Summary of ANNAPOLIS BANCORP INC

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The following is management's discussion and analysis of the financial condition and results of operations of Annapolis Bancorp, Inc. on a consolidated basis with its wholly owned subsidiary, BankAnnapolis, for the periods presented, and should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this annual report.

The Bank and, as a result, the Company, have not been immune to the impact of the economic downturn in the United States during 2008. With real estate collateral values continuing to fall and economic conditions worsening the Bank continued to build its reserve for credit losses recording a provision of $2.4 million in 2008 compared to $448 thousand in 2007.

The Company reported net income for 2008 of $1.4 million, a decrease of $997 thousand or 41.1% from 2007 net income of $2.4 million. The decrease in 2008 earnings was primarily due to the higher provision for credit losses noted above, lower interest income and higher noninterest expense. Earnings per diluted share were $0.35 compared to $0.58 per share in 2007.

The primary source of income of the Bank is interest on its loan and investment portfolios, while one of the principal expenses of the Bank is interest on its deposit accounts and borrowings. The difference between interest income on interest earning assets and interest expense on interest bearing liabilities is referred to as net interest income. Net interest income was $13.0 million for 2008, an increase of $1.2 million or 10.0% compared to $11.8 million in 2007. Total assets were $394.9 million as of December 31, 2008, a $33.0 million or a 9.1% increase over December 31, 2007 total assets of $361.9 million. The Company's return on average assets was 0.38% and 0.69% for the years ending December 31, 2008, and 2007, respectively. The Company's return on average equity was 5.41% and 9.51% for the years ending December 31, 2008, and 2007, respectively.

At December 31, 2008 the Bank's gross loan portfolio totaled $268.4 million. Of this amount, $53.4 million or 19.9% were commercial loans, $78.2 million or 29.1% were commercial real estate loans, $28.4 million or 10.6% were construction loans, $66.9 million or 24.9% were one- to four-family residential mortgage loans, $27.1 million or 10.1% were home equity loans, and $14.4 million or 5.4% were consumer and other loans.

Application of 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 may 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 must 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 either based on quoted market prices or are provided by other third-party sources, when available.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements which can be found on page 35 and continuing to page 39. 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 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 sheet. Note 1 to the consolidated financial statements found on pages 35 and 36 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 Credit Risk Management section of this financial analysis.

Financial Condition as of December 31, 2008 and 2007 and Results of Operations for the Years then Ended

The Company, through its Bank subsidiary, functions as a financial intermediary, and as such its financial condition and results of operations can be examined in terms of developing trends in its sources and uses of funds. These trends are the result of both external environmental factors, such as changing economic conditions, regulatory changes and competition, and also internal environmental factors such as management's evaluation as to the best use of funds in these changing conditions.

Total assets increased by $33.0 million or 9.1% during 2008 to $394.9 million from $361.9 million at December 31, 2007. Total deposits and securities sold under agreements to repurchase, the Company's primary sources of funds, increased $8.4 million or 2.7% to $313.3 million from $304.9 million at December 31, 2007. Time deposits totaled $92.5 million or 30.8% of the Bank's total deposits at December 31, 2008, compared to $95.1 million or 32.6% in 2007. Savings and money market accounts, the largest portion of the Bank's total deposits, totaled $143.1 million or 47.6% of the Bank's total deposits at December 31, 2008, compared to $130.1 million or 44.6% in 2007. The increase in savings and money market deposits was due to the success of the Bank's premium rate savings account that attracted new savings customers. NOW accounts totaled $26.0 million or 8.6% and

$28.3 million or 9.7% of total deposits at December 31, 2008 and 2007, respectively. The decrease in NOW accounts is the result of lower balances in mortgage title company accounts. Demand, noninterest bearing accounts totaled $39.1 million or 13.0% of total deposits at December 31, 2008 and $38.1 million or 13.1% at December 31, 2007. Securities sold under agreements to repurchase decreased $0.7 million or 5.2% to $12.6 million at December 31, 2008 compared to $13.3 million at December 31, 2007. Overnight borrowings at December 31, 2008 were zero compared to $4.2 million at December 31, 2007 while long-term borrowings were $40.0 million at December 31, 2008 compared to $20.0 million at December 31, 2007.

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 proceeds of the securities were used to provide funding for future growth and to improve the Company's capital ratios. The current cost of these securities is 4.62%.

The Company's primary uses of funds are for loans and investments. Loans, excluding deferred fees/costs and discounts and the allowance for credit losses, increased by $22.0 million or 8.9% to $268.4 million at December 31, 2008 from $246.3 million a year earlier. Real estate loan balances increased by $14.5 million or 9.2% ,commercial loans increased by $7.3 million or 16.0% and construction loans increased by $3.8 million or 15.5%, while installment and other consumer loans decreased by $3.6 million or 20.2%.

Operating Results

The following discussion outlines some of the more important factors and trends affecting the earnings of the Company as presented in its consolidated statements of income.

Net Interest Income

Net interest income is the difference between interest income and interest expense and is generally affected by increases or decreases in the amount of outstanding interest earning assets and interest bearing liabilities (volume variance). This volume variance coupled with changes in interest rates on these same assets and liabilities (rate variance) equates to the total change in net interest income in any given period. The table on page 15 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).

Net interest income for the year ended December 31, 2008, was $13.0 million, representing an increase of $1.2 million or 10.0% from net interest income of $11.8 million for the year ended December 31, 2007. The increase in net interest income is due primarily to increased average loan and interest bearing deposits with other banks balances and a decrease in the cost of interest bearing deposits. The net interest margin was 3.65% for the year ended December 31, 2008 and 3.59% for the year ended December 31, 2007. Net interest income for 2008 includes $176 thousand of interest collected on a cash basis related to loans on nonaccrual status, compared to $147 thousand of interest collected on nonaccrual loans in 2007.

Rate/Volume Analysis



                                                       2008 vs. 2007                                        2007 vs. 2006

                                       Increase               Due to Change in               Increase              Due to Change in
                                          or                                    Rate/           or                                   Rate/
                                      (Decrease)      Volume        Rate       Volume       (Decrease)      Volume       Rate       Volume
                                                                             (Dollars in thousands)
Interest income on:
Loans                                $       (614 )   $ 1,585     $ (2,019 )   $  (180 )   $      1,764     $ 1,437     $   300     $    27
Investment securities                         289          31          256           2              657         384         243          30
Interest bearing deposits in other
banks                                         247         357           (8 )      (102 )             29          -           -           29
Federal funds sold and other
overnight investments                        (588 )      (119 )       (542 )        73              170         169           1          -

Total interest income                        (666 )     1,854       (2,313 )      (207 )          2,620       1,990         544          86

Interest expense on:
NOW accounts                                  (12 )       (11 )         (1 )        -               (11 )       (13 )         2          -
Money market accounts                      (1,866 )      (726 )     (1,467 )       327              969         616         278          75
Savings accounts                              900       1,047          (70 )       (77 )            885          68         404         413
Certificates of deposit                    (1,044 )      (551 )       (559 )        66              871         231         603          37
Repurchase agreements                        (356 )        46         (374 )       (28 )             91          56          32           3
Short-term borrowing                           (1 )        -            -           (1 )              1          -           -            1
Long-term borrowing                           625         929         (120 )      (184 )           (235 )      (179 )       (70 )        14
Junior subordinated debt                      (97 )        -           (97 )        -                11          -           11          -

Total interest expense                     (1,851 )       734       (2,688 )       103            2,582         779       1,260         543


Net interest income                  $      1,185     $ 1,120     $    375     $  (310 )   $         38     $ 1,211     $  (716 )   $  (457 )

Interest Income

The Company's interest income decreased $666 thousand or 3.0% to $21.8 million for the year ended December 31, 2008 from $22.5 million for the year ended December 31, 2007. The decrease in interest income can be attributed to an increase in average earning assets offset by a decrease in the yield earned on those assets. Average loans increased $20.8 million or 8.9%, while the loan yield decreased to 6.77% for the year ended December 31, 2008 from 7.63% for the year ended December 31, 2007. Contributing to the increase in interest income is an increase in average interest bearing balances with other banks and an improvement in the yield on the securities portfolio. Average interest bearing balances with banks increased in total by $7.8 million or 1245.9%, while the yield on investment securities increased to 5.05% for the year ended December 31, 2008 from 4.77% for the year ended December 31, 2007.

Interest Expense

The Company's interest expense decreased $1.8 million or 17.4% to $8.8 million for 2008, compared to $10.6 million for 2007. The decrease in interest expense for the year ended December 31, 2008 can be attributed primarily to lower interest rates on the Bank's indexed money market accounts, certificates of deposit, repurchase agreement accounts and the junior subordinated debentures. Offsetting these decreases was an increase in the cost of Federal Home Loan Bank borrowings, increasing $625 thousand as the average balance increased $24.2 million to $39.7 million from $15.5 million for the year ended December 31, 2008 compared to the year ended December 31, 2007.

Provision for Credit Losses

The Company recorded a provision for credit losses of $2.4 million for the year ended December 31, 2008 compared to $448 thousand for the year ended December 31, 2007. The increase in provision was primarily the result of an increase in gross loans of $22.0 million, the need to replenish the reserve for net charge-offs and an increase in nonperforming assets. Nonperforming loans at year end increased to $6.5 million for the year ended December 31, 2008 from $1.1 million for the year ended December 31, 2007. Net charge-offs of loans deemed uncollectible totaled $535 thousand for the year ended December 31, 2008 compared to net charge-offs of $141 thousand for the year ended December 31, 2007. The charge-offs were concentrated in the consumer installment loan portfolio (primarily boat loans), one builder spec construction loan and a commercial loan to a retail business that shut down without notice. Where reasonable opportunities exist we are continuing efforts to recover our losses. See the discussion under the heading "Provision for Credit Losses and Credit Risk Management" for greater analysis regarding the Allowance for Credit Losses and related provision.

Noninterest Income

The Company's primary sources of noninterest income are fees charged on deposit products, fees generated by the Bank's VISA

check card program, fees recognized on the origination of brokered residential mortgage loans and rental income from leasing space at the Bank's headquarters building. Noninterest income decreased $78 thousand for the year ended December 31, 2008 to $1.7 million compared to $1.8 million for the year ended December 31, 2007, a decrease of 4.3%. Included in noninterest income for the year ended December 31, 2008 are losses on the disposal of obsolete fixed assets of $7 thousand and losses on the sale of repossessed boats of $24 thousand with no losses of either type for the year ended December 31, 2007. Fees charged on deposit products decreased $29 thousand or 2.3%, while mortgage banking fees totaled $58 thousand for the year ended December 31, 2008, a 7.4% increase from fees of $54 thousand for the year ended December 31, 2007. The Company recorded a gain on the sale of loans in the secondary market of $6 thousand for the year ended December 31, 2008. The Company did not fund mortgage loans sold in the secondary market in 2007. Rental income on the headquarters building totaled $190 thousand for year ended December 31, 2008 compared to $186 thousand for the year ended December 31, 2007.

Noninterest Expense

Noninterest expense increased $835 thousand or 8.8% to $10.3 million for the year ended December 31, 2008, compared to $9.5 million for the year ended December 31, 2007. The increase in noninterest expense was primarily due to increases in personnel expense related to the expansion of the Bank's Business Development Group and higher occupancy costs associated with the Bank's new Annapolis Towne Centre branch and extensive renovations at the Bank's Edgewater branch.

Personnel expense increased $510 thousand or 9.2% to $6.0 million from $5.5 million, with $477 thousand related to additional business development and branch staff, annual salary increases and option expense and $136 thousand related to higher payroll tax and benefit costs. Offsetting these increases was a reduction in the cost of recruiting personnel of $103 thousand.

Occupancy and equipment expense increased $53 thousand or 4.3% due to increased utility costs of $26 thousand, increased amortization and depreciation of property and equipment of $12 thousand, costs associated with the new Annapolis Towne Centre branch of $12 thousand and increased property taxes of $4 thousand.

Marketing expense decreased $65 thousand or 17.0% as cable television advertising was reduced. Data processing expense increased $11 thousand or 1.4% due to account volume and new services such as remote deposit capture. FDIC expense increased $105 thousand for the year ended December 31, 2008 compared to the year ended December 31, 2007 as new rates took effect and a one time assessment credit allocated by the FDIC was used up.

Provision for Income Taxes

The Company and the Bank file consolidated federal income tax returns and separate Maryland income tax returns. The Company recognized $661 thousand and $1.3 million in income tax expense for the years ended December 31, 2008 and 2007, respectively, for an effective tax rate of 31.7% in 2008 and 35.2% in 2007. The decrease in the effective tax rate was due to nontaxable income increasing while income before taxes decreased substantially.

Results of Operations for the Years Ended December 31, 2007 and 2006

Net Income

Net income for the year ended December 31, 2007 totaled $2.4 million, a decrease of $527 thousand or 17.9% from 2006 earnings of $3.0 million. Earnings per diluted share were $0.58 for the year ended December 31, 2007 compared to $0.70 per diluted share for the year ended December 31, 2006.

Operating Results

The following discussion outlines some of the more important factors and trends affecting the earnings of the Company as presented in its consolidated statements of income.

Net Interest Income

Net interest income for the year ended December 31, 2007 was $11.8 million, representing an increase of $38 thousand or 0.3% from net interest income of $11.8 million for the year ended December 31, 2006. The increase in net interest income was due primarily to increased average loan and investment balances.

Interest Income

Interest income increased $2.6 million or 13.2% in 2007 compared to 2006, primarily due to an increase in earning assets and asset

yields as average loans increased $19.2 million or 9.0% in 2007 and loan yields increased to 7.63% for the year ended December 31, 2007 from 7.49% for the year ended December 31, 2006. Average investment securities, including federal funds sold and other overnight investments, increased $12.6 million or 14.9%, while the yield on those same investments increased to 4.81% for the year ended December 31, 2007 from 4.52% for the year ended December 31, 2006.

Interest Expense

Interest expense increased $2.6 million or 32.1% to $10.6 million in 2007 compared to $8.0 million in 2006. The increase in interest expense for the year ended December 31, 2007 can be attributed to higher deposit costs offset by a decrease in the cost of Federal Home Loan Bank borrowings which decreased to 3.84% from 4.19% for the year ended December 31, 2006.

Provision for Credit Losses

The Company recorded a provision for credit losses of $448 thousand for the year ended December 31, 2007 compared to $12 thousand for the year ended December 31, 2006. See the discussion under the heading "Provision for Credit Losses and Credit Risk Management" for greater analysis and the methodology used regarding the Allowance for Credit Losses and related provision.

Noninterest Income

Noninterest income decreased $19 thousand or 1.0% during 2007 remaining at $1.8 million compared to 2006. Included in noninterest income for the year ended December 31, 2006 is a gain of $23 thousand on the prepayment of a Federal Home Loan Bank convertible advance of $5.0 million. Mortgage broker fees decreased $112 thousand for the year ended December 31, 2007. Fees charged on deposit products increased $81 thousand or 6.9%.

Noninterest Expense

Noninterest expense increased $531 thousand or 5.9% to $9.5 million in 2007 from $9.0 million in 2006. The increase in noninterest expense was primarily due to increases in business development staff and higher benefit costs. Occupancy and equipment costs increased $73 thousand for the year ended December 31, 2007 compared to 2006 due to full year costs associated with the new Kent Island and Market House branches.

Provision for Income Taxes

The Company and the Bank file consolidated federal income tax returns and separate Maryland income tax returns. The Company recognized $1.3 million and $1.7 million in income tax expense for the years ended December 31, 2007 and 2006, respectively, for an effective tax rate of 35.2% in 2007 and 37.1% in 2006.

Consolidated Average Balances, Yields and Rates

The following table presents a condensed average balance sheet as well as income/expense and yields/costs of funds thereon for the years ended December 31, 2008, 2007 and 2006. The yields and costs are derived by dividing income or expense by the average balance of assets or liabilities for the periods shown. Average balances are derived from average daily balances. The yields and costs include loan fees that are considered adjustments to yields. Net interest spread, the difference between the average rate on interest bearing assets and the average rate on interest bearing liabilities, increased to 3.28% for the year ended December 31, 2008 from 3.06% at December 31, 2007.

--------------------------------------------------------------------------------
                                                                              Years Ended
                                        December 31, 2008                  December 31, 2007                  December 31, 2006
                                   Average    Interest    Yield/      Average    Interest    Yield/      Average    Interest    Yield/
                                   Balance       (1)       Rate       Balance       (1)       Rate       Balance       (1)       Rate
                                                                         (Dollars in thousands)
Assets
Interest Earning Assets
Federal funds sold and other
overnight investments             $  14,614   $     291     1.99 %   $  17,531   $     879     5.01 %   $  13,648   $     708     5.19 %
Interest bearing balances in
other banks                           8,439         275     3.26 %         627          29     4.63 %          -           -        -
Investment securities                80,694       4,075     5.05 %      79,403       3,785     4.77 %      71,273       3,129     4.39 %
Loans                               253,581      17,159     6.77 %     232,819      17,773     7.63 %     213,640      16,009     7.49 %

Total interest earning assets       357,328      21,800     6.10 %     330,380      22,466     6.80 %     298,561      19,846     6.65 %
Noninterest Earning Assets
Cash and due from banks               5,413                              5,636                              6,205
Other assets                         13,949                             14,061                             13,856

Total Assets                      $ 376,690                          $ 350,077                          $ 318,622


Liabilities and Stockholders'
Equity
Interest Bearing Deposits
NOW accounts                      $  26,145   $      53     0.20 %   $  31,699   $      65     0.21 %   $  37,789   $      76     0.20 %
Money market accounts                62,402       1,396     2.24 %      80,262       3,262     4.06 %      63,270       2,293     3.62 %
Savings accounts                     71,090       1,851     2.60 %      33,842         951     2.81 %      16,750          66     0.39 %
Certificates of deposit              89,799       3,647     4.06 %     101,743       4,692     4.61 %      95,935       3,821     3.98 %
Repurchase agreements                16,749         257     1.53 %      15,590         613     3.93 %      14,084         522     3.71 %
Short-term borrowings                    -           -      0.00 %          13           1     3.87 %          -           -      0.00 %
Long-term borrowings                 39,708       1,229     3.10 %      15,493         603     3.89 %      19,718         838     4.19 %
Junior subordinated debt              5,000         332     6.64 %       5,000         429     8.46 %       5,000         418     8.25 %

Total interest bearing
liabilities                         310,893       8,765     2.82 %     283,642      10,616     3.74 %     252,546       8,034     3.18 %

Noninterest Bearing Liabilities
Demand deposit accounts              37,819                             39,794                             42,714
Other liabilities                     1,577                              1,153                              1,172
Stockholders' Equity                 26,401                             25,488                             22,190

Total Liabilities and
Stockholders' Equity              $ 376,690                          $ 350,077                          $ 318,622


Interest rate spread                                        3.28 %                             3.06 %                             3.47 %
. . .