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) ASC Topic 450, "Contingencies", which requires that losses be accrued when they are probable of occurring and estimable, and
(ii) ASC Topic 310, "Receivables", 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.

OVERVIEW

Net income for the third quarter of 2009 was $1.951 million, or diluted earnings per common share of $0.23, compared to $3.1 million, or diluted earnings per common share of $0.37, for the third quarter of 2008. For the second quarter of 2009, net income was $354 thousand or $0.04 diluted earnings per common share. Annualized return on average assets was 0.66% for the three months ended September 30, 2009, compared to 1.19% for the same period in 2008. Annualized return on average stockholders' equity was 6.03% for the third quarter of 2009, compared to 9.81% for the third quarter of 2008. For the second quarter of 2009, annualized return on average assets was 0.13% and return on average equity was 1.07%.

Net income for the first nine months of 2009 was $4.2 million, or diluted earnings per common share of $0.50, compared to $9.2 million, or diluted earnings per common share of $1.10, for the first nine months of 2008. Annualized return on average assets was 0.50% for the nine months ended September 30, 2009, compared to 1.23% for the same period in 2008. Annualized return on average stockholders' equity was 4.08% for the first nine months of 2009, compared to 9.95% for the first nine months of 2008.

During the first nine months of 2009, net income available to common stockholders was negatively impacted by $1.9 million in 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. These dividends and discount accretion had no impact on net income available to common stockholders for the third quarter of 2009.

RESULTS OF OPERATIONS

Net Interest Income
Net interest income for the three months ended September 30, 2009 was $10.4 million, an increase of 5.2% 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 3.79% for the third quarter of 2009, a decrease of 31 basis points when compared to the third 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 3.4% from the second quarter of 2009, also due to a higher volume of average earning assets and lower rates paid partially offset by lower yields earned. The net interest margin decreased six basis points from 3.85% for the second quarter of 2009.

Interest income was $14.9 million for the third quarter of 2009, a decrease of 2.5% from the third quarter of 2008. Average earning assets increased 13.3% during the third quarter of 2009 when compared to the same period in 2008, while yields earned decreased 89 basis points to 5.41%. Average loans increased 7.7% while the yield earned on loans decreased 57 basis points. Loans comprised 83.6% of total average earning assets for the third quarter of 2009, a decrease from the 87.9% for the third quarter of 2008. The mix of earning assets shifted from loans and securities to Federal funds sold which comprised 7.4% of total earning assets compared to 1.8% for the third quarter of 2008. Interest income increased 1.9% when compared to the second quarter of 2009. Average earning assets increased 3.7% during the third quarter of 2009 when compared to the second quarter of 2009, while yields earned decreased 15 basis points.

Interest expense decreased 16.8% for the three months ended September 30, 2009 when compared to the same period last year. Average interest bearing liabilities increased 15.8%, while rates paid decreased 78 basis points to 1.97%. During the second quarter of 2009, the Company began to participate in the Promontory Insured Network Deposits Program ("IND"). The $165.0 million increase in average interest bearing deposits for the third quarter of 2009 over the same period of 2008 included approximately $88.9 million from the IND program. The Company incurs the largest amount of interest expense from time deposits. For the three months ended September 30, 2009, the average balance of certificates of deposit $100,000 or more increased 39.5% when compared to the same period last year, while the average rate paid on these certificates of deposit decreased 113 basis points to 2.82%. Comparing the third quarter of 2009 to the third quarter of 2008, average other time deposits increased 5.2% while the rate paid on average other time deposits decreased 73 basis points. Comparing the third quarter of 2009 to the second quarter of 2009, interest expense decreased 1.3% and average interest bearing liabilities increased 4.3%, while rates paid decreased 13 basis points. Average interest bearing deposits for the third quarter of 2009 included approximately $88.9 million from the IND program, compared to approximately $60.6 million for the second quarter of 2009.

Net interest income for the nine months ended September 30, 2009 was $30.6 million, an increase of 3.4% 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 3.90% for the first nine months of 2009, a decrease of 31 basis points when compared to the first nine months of 2008.

Interest income was $44.0 million for the first nine months of 2009, a decrease of 5.0% from the first nine months of 2008. Average earning assets increased 11.7% during the nine months ended September 30, 2009 when compared to the same period in 2008, while yields earned decreased 99 basis points to 5.60%. Comparing the nine months ended September 30, 2009 to the same period of last year, average loans increased 10.4% while the yield earned on loans decreased 85 basis points. Loans comprised 86.2% and 87.2% of total average earning assets for the first nine months of 2009 and 2008, respectively.

Interest expense decreased 19.9% for the nine months ended September 30, 2009 when compared to the same period last year. Average interest bearing liabilities increased 12.3%, while rates paid decreased 84 basis points to 2.10%. For the nine months ended September 30, 2009, the average balance of certificates of deposit $100,000 or more increased 35.4% when compared to the same period last year, while the average rate paid on these certificates of deposit decreased 113 basis points to 3.13%. Average other time deposits increased 6.8%, while the rate paid on average other time deposits decreased 79 basis points when compared to the first nine 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 September 30, 2009 and 2008.

                                   For the Three Months Ended                     For the Three Months Ended
                                       September 30, 2009                             September 30, 2008
                             Average        Income(1)/       Yield/         Average        Income(1)/        Yield/
(Dollars in thousands)       Balance         Expense          Rate          Balance         Expense           Rate
Earning assets
Loans (2), (3)             $   920,241     $     14,042          6.05 %   $   854,371     $     14,225           6.62 %
Investment securities
Taxable                         89,101              800          3.56          84,713              924           4.34
Tax-exempt                       8,125              118          5.76          10,320              145           5.63
Federal funds sold              81,466               31          0.16          17,921               79           1.74
Interest bearing
deposits                         1,605                4          0.77           4,218               21           2.01
Total earning assets         1,100,538           14,995          5.41 %       971,543           15,394           6.30 %
Cash and due from banks         20,042                                         14,306
Other assets                    57,049                                         50,358
Allowance for credit
losses                         (11,042 )                                       (8,468 )
Total assets               $ 1,166,587                                    $ 1,027,739

Interest bearing
liabilities
Demand deposits            $   125,233               82          0.26 %   $   112,000               97           0.34 %
Money market and savings
deposits                       245,801              412          0.67         183,408              673           1.46
Certificates of deposit
$100,000 or more               274,580            1,954          2.82         196,810            1,953           3.95
Other time deposits            237,757            1,920          3.20         226,110            2,232           3.93
Interest bearing
deposits                       883,371            4,368          1.96         718,328            4,955           2.74
Short-term borrowings           18,373               19          0.42          53,450              344           2.56
Long-term debt                   1,947               98         19.90           8,485               90           4.21
Total interest bearing
liabilities                    903,691            4,485          1.97 %       780,263            5,389           2.75 %
Noninterest bearing
deposits                       117,933                                        111,915
Other liabilities               16,554                                         10,978
Stockholders' equity           128,409                                        124,583
Total liabilities and
stockholders' equity       $ 1,166,587                                    $ 1,027,739

Net interest spread                        $     10,510          3.44 %                   $     10,005           3.55 %
Net interest margin                                              3.79 %                                          4.10 %

Tax-equivalent
adjustment
Investment securities                      $         41                                   $         50
Loans                                                41                                             46
                                           $         82                                   $         96

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

                                    For the Nine Months Ended                       For the Nine Months Ended
                                       September 30, 2009                              September 30, 2008
                             Average        Income(1)/        Yield/         Average        Income(1)/        Yield/
(Dollars in thousands)       Balance         Expense           Rate          Balance         Expense           Rate
Earning assets
Loans (2), (3)             $   910,842     $     41,497           6.09 %   $   824,775     $     42,829           6.94 %
Investment securities
Taxable                         79,797            2,324           3.89          86,633            2,949           4.55
Tax-exempt                       8,443              371           5.87          11,395              502           5.89
Federal funds sold              53,227               61           0.15          17,893              284           2.12
Interest bearing
deposits                         4,053               11           0.35           4,746               88           2.49
Total earning assets         1,056,362           44,264           5.60 %       945,442           46,652           6.59 %
Cash and due from banks         16,960                                          14,408
Other assets                    52,700                                          50,690
Allowance for credit
losses                         (10,523 )                                        (8,097 )
Total assets               $ 1,115,499                                     $ 1,002,443

Interest bearing
liabilities
Demand deposits            $   123,821              230           0.25 %   $   112,309              363           0.43 %
Money market and savings
deposits                       207,588              937           0.60         180,087            2,032           1.51
Certificates of deposit
$100,000 or more               252,978            5,920           3.13         186,879            5,963           4.26
Other time deposits            236,643            6,007           3.39         221,564            6,937           4.18
Interest bearing
deposits                       821,030           13,094           2.13         700,839           15,295           2.92
Short-term borrowings           27,718               96           0.46          47,409            1,026           2.89
Long-term debt                   5,925              247           5.57          12,821              456           4.75
Total interest bearing
liabilities                    854,673           13,437           2.10 %       761,069           16,777           2.94 %
Noninterest bearing
deposits                       110,663                                         106,328
Other liabilities               13,074                                          11,419
Stockholders' equity           137,089                                         123,627
Total liabilities and
stockholders' equity       $ 1,115,499                                     $ 1,002,443

Net interest spread                        $     30,827           3.50 %                   $     29,875           3.65 %
Net interest margin                                               3.90 %                                          4.22 %

Tax-equivalent
adjustment
Investment securities                      $        130                                    $        175
Loans                                               125                                             129
                                           $        255                                    $        304

(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 third quarter of 2009 decreased $527 thousand, or 10.0%, when compared to the third quarter of 2008. The decrease from the third quarter of 2008 was primarily due to a $1.3 million gain on the sale of a bank branch in August 2008. The gain on the branch sale was partially offset by a $371 thousand other than temporary impairment of Freddie Mac Preferred Stock and a $337 thousand loss on the sale of the Company's investment in Delmarva Bank Data Processing Center, Inc., an unconsolidated subsidiary. A mark to market gain on interest rate swaps of $420 thousand during the second quarter of 2009 and a decrease in insurance agency commissions of $149 thousand accounted for most of the decrease from the second quarter of 2009.

Noninterest income for the first nine months of 2009 decreased $526 thousand, or 3.3%, when compared to the same period in 2008. The mark to market gain on interest rate swaps of $420 thousand during the second quarter of 2009, offset by a decrease in insurance agency commissions of $623 thousand, accounted for part of the decrease compared to the first nine months of 2008. In addition, noninterest income for the first nine months in 2008 included the previously mentioned $1.3 million gain on the branch sale and the $708 thousand combined loss relating to the other than temporary impairment and the sale of the investment in the unconsolidated subsidiary.

Noninterest Expense
Noninterest expense for the third quarter of 2009 increased $868 thousand, or 9.2%, when compared to the third quarter of 2008. The increase was primarily attributable to higher FDIC insurance premiums of $323 thousand and write-downs of other real estate owned of $159 thousand. Noninterest expense decreased $396 thousand, or 3.7%, from the second quarter of 2009 primarily due to lower FDIC insurance premiums of $462 thousand. The second quarter 2009 FDIC insurance premium included a special one-time assessment of $513 thousand.

Noninterest expense for the first nine months of 2009 increased $2.1 million, or 7.4%, when compared to the first nine months of 2008. The increase was primarily attributable to higher FDIC insurance premiums of $1.4 million. The increase in FDIC insurance premiums was attributable to higher overall rates, a one-time special assessment of $513 thousand and growth in the Company's total deposits.

Income Taxes
The Company's effective tax rate was 38.0% for the three months ended September 30, 2009, compared to 36.7% for the same period last year. For the nine months ended September 30, 2009 and 2008, the effective tax rates were 38.2% and 37.8%, respectively. Management is not aware of any development with respect to tax law or our tax structure that is likely to have a material impact on our future effective tax rate.

ANALYSIS OF FINANCIAL CONDITION

Loans
Loans, net of unearned income, totaled $918.6 million at September 30, 2009, an increase of $30.1 million, or 3.4%, since December 31, 2008. Average loans, net of unearned income, were $920.2 million for the three months ended September 30, 2009, an increase of $65.9 million, or 7.7%, when compared to the same period last year. Average loans, net of unearned income, were $910.8 million for the nine months ended September 30, 2009, an increase of $86.1 million, or 10.4%, 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 . . .