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 2008 consolidated financial statements which can be found on the Company's Form 10-K. 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 continued 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.

Activity in the allowance for credit losses for the three months ended March 31, 2009 and 2008 is shown below:

(Dollars in thousands)

                                                              2009          2008
  Total loans outstanding - at March 31                     $ 270,718     $ 244,548
  Average loans outstanding year-to-date                      269,308       245,958

  Allowance for credit losses at beginning of period        $   4,123     $   2,283

  Provision charged to expense                                  1,208           121

  Chargeoffs:
  Commercial loans                                                 -              4
  Consumer and other loans                                        178            -

  Total                                                           178             4


  Recoveries:
  Commercial loans                                                 -             -
  Consumer and other loans                                          6             4

  Total                                                             6             4


  Net chargeoffs                                                  172            -

  Allowance for credit losses at end of period              $   5,159     $   2,404


  Allowance for credit losses as a percent of total loans        1.91 %        0.98 %
  Net chargeoffs recoveries as a percent of average loans        0.06 %        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 $11.7 million at March 31, 2009, compared to $6.5 million at December 31, 2008. The percentage of nonperforming loans to total loans was 4.32% at March 31, 2009, compared to 2.42% at December 31, 2008.

The Company is continuing to experience weaknesses in its residential construction, home equity, commercial mortgage, and one-to-four family residential loan portfolios as loan delinquencies increase and the potential for foreclosures increases. General downward economic trends and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit (especially its boat loan portfolio), resulting in additional write-downs and loans placed on nonaccrual. At March 31, 2009, $8.6 million in loans were classified as nonaccrual compared to $4.3 million at December 31, 2008. Nearly half of the quarter-end nonaccrual total consisted of loans to two builder developers and one residential mortgage loan where the borrower was tragically killed in an accident.

The Company continues to monitor and modify its allowance for credit losses as conditions dictate. While management believes that, based on information currently available, the Company's allowance for credit losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurances can be given that the Company's level of allowance for credit losses will be sufficient to cover future loan losses incurred by the Company or that future adjustments to the allowance for credit losses will not be necessary if economic and other conditions differ substantially from economic and other conditions at the time management determined the current level of the allowance for credit losses. Management may in the future increase the level of the allowance as its loan portfolio increases or as circumstances dictate.

Comparison of Financial Condition at March 31, 2009 and December 31, 2008

Total assets at March 31, 2009 were $469.6 million, an increase of $74.7 million or 18.9% from total assets at December 31, 2008 of $394.9 million. The increase in total assets was due to the success of the Company's Superior Savings deposit campaign that raised nearly $70 million in new deposits. The excess liquidity derived from the campaign resulted in the increases in interest bearing deposits with banks, federal funds sold and other overnight investments and investment securities available for sale. Investment securities available for sale increased $24.0 million or 28.7% increasing to $107.7 million from $83.7 million, while federal funds sold increased to $46.7 million from $23.8 an increase of $22.9 million or 96.6%. Interest-bearing deposits with banks increased to $21.0 million from $1.0 million at December 31, 2008.

Gross loans at March 31, 2009 were $270.7 million, up $2.5 million from $268.2 million at December 31, 2008, an increase of 0.93%. The change resulted from increased mortgage activity with mortgage loans held for sale balances increasing by $1.2 million. Construction loan balances also increased rising $2.1 million or 7.5% compared to December 31, 2008. Decreases in installment loan balances, as repossessed boats were moved to other assets and adjustable rate mortgages as loans were refinanced, offset the increases in construction loans and loans held for sale.

The allowance for credit losses increased $1.0 million rising to $5.2 million at March 31, 2009 compared to $4.1 million at December 31, 2008. The increase in the allowance is attributed to the addition of a provision for credit losses of $1.2 million offset by net charge-offs of loans deemed uncollectible of $172,000. The Company recorded charge-offs of $178,000 for the quarter and received recoveries of $6,000 for the three months ended March 31, 2009. 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 March 31, 2009 and December 31, 2008, the allowance for credit losses to total loans was 1.91% and 1.54%, respectively. Nonperforming assets as of March 31, 2009 and December 31, 2008 were $11.7 million and $6.5 million, respectively.

Deposits of $368.8 million at March 31, 2009 compared to deposits of $300.6 million at December 31, 2008 represent an increase of $68.2 million or 22.7%. The increase was the result of the success of the Superior Savings campaign as savings deposits increased $68.6 million. Money market account balances decreased $3.7 million or 7.34% from December 31, 2008 to March 31, 2009 while certificates of deposit increased $4.4 million or 4.8% over the same period.

Long-term borrowings consisting of Federal Home Loan Bank ("FHLB") borrowings totaled $40.0 million at March 31, 2009 and December 31, 2008. All $40.0 million in borrowings were made under the FHLB of Atlanta's convertible advance program with an average remaining life of 3.88 years to maturity and 0.34 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 4.38%. The capital securities are scheduled to mature on March 26, 2033. The capital securities are now callable on a quarterly basis.

On January 30, 2009, the Company sold 8,152 shares of the Company's Fixed Rate Cumulative Preferred Stock, Series A (the "Series A Preferred Stock"), having a liquidation amount per share equal to $1,000, and a warrant to purchase 299,706 shares of the Company's common stock, at an exercise price of $4.08 per share, to the U. S. Treasury under the Troubled Asset Relief Program ("TARP") Capital Purchase Program ("CPP") for a total purchase price of $8,152,000.

Comparison of Operating Results for the Three Months Ended March 31, 2009 and 2008.

General. The Company recorded a loss of $450,000 for the three months ended March 31, 2009 or ($0.14) per basic and diluted common share, compared to net income of $525,000, or $0.13 per basic and $0.13 per diluted common share, for the three months ended March 31, 2008 due to an increase in the provision for credit losses. Net interest income decreased by $201,000 or 6.4% for the three months ended March 31, 2009 compared to the same in period in 2008 while noninterest income improved by $16,000, a 3.7% increase. Noninterest expense increased $265,000 or 10.1%. The Bank recorded $1.2 million in provision for credit losses during the three months ended March 31, 2009, compared to $121,000 in provision for credit losses during the same period in 2008.

Interest Income. Interest income decreased $649,000 or 11.5% for the quarter ended March 31, 2009 compared to the same quarter in 2008 as a result of lower loan, federal funds sold and interest bearing deposits with bank yields. Average loan balances increased $23.3 million for the three months ended March 31, 2009 over average loan balances for the three months ended March 31, 2008 but were offset by a drop in loan yield due to numerous Federal Reserve interest rate reductions. The yield on the loan portfolio fell to 5.91% for the three months ended March 31, 2009 from 7.29% for the three months ended March 31, 2008. Total investment income decreased $119,000 for the quarter ended March 31, 2009 compared to the same period in 2008 despite an increase in the yield on investment securities, to 4.95% from 4.90%. The yield on federal funds sold dropped to 0.21% from 2.96% for the quarter ended March 31, 2009 compared to the quarter ended March 31, 2008.

Interest Expense. Interest expense decreased by $448,000 or 17.9% for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 despite the increase of $44.8 million in average interest-bearing deposit balances. Interest expense on interest-bearing deposits for the quarter ended March 31, 2009 was $1.7 million compared to $2.0 million for the same period in 2008, an 18.2% decrease. The decrease was the result of lowering the cost of money market accounts to 1.03% from 3.05% and the cost of certificates of deposit to 3.20% from 4.60%. The total cost of interest-bearing liabilities decreased for the quarter ended March 31, 2009 to 2.37% from 3.32% for the quarter ended March 31, 2008. The Company's overall cost of funds decreased to 2.15% from 2.96% for the same period. Interest expense on long-term borrowings and junior subordinated debentures was $363,000 for the three months ended March 31, 2009 compared to $367,000 for the three months ended March 31, 2008.

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 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)



                                                          Quarter Ended March 31, 2009 vs. 2008
                                                                              Due to Change in
                                                 Increase or                                       Rate/
                                                 (Decrease)          Volume           Rate        Volume
Interest income on:
Loans                                           $        (530 )     $     423       $   (871 )    $   (82 )
Investment securities                                      64              62              2           -
Interest bearing deposits in other banks                  (99 )            36           (101 )        (34 )
Federal funds sold and other overnight
investments                                               (84 )           166            (97 )       (153 )

Total interest income                                    (649 )           687         (1,067 )       (269 )

Interest expense on:
NOW accounts                                               -               -              -            -
Money market accounts                                    (488 )          (248 )         (404 )        164
Savings accounts                                          448             558            (41 )        (69 )
Certificates of deposit                                  (332 )             7           (337 )         (2 )
Repurchase agreements                                     (72 )           (15 )          (67 )         10
Long-term borrowing                                        38              46             (7 )         (1 )
Junior subordinated debt                                  (42 )            -             (42 )         -

Total interest expense                                   (448 )           348           (898 )        102


Net interest income                             $        (201 )     $     339       $   (169 )    $  (371 )

Consolidated Average Balances, Yields and Rates



(Balances in thousands)                                       Three Month Periods Ended
                                                 March 31, 2009                      March 31, 2008
                                          Average     Interest    Yield/      Average     Interest    Yield/
                                          Balance       (1)        Rate       Balance       (1)        Rate
Assets
Interest Earning Assets
Federal funds sold and other overnight
investments                              $  42,675   $       22     0.21 %   $  14,396   $      106     2.96 %
Interest bearing deposits in other
banks                                        5,445            7     0.52 %      10,731          107     4.01 %
Investment securities                       84,368        1,030     4.95 %      79,245          965     4.90 %
Loans                                      269,308        3,927     5.91 %     245,958        4,457     7.29 %

Total interest earning assets              401,796        4,986     5.03 %     350,330        5,635     6.47 %
Noninterest Earning Assets
Cash and due from banks                      6,808                               6,009
Other assets                                13,536                              13,660

Total Assets                             $ 422,140                           $ 369,999


Liabilities and Stockholders' Equity
Interest Bearing Deposits
NOW accounts                             $  25,525   $       13     0.21 %   $  27,151   $       13     0.19 %
Money market accounts                       47,839          122     1.03 %      80,558          610     3.05 %
Savings accounts                           125,220          780     2.53 %      46,783          332     2.85 %
Certificates of deposit                     96,177          759     3.20 %      95,454        1,091     4.60 %
Repurchase agreements                       12,590           24     0.77 %      14,898           96     2.59 %
Long-term borrowings                        40,000          306     3.10 %      34,139          268     3.11 %
Junior subordinated debt                     5,000           57     4.62 %       5,000           99     7.83 %

Total interest bearing liabilities         352,351        2,061     2.37 %     303,983        2,509     3.32 %

Noninterest Bearing Liabilities
Demand deposit accounts                     36,357                              37,324
Other liabilities                            1,616                               1,233
Stockholders' Equity                        31,816                              27,459

Total Liabilities and Stockholders'
Equity                                   $ 422,140                           $ 369,999


Interest rate spread                                                2.66 %                              3.15 %
Ratio of interest earning assets to
interest bearing liabilities                                      114.03 %                            115.25 %
Net interest income and net interest
margin                                               $    2,925     2.95 %               $    3,126     3.59 %

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

Net interest income decreased by $201,000 or 6.4% for the three months ended March 31, 2009 compared to the three months ended March 31, 2008. The decrease was due to the drop in yield on the loan portfolio from 7.29% to 5.91% and the impact of the volume of new interest-bearing deposit balances.

For the three months ended March 31, 2009, the net interest margin decreased to 2.95% compared to 3.59% for the three months ended March 31, 2008, with the interest rate spread for the same period falling to 2.66% from 3.15%. The decrease in net interest margin for the quarter ended March 31, 2009 was the result of a drop in the yield on interest earning assets to 5.03% from 6.47% for the quarter ended March 31, 2008.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $1.2 million for the three months ended March 31, 2009 compared to $121,000 for the same period in 2008. The increase in the provision was due to an increase in nonperforming loan balances and risk rating downgrades to certain loans in the Company's portfolio. The Bank

recorded net charge-offs of $172,000 for the quarter ended March 31, 2009 compared to a net recovery of less than $1 thousand for the quarter ended March 31, 2008.

Noninterest Income. Noninterest income increased by $16,000 or 3.7% to $450,000 for the three months ended March 31, 2009 from $434,000 for the same period of 2008. The improvement in noninterest income was due to gains recognized on the sale of loans held for sale of $16,000.

Noninterest Expense. Noninterest expense increased by $265,000 or 10.1% for the three months ended March 31, 2009 compared to the same quarter in 2008. The increase in noninterest expense was primarily due to increased personnel costs of $71,000, occupancy and equipment expense of $69,000 and other expenses of $89,000. The increases in personnel expense and occupancy and equipment expense are due to opening a new branch in the fourth quarter of 2008. There were no costs associated with the new branch in the quarter ended March 31, 2008. Other operating expense increased $90,000 for the quarter ended March 31, 2009 compared to the quarter ended March 31, 2008 and included an increase of $44,000 in FDIC insurance expense and $20,000 in costs incurred relating to the Company's repossessed assets.

Income Tax Expense. The Company recorded a current tax benefit for the three-month period ended March 31, 2009 of $268,000. This amount includes $248,000 of federal and $20,000 of state income tax benefits. The Company's combined effective federal and state income tax rate was approximately 37.3% for the three months ended March 31, 2009 versus 35.8% for the three months ended March 31, 2008.

Liquidity

Liquidity is the capacity to change the nominal level and mix of assets or liabilities, for any purpose, quickly and economically. Poor or inadequate liquidity risk management could result in a critical situation in which the Bank would be unable to meet deposit withdrawal or loan funding requests from its customers. Either situation could potentially harm both the profits and reputation of the Bank.

The Company's major source of liquidity is its deposit base. At March 31, 2009, total deposits were $368.8 million. Core deposits, considered to be stable funding sources and defined as all deposits except time deposits totaled $271.9 million or 73.7% of total deposits. Liquidity is also provided through the Company's overnight investment in federal funds sold, interest-bearing deposits with banks as well as securities available-for-sale and investment securities with maturities less than one year. At March 31, 2009, interest-bearing deposits with banks, federal funds sold and other overnight investments totaled $67.7 million while investment securities available-for-sale totaled $107.7 million.

In addition, the Bank has external sources of funds, which can be used as . . .