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 and recent accounting provisions adopted have been presented herein in Note I. 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 FASB guidance on "Accounting for Contingencies," and "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.

During the third quarter of 2009, management moved a $4.8 million commercial loan secured by a first lien on the assets of two operating restaurants to nonaccrual status. At origination, in addition to the first lien on the restaurants, a blanket lien on two life insurance policies with a cash surrender value of $7.5 million was presented as collateral. On May 13, 2009, Management discovered the life insurance policies were fraudulent. As of September 30, 2009, the restaurants continue to operate and payments on the outstanding loan balance of $4.6 million continue to be made under the terms of a forbearance agreement, and will be recognized by the Bank on a cash basis pending further developments. Management is evaluating the loan's collateral position and various collection options, including but not limited to, selling the restaurants that collateralize the loan or transferring the loan to individuals who could continue to operate the restaurants and make payments on the loan.

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 nine months ended September 30, 2009 and 2008 is shown below:

                                                              For the Nine Months
                                                              Ended September 30,
(dollars in thousands)                                        2009           2008
Total loans outstanding - at September 30(1)                $ 279,144      $ 260,368
Average loans outstanding year-to-date                        271,843        249,962

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

Provision charged to expense                                    6,113          1,419

Chargeoffs:
Commercial loans                                                  369            156
Real estate and construction                                      168             42
Consumer and other loans                                          715             -

Total                                                           1,252            198

Recoveries:
Commercial loans                                                   95             -
Consumer and other loans                                           13             17

Total                                                             108             17


Net chargeoffs                                                  1,144            181

Allowance for credit losses at end of year                  $   9,092      $   3,521


Allowance for credit losses as a percent of total loans          3.26 %         1.35 %
Net chargeoffs (recoveries) as a percent of average loans        0.42 %         0.07 %

(1) Includes loans held for sale.

The Company's nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, loans with repossessed collateral and repossessed assets, totaled $16.2 million at September 30, 2009, compared to $6.5 million at December 31, 2008. The percentage of nonperforming assets to total loans was 5.80% at September 30, 2009, compared to 2.42% at December 31, 2008. This increase in nonperforming assets is principally attributable to the transfer of one commercial loan with a remaining balance of $4.6 million to nonaccrual status.

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 September 30, 2009, $16.2 million in loans were classified as nonperforming compared to $6.5 million at December 31, 2008. The $16.2 million in nonperforming loans at September 30, 2009 included $15.6 million in nonaccrual loans, $278,000 in loans delinquent 90 days or more and $345,000 in other assets. Of the $15.9 in nonaccrual and loans delinquent 90 days or more at September 30, 2009 $8.0 million were secured by real estate, $7.6 million were commercial loans and $600,000 were consumer and other loans. At December 31, 2008 loans classified as nonperforming totaled $6.5 million and consisted of $4.3 million in nonaccrual loans, $2.0 million in loans delinquent 90 days or more and $182,000 in other assets. Included in the $6.3 million of nonaccrual and loans delinquent 90 days or more was $5.4 million of loans secured by real estate, $600,000 of consumer and other loans and $300,000 of commercial loans.

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 September 30, 2009 and December 31, 2008

Total assets at September 30, 2009 were $445.5 million, an increase of $50.6 million or 12.8% from total assets at December 31, 2008 of $394.9 million. The increase in total assets was due to the Company's Superior Savings deposit campaign that raised $45.7 million in net new deposits through the first nine months of 2009. The excess liquidity derived from the campaign resulted in the increase in interest bearing deposits with banks and investment securities available for sale. Federal funds sold balances decreased $8.1 million or 34.2% as funds were moved in higher yielding investment securities and interest bearing deposits with banks. Investment securities available for sale increased $41.7 million or 49.8% increasing to $125.3 million at September 30, 2009 from $83.7 million at

December 31, 2008, while interest bearing deposit with banks increased to $7.0 million from $1.0 million at December 31, 2008. The returns on federal funds sold, interest bearing balances with banks, and the overall investment portfolio were also negatively impacted by the lower rate environment as re-investment rates have fallen considerably year-over-year.

Gross loans at September 30, 2009 were $279.1 million, an increase of $10.9 million or 4.1% from gross loans of $268.2 million at December 31, 2008. The increase resulted from net additions to construction loans of $9.1 million, commercial loans of $4.2 million and loans held for sale of $0.2 million offset by decreases in real estate loans of $1.7 million and consumer loans of $0.9 million. The decrease in real estate loans was the result of adjustable rate mortgages refinanced outside of the Bank.

The allowance for credit losses increased $5.0 million rising to $9.1 million at September 30, 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 $6.1 million and the impact on the allowance of net charge-offs of $1.1 million. The Company recorded the significant increase in the allowance for credit losses to provide for the deterioration of the Company's loan portfolio primarily related to the reclassification and downgrades for several loans in the commercial term, commercial real estate and builder loan categories as nonaccrual. The Company recorded charge-offs of $1.2 million for the nine months ended September 30, 2009 and received recoveries of $108,000 for the same period. Management makes periodic provisions to the allowance for credit losses to maintain the allowance at an acceptable level commensurate with management's assessment of the credit risk inherent in the loan portfolio as of the balance sheet date. At September 30, 2009 and December 31, 2008, the allowance for credit losses to total loans was 3.26% and 1.54%, respectively. Nonperforming assets as of September 30, 2009 and December 31, 2008 were $16.2 million and $6.5 million, respectively. At September 30, 2009 nonperforming assets included $15.6 million in nonaccrual loans, $278,000 in loans delinquent 90 days or more and $345,000 in other assets. At December 31, 2008 nonperforming assets included $4.3 million in nonaccrual loans, $2.0 million in loans delinquent 90 days or more and $182,000 in other assets.

Deposits of $349.6 million at September 30, 2009 represent an increase of $49.0 million or 16.3% from December 31, 2008 deposits of $300.6 million. The majority of the increase was due to the Company's Superior Savings campaign with savings balances increasing $45.6 million to $138.4 million at September 30, 2009 from $92.7 million at December 31, 2008, an increase of 49.2%. Money market account balances decreased $6.7 million or 13.2% as balances shifted to the Company's "Superior Savings" product. Certificates of deposit which include deposits placed with the Certificate of Deposit Account Registry Service (CDARS) increased $4.9 million or 5.37% to $97.4 million at September 30, 2009 from $92.5 million at December 31, 2008.

Long-term borrowings consisting of Federal Home Loan Bank ("FHLB") borrowings remained at $40.0 million at September 30, 2009 compared to 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 3.63 years to maturity and 0.19 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 3.43%. 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 Nine Months Ended September 30, 2009 and 2008

General. The Company recorded a net loss of $2.1 million for the nine months ended September 30, 2009. The net loss available to common shareholders for the nine months ended September 30, 2009 was $2.4 million or $0.63 per basic and diluted common share, compared to net income available to common shareholders of $1.3 million, or $0.33 per basic and $0.32 per diluted common share, for the nine months ended September 30, 2008. Net interest income increased by $309,000 or 3.2% for the nine months ended September 30, 2009 compared to the same period in 2008. The provision for credit losses increased $4.7 million for the nine months ended September 30, 2009 compared to the same period in 2008.

Interest Income. Total interest income decreased $801,000 or 4.8% for the nine months ended September 30, 2009 compared to the same period in 2008 as a result of lower yields on average loan balances and the reversal of interest on nonaccrual loans of $165,000. The yield on the loan portfolio decreased to 5.83% for the nine months ended September 30, 2009 from 6.91% for the nine months ended September 30, 2008. The yield on investment securities decreased to 4.65% from 5.06% for the nine months ended September 30, 2009 compared to the same period in 2008.

Interest Expense. Total interest expense decreased by $1.1 million or 16.5% for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. The decrease was due to reducing the cost of the Company's portfolio of higher paying certificates of deposit and reducing the Company's "Superior Savings" product rate compared to the rate paid in 2008. The decrease in interest expense resulting from the lower rate on the Company's savings product was somewhat offset by the increase in savings average balances that resulted from the popularity of the Company's "Superior Savings" product. Savings balances increased on average to $141.8 million for the nine months ended September 30, 2009 compared to an average balance of $64.6 million for the nine months ended September 30, 2008, an increase in average balance of $77.2 million. Contributing to the decrease in interest expense was the lower cost of money market accounts, certificates of deposit and repurchase agreements. The average rate of interest paid on all interest-bearing liabilities was 2.02% for the nine months ended September 30, 2009 compared to 2.90% for the nine months ended September 30, 2008. Interest expense on short-term and long-term borrowings and junior subordinated debentures was $1.1 million for the nine months ended

September 30, 2009 compared to $1.2 million for the nine months ended September 30, 2008, a decrease of $78,000. The decrease was a result of the lower cost of the trust preferred offering with a decrease in yield to 4.22% for the nine months ended September 30, 2009 compared to 6.54% for the same period in 2008.

Net Interest Income. Net interest income increased by $309,000 or 3.2% for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. The increase was due primarily to the lower cost of funds, which decreased to 1.83% for the nine months ended September 30, 2009 compared to 2.59% for the nine months ended September 30, 2008.

For the nine months ended September 30, 2009, the net interest margin decreased to 3.18% compared to 3.67% for the nine months ended September 30, 2008. The decrease in net interest margin was the result of the lower yield on earning assets and interest reversed on nonaccrual loans. The yield on earning assets decreased to 4.95% for the nine months ended September 30, 2009 from 6.20% for the same period in 2008. Interest of $165,000 on loans placed on nonaccrual during the nine months ended September 30, 2009 was reversed during the period compared to zero for the nine months ended September 30, 2008.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $6.1 million for the nine months ended September 30, 2009 compared to $1.4 million for the same period in 2008. The provision was based on the composition and credit quality of the loan portfolio as of September 30, 2009 and reflected increases in provision related to downgrades of certain credits and to changes in the qualitative factors used to calculate the allowance for credit losses relating to historical delinquencies and losses and to factors relating to local economic conditions. Total loans grew by $10.9 million for the nine month period ended September 30, 2009. The Bank recorded net charge-offs on loans deemed uncollectible of $1.1 million for the nine months ended September 30, 2009 compared to $181,000 for the same period in 2008.

Noninterest Income. Total noninterest income improved by $118,000 or 8.9% to $1.4 million for the nine months ended September 30, 2009 from $1.3 million for the same period in 2008. The increase in noninterest income was due to the increase in fees earned from the Bank's mortgage operations including gains recorded on the sale of loans held for sale.

Noninterest Expense. Total noninterest expense increased by $1.2 million or 15.1% for the nine months ended September 30, 2009 compared to the same period in 2008. The increase in total noninterest expense during the first nine months of 2009 compared with the same period in 2008 resulted from increased FDIC expense of $375,000 related to increased ongoing deposit insurance premiums and a Special Assessment of $212,000 recognized in the second quarter of 2009. Costs associated with a new branch which was not open in the first nine months of 2008 totaled $436,000 with $129,000 related to personnel expense. Also contributing to the increase in noninterest expense was $174,000 in personnel expense related to additions to staff. Legal expense, a component of professional fees, increased by $209,000 over the same nine month period in 2008 due to costs associated with participating in the TARP, to loan collection efforts and to costs associated with ongoing tenant issues at the Bank's Market House branch. Data processing expense increased by $45,000 due to the addition of new products. and services and to increases in account volume.

Income Tax Expense. The Company recorded an income tax benefit for the nine-month period ended September 30, 2009 of $1.4 million. The Company's combined effective federal and state income tax rate was approximately 39.7%
(benefit) for the nine months ended September 30, 2009 versus 35.1% (expense)
for the nine months ended September 30, 2008.

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

Rate/Volume Analysis

(dollars in thousands)



                                                      Nine Months Ended September 30, 2009 vs. 2008
                                                                               Due to Change in
                                              Increase or                                             Rate/
                                               (Decrease)            Volume            Rate          Volume
Interest income on:
Loans                                        $       (1,088 )      $    1,132        $  (2,041 )     $  (179 )
Investment securities                                   700             1,028             (246 )         (82 )
Interest-bearing deposits in other banks               (204 )              82             (216 )         (70 )
Federal funds sold and other overnight
investments                                            (209 )             278             (233 )        (254 )

Total interest income                                  (801 )           2,520           (2,736 )        (585 )

Interest expense on:
NOW accounts                                             (1 )               1               (2 )          -
Money market accounts                                  (833 )            (345 )           (696 )         208
Savings accounts                                        730             1,534             (366 )        (438 )
Certificates of deposit                                (798 )             182             (922 )         (58 )
Repurchase agreements                                  (130 )             (23 )           (119 )          12
Short-term borrowing                                     (3 )              (3 )             (3 )           3
Long-term borrowing                                      14                14               -             -
Junior subordinated debt                                (89 )              -               (89 )          -

Total interest expense                               (1,110 )           1,360           (2,197 )        (273 )


Net interest income                          $          309        $    1,160        $    (539 )     $  (312 )

Consolidated Average Balances, Yields and Rates



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