company's "Superior Savings" product, which paid an average of 2.65%. The Company's new savings product had balances in excess of $76.8 million at September 30, 2008 compared to $31.6 million at September 30, 2007, an increase of $45.2 million or 143.0%. Contributing to the decrease in interest expense was the lower cost of money market accounts, certificates of deposit and repurchase agreements. The average rate of interest paid on all interest-bearing liabilities was 2.90% for the nine months ended September 30, 2008 compared to 3.76% for the nine months ended September 30, 2007. Interest expense on short-term and long-term borrowings and junior subordinated debentures was $1.2 million for the nine months ended September 30, 2008 compared to $849,000 for the nine months ended September 30, 2007, an increase of $316,000. The increase was a result of higher average year-to-date borrowings for the nine months ended September 30, 2008 compared to the same period in 2007.

Net Interest Income. Net interest income improved by $954,000 or 10.8% for the nine months ended September 30, 2008 compared to the nine months ended September 30, 2007. The improvement was due primarily to the Company's lower cost of funds, which decreased to 2.59% for the nine months ended September 30, 2008 compared to 3.29% for the nine months ended September 30, 2007.

For the nine months ended September 30, 2008, the net interest margin improved to 3.67% compared to 3.59% for the nine months ended September 30, 2007. The increase in net interest margin was the result of the lower cost of funds.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $1.4 million for the nine months ended September 30, 2008 compared to $153,000 for the same period in 2007. The provision was based on the composition and credit quality of the loan portfolio as of September 30, 2008 and reflected increases in provision related to changes in the qualitative factors relating to local economic conditions and downgrades of several real estate and boat loans. Total gross loans grew by $14.2 million for the nine month period ended September 30, 2008. The Bank recorded net charge-offs on loans deemed uncollectible of $181,000 for the nine months ended September 30, 2008 compared to $1,000 for the same period in 2007.

Noninterest Income. Total noninterest income decreased by $55,000 or 4.0% to $1.3 million for the nine months ended September 30, 2008 from $1.4 million for the same period in 2007. The decrease in noninterest income was due to lower transaction-based deposit fees.

Noninterest Expense. Total noninterest expense increased by $565,000 or 7.9% for the nine months ended September 30, 2008 compared to the same period in 2007. The increase in total noninterest expense during the first nine months of 2008 compared with the same period in 2007 resulted from a $305,000 increase in personnel expense, a $92,000 increase in professional fees, including legal, consulting and audit fees, and an increase in FDIC expense of $65,000. The increase in personnel expense was related to the full year impact of hiring additional business development officers to help achieve the Company's growth plans offset by the elimination of previously accrued year-end performance bonus payments. Legal expense, a component of professional fees, increased $54,000 due in part to loan collection efforts and to costs associated with preparing the Company's annual proxy statement, and for implementing a 10b-5 stock repurchase plan. Audit and accounting fees increased $32,000 for the nine month period ended September 30, 2008 compared to the same period in 2007 related to reviewing additional Securities and Exchange Commission filings and to Sarbanes-Oxley Act of 2002 Section 404 testing. Included in professional fees are consulting fees. The Company entered into a consulting arrangement with one of its directors Kendel Ehrlich, whereby Ms. Ehrlich receives consulting fees of approximately $35,000 per annum to assist the Company in developing new business relationships. For each of the nine month periods ended September 30, 2008 and 2007, Ms. Ehrlich earned approximately $26,000 in consulting fees.

Income Tax Expense. The Company recorded current and deferred income tax expense for the nine-month period ended September 30, 2008 of $694,000. This amount includes $670,000 of federal income taxes and $24,000 of state taxes. The Company's combined effective federal and state income tax rate was approximately 35.1% for the nine months ended September 30, 2008 versus 34.9% for the nine months ended September 30, 2007.

The table below sets forth certain information regarding changes in interest income and interest expense attributable to (1) changes in volume (change in volume multiplied by the old rate); (2) changes in rates (change in rate multiplied by the old volume); and (3) changes in rate/volume (change in rate multiplied by change in volume).

Rate/Volume Analysis

(Dollars in thousands)



                                                      Nine Months Ended September 30, 2008 vs. 2007
                                                                              Due to Change in
                                              Increase or                                            Rate/
                                               (Decrease)          Volume              Rate         Volume
Interest income on:
Loans                                         $       (291 )     $     1,137       $     (1,315 )   $  (113 )
Investment securities                                  318               101                209           8
Interest-bearing deposits in other banks               252                -                  -          252
Federal funds sold and other overnight
investments                                           (530 )            (221 )             (430 )       121

Total interest income                                 (251 )           1,017             (1,536 )       268

Interest expense on:
NOW accounts                                           (11 )             (10 )               (1 )        -
Money market accounts                               (1,281 )            (386 )           (1,064 )       169
Savings accounts                                       664               697                (15 )       (18 )
Certificates of deposit                               (672 )            (423 )             (283 )        34
Repurchase agreements                                 (221 )              61               (248 )       (34 )
Long-term borrowing                                    386               664               (123 )      (155 )
Junior subordinated debt                               (73 )              -                 (73 )        -

Total interest expense                              (1,208 )             603             (1,807 )        (4 )

Net interest income                           $        957       $       414       $        271     $   272

Consolidated Average Balances, Yields and Rates



(Balances in thousands)                                      Nine Month Periods Ended
                                               September 30, 2008                 September 30, 2007
                                          Average    Interest    Yield/      Average    Interest    Yield/
                                          Balance       (1)       Rate       Balance       (1)       Rate
Assets
Interest earning assets
Federal funds sold and other overnight
investments                              $  14,382   $     255     2.37 %   $  20,017   $     785     5.24 %
Interest-bearing deposits with banks        10,345         252     3.25 %          -           -        -
Investment securities                       81,741       3,095     5.06 %      78,871       2,777     4.69 %
Loans                                      249,962      12,932     6.91 %     230,175      13,223     7.68 %

Total interest earning assets              356,430      16,534     6.20 %     329,063      16,785     6.82 %
Noninterest earning assets
Cash and due from banks                      5,540                              5,691
Other assets                                13,827                             14,201

Total Assets                             $ 375,797                          $ 348,955

Liabilities and Stockholders' Equity
Interest-bearing deposits
NOW accounts                             $  26,430   $      40     0.20 %   $  32,559   $      51     0.21 %
Money market accounts                       66,571       1,154     2.32 %      79,097       2,435     4.12 %
Savings accounts                            64,567       1,282     2.65 %      30,351         618     2.72 %
Certificates of deposit                     90,785       2,870     4.22 %     103,099       3,542     4.59 %
Repurchase agreements                       16,820         221     1.76 %      14,768         442     4.00 %
Short-term borrowings                          231           3     1.71 %          -           -        -
Long-term borrowings                        39,380         913     3.05 %      17,418         527     3.99 %
Junior subordinated debt                     5,000         249     6.54 %       5,000         322     8.49 %

Total interest-bearing liabilities         309,784       6,732     2.90 %     282,292       7,937     3.76 %

Noninterest-bearing Liabilities
Demand deposit accounts                     38,072                             40,310
Other liabilities                            1,494                              1,451
Stockholders' Equity                        26,447                             24,902

Total Liabilities and Stockholders'
Equity                                   $ 375,797                          $ 348,955

Interest rate spread                                               3.30 %                             3.06 %
Ratio of interest earning assets to
interest-bearing liabilities                                     115.06 %                           116.57 %
Net interest income and net interest
margin                                               $   9,802     3.67 %               $   8,848     3.59 %

(1) No tax-equivalent adjustments are made, as the effect would not be material.

Comparison of Operating Results for the Three Months Ended September 30, 2008 and 2007.

General. Net income for the three months ended September 30, 2008 totaled $299,000, or $0.08 per basic and $0.08 per diluted share, compared to $662,000, or $0.16 per basic and $0.16 per diluted share, for the three months ended September 30, 2007. Net interest income improved by $397,000 or 13.2% for the three months ended September 30, 2008 compared to the same in period in 2007. The Bank recorded $931,000 in provision for credit losses during the three months ended September 30, 2008, compared to $133,000 in provision for credit losses during the same period in 2007.

The Bank has invested in bank-owned life insurance to finance supplemental retirement benefits for senior bank executives. The cash surrender value of the policies was $4.0 million at September 30, 2008 and December 31, 2007. The Bank recorded income from the insurance policies for the three-month period ended September 30, 2008 of $41,000 compared to $39,000 for the same period in 2007 and incurred $45,000 in expense to accrue the retirement benefits for the three months ended September 30, 2008 compared to $41,000 for the same period in 2007. During the first quarter of 2008 the Company adopted EITF 06-4 "Accounting for . . .