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.

Forward-Looking Information
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.

Introduction
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".

Shore Bancshares, Inc. maintains an Internet site at www.shbi.net on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

Critical Accounting Policies
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.

RECENT DEVELOPMENTS

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.

OVERVIEW

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.

RESULTS OF OPERATIONS

Net Interest Income
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.

Analysis of Interest Rates and Interest Differentials 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.

                                   For the Three Months Ended                      For the Three Months Ended
                                          June 30, 2009                                   June 30, 2008
                             Average        Income(1)/        Yield/         Average        Income(1)/        Yield/
(Dollars in thousands)       Balance         Expense           Rate          Balance         Expense           Rate
Earning assets
Loans (2), (3)             $   913,671     $     13,795           6.06 %   $   822,781     $     14,003           6.85 %
Investment securities
Taxable                         75,277              768           4.09          83,654              945           4.54
Tax-exempt                       8,110              122           6.02          11,200              167           6.01
Federal funds sold              55,699               23           0.16          15,194               83           2.21
Interest bearing
deposits                         8,129                6           0.33           5,812               29           2.01
Total earning assets         1,060,886           14,714           5.56 %       938,641           15,227           6.53 %
Cash and due from banks         18,705                                          16,618
Other assets                    51,595                                          50,315
Allowance for credit
losses                         (10,848 )                                        (8,102 )
Total assets               $ 1,120,338                                     $   997,472

Interest bearing
liabilities
Demand deposits            $   125,076               76           0.24 %   $   109,716               95           0.35 %
Money market and savings
deposits                       222,825              351           0.63         183,392              659           1.45
Certificates of deposit
$100,000 or more               245,210            1,954           3.20         183,108            1,940           4.26
Other time deposits            239,668            2,060           3.45         219,250            2,303           4.23
Interest bearing
deposits                       832,779            4,441           2.14         695,466            4,997           2.89
Short-term borrowings           25,435               28           0.45          45,354              316           2.80
Long-term debt                   7,947               75           3.78          15,101              182           4.85
Total interest bearing
liabilities                    866,161            4,544           2.10 %       755,921            5,495           2.92 %
Noninterest bearing
deposits                       109,652                                         106,035
Other liabilities               11,918                                          11,686
Stockholders' equity           132,607                                         123,830
Total liabilities and
stockholders' equity       $ 1,120,338                                     $   997,472

Net interest spread                        $     10,170           3.46 %                   $      9,732           3.61 %
Net interest margin                                               3.85 %                                          4.17 %

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

                                    For the Six Months Ended                       For the Six Months Ended
                                          June 30, 2009                                  June 30, 2008
                             Average        Income(1)/        Yield/        Average       Income(1)/        Yield/
(Dollars in thousands)       Balance         Expense           Rate         Balance        Expense           Rate
Earning assets
Loans (2), (3)             $   906,066     $     27,455           6.11 %   $ 809,815     $     28,604           7.10 %
Investment securities
Taxable                         75,067            1,524           4.09        87,638            2,025           4.65
Tax-exempt                       8,605              253           5.92        11,938              357           6.01
Federal funds sold              38,873               30           0.15        15,856              205           2.61
Interest bearing
deposits                         5,298                7           0.28         5,013               67           2.69
Total earning assets         1,033,909           29,269           5.71 %     930,260           31,258           6.76 %
Cash and due from banks         15,395                                        16,482
Other assets                    50,487                                        50,855
Allowance for credit
losses                         (10,259 )                                      (7,909 )
Total assets               $ 1,089,532                                     $ 989,688

Interest bearing
liabilities
Demand deposits            $   123,104              148           0.24 %   $ 112,465              266           0.48 %
Money market and savings
deposits                       188,165              525           0.56       179,378            1,364           1.53
Certificates of deposit
$100,000 or more               241,997            3,966           3.30       181,831            4,010           4.44
Other time deposits            236,077            4,087           3.50       218,323            4,700           4.33
Interest bearing
deposits                       789,343            8,726           2.23       691,997           10,340           3.00
Short-term borrowings           32,469               77           0.48        44,354              682           3.09
Long-term debt                   7,947              149           3.78        15,013              366           4.90
Total interest bearing
liabilities                    829,759            8,952           2.18 %     751,364           11,388           3.05 %
Noninterest bearing
deposits                       106,968                                       103,508
Other liabilities               11,304                                        11,642
Stockholders' equity           141,501                                       123,174
Total liabilities and
stockholders' equity       $ 1,089,532                                     $ 989,688

Net interest spread                        $     20,317           3.53 %                 $     19,870           3.71 %
Net interest margin                                               3.96 %                                        4.30 %

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 35% exclusive of the alternative minimum tax rate and nondeductible interest expense.

(2) Average loan balances include nonaccrual loans.

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

Noninterest Income
Noninterest income for the second quarter of 2009 increased $153 thousand, or 2.9%, when compared to the second quarter of 2008. Included in other noninterest income was a $420 thousand mark-to-market gain on interest rate swaps. This was partially offset by a reduction in insurance agency commissions of $326 thousand. Noninterest income for the second quarter of 2009 remained relatively unchanged when compared to the first quarter of 2009.

Noninterest income for both the first six months of 2009 and 2008 was $10.7 million. The increase in other noninterest income, which included the $420 thousand mark-to-market gain on interest rate swaps, was mainly offset by decreases in insurance agency commissions.

Noninterest Expense
Noninterest expense for the second quarter of 2009 increased $964 thousand, or 9.9%, when compared to the second quarter of 2008. The increase was primarily attributable to higher FDIC insurance premiums of $860 thousand and increased salaries of $191 thousand. The second quarter 2009 FDIC insurance premium included a special one-time assessment of $513 thousand. Noninterest expense increased $810 thousand, or 8.2%, from the first quarter of 2009 primarily due to higher FDIC insurance premiums of $676 thousand.

Noninterest expense for the first six months of 2009 increased $1.3 million, or 6.5%, when compared to the first six months of 2008. The increase was primarily attributable to higher FDIC insurance premiums of $1.1 million and increased salaries of $124 thousand.

Income Taxes
The effective tax rate was 38.1% for the three months ended June 30, 2009, compared to 38.3% for the same period last year. For the six months ended June 30, 2009 and 2008, the effective tax rates were 38.2% and 38.4%, respectively. Management believes that currently there are no additional changes in tax laws or to our tax structure that are likely to have a material impact on our future effective tax rate.

ANALYSIS OF FINANCIAL CONDITION

Loans
Loans, net of unearned income, totaled $919.1 million at June 30, 2009, an increase of $30.6 million, or 3.4%, since December 31, 2008. Average loans, net of unearned income, were $913.7 million for the three months ended June 30, 2009, an increase of $90.9 million, or 11.1%, when compared to the same period last year. Average loans, net of unearned income, were $906.1 million for the six months ended June 30, 2009, an increase of $96.3 million, or 11.9%, when compared to the same period in 2008.

Allowance for Credit Losses
We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts. The allowance is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based upon this analysis. The evaluation of the adequacy of the allowance for credit losses is based on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans based on factors such as past credit loss experience, local economic trends, nonperforming and problem loans, and other factors which may impact collectibility. A loan is placed on nonaccrual when it is specifically determined to be impaired and principal and interest is delinquent for 90 days or more. Please refer to the discussion above . . .