ANNAPOLIS BANCORP INC - FORM 10-Q

ANNAPOLIS BANCORP INC - FORM 10-Q - August 12, 2011

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2011

¨	TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-22961

ANNAPOLIS BANCORP, INC.

(Exact name of registrant as specified in its charter)

Maryland

52-1595772

(State or other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

1000 Bestgate Road, Annapolis, Maryland 21401

(Address of principal executive offices)

(410) 224-4455

(Registrants telephone number, including area code)

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for a shorter period that the registrant was required to submit and post such files). YES x NO ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x

At July 31, 2011, the Registrant had 3,952,514 shares of common stock outstanding.

TABLE OF CONTENTS


	PAGE
PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements
Consolidated Balance Sheets as of June 30, 2011 (unaudited) and December 31, 2010		4
Consolidated Statements of Operations for the Three and Six Month Periods Ended June 30, 2011 and 2010 (unaudited)		5
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the Six Month Periods Ended June 30, 2011 and 2010 (unaudited)		6
Consolidated Statements of Cash Flows for the Six Month Periods Ended June 30, 2011 and 2010 (unaudited)		7-8
Notes to Consolidated Financial Statements (unaudited)		9-30
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations		30-41
Item 3 – Quantitative and Qualitative Disclosures About Market Risk		41
Item 4 – Controls and Procedures		41

PART II - OTHER INFORMATION

Item 1 – Legal Proceedings		41

Item 1A – Risk Factors		42

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds		42

Item 3 – Defaults Upon Senior Securities		42

Item 4 – Reserved		42

Item 5 – Other Information		42

Item 6 – Exhibits		43

SIGNATURES		44

CERTIFICATIONS

This Quarterly Report on Form 10-Q contains statements which constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements appear in a number of places in this Report and include all statements regarding the intent, belief or current expectations of Annapolis Bancorp, Inc. (the “Company”), its directors or its officers with respect to, among other things: (i) the Company’s financing plans; (ii) trends affecting the Company’s financial condition, results of operations; plans and objectives (iii) the Company’s growth strategy; (iv) the Company’s future performance and business, including, but not limited to statements with respect to the adequacy of the allowance for loan and lease losses, delinquency trends, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings and new accounting standards on the Company’s financial condition and results of operations; and (v) the declaration and payment of dividends. All statements contained herein that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “continues,” “expect,” “estimate,” “intend,” “project” and similar expressions and future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may,” or similar expressions are generally intended to identify forward-looking statements. Investors are cautioned that any such forward-looking statements are not

guarantees of future performance and involve certain risks and uncertainties which could cause actual results to differ materially from those expressed in forward-looking statements. Factors that might cause such a difference may, include, but are not limited to: (i) the rate of declining growth in the economy and employment levels, as well as general business and economic conditions; (ii) changes in interest rates, as well as the magnitude of such changes; (iii) the fiscal and monetary policies of the federal government and its agencies; (iv) changes in federal bank regulatory and supervisory policies, including required levels of capital; (v) the relative strength or weakness of the consumer and commercial credit sectors and of the real estate market; (vi) the performance of the stock and bond markets; (vii) competition in the financial services industry, (viii) possible legislative, tax or regulatory changes, and such other risks and uncertainties as set forth in the Company’s filings with the Securities and Exchange Commission. All forward-looking statements included in this quarterly report on Form 10-Q are based upon information available to the Company as of the date of this report, and other than to the extent required by applicable law, including the requirements of applicable securities laws, the Company undertakes no obligation to publicly release the results of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

Annapolis Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

as of June 30, 2011 and December 31, 2010

(in thousands)


	(Unaudited) June 30, 2011		(Audited) December 31, 2010
Assets
Cash and due from banks	$	2,724	$	7,854
Interest bearing balances with banks		8,713		16,856
Federal funds sold and other overnight investments		25,191		11,984
Investment securities available for sale, at fair value		89,444		96,295
Federal Reserve and Federal Home Loan Bank stock		3,013		3,035
Loans held for sale		0		1,379
Loans, less allowance for credit losses of $7,272 and $6,853		282,868		271,684
Premises and equipment, net		8,651		8,787
Accrued interest receivable		1,376		1,567
Deferred income taxes		2,956		2,929
Investment in bank owned life insurance		5,531		5,442
Real estate owned		1,540		1,608
Other assets		1,958		2,720

Total Assets	$	433,965	$	432,140


Liabilities and Stockholders’ Equity
Deposits
Noninterest bearing	$	48,774	$	45,514
Interest bearing		291,125		295,400
Securities sold under agreements to repurchase		16,161		14,558
Long-term borrowings		35,000		35,000
Guaranteed preferred beneficial interests in junior subordinated debentures		5,000		5,000
Accrued interest payable and other liabilities		2,140		1,894

Total liabilities		398,200		397,366


Stockholders’ Equity
Preferred stock, par value $0.01 per share; authorized 5,000,000 shares; Series A, $1,000 per share liquidation preference, shares issued and outstanding 8,152 shares at June 30, 2011 and at December 31, 2010, net of discount of $48 and $89		8,104		8,063
Common stock, par value $0.01 per share; authorized 10,000,000 shares; issued and outstanding 3,952,272 shares at June 30, 2011 and 3,922,006 at December 31, 2010		39		39
Warrants		234		234
Paid in capital		11,717		11,643
Retained earnings		15,089		14,499
Accumulated other comprehensive income		582		296

Total stockholders’ equity		35,765		34,774

Total liabilities and stockholders’ equity	$	433,965	$	432,140

Annapolis Bancorp, Inc. and Subsidiaries

Consolidated Statements of Operations

for the Three and Six Month Periods Ended June 30, 2011 and 2010

(unaudited)

(in thousands, except Shares and Per Share data)


	For the Three Months					For the Six Months
	Ended June 30,					Ended June 30,
	2011			2010		2011			2010
Interest and dividend income
Loans, including fees	$	4,268		$	3,886	$	8,459		$	8,006
Interest bearing balances with banks		5			8		9			14
Federal funds sold and other overnight investments		8			9		15			15
Mortgage-backed securities		370			481		718			1,066
U.S. Treasury securities and obligations of other U. S. Government agencies		296			501		625			1,108
State and municipal securities		11			11		22			22
Equity securities		19			21		39			35

Total interest and dividend income		4,977			4,917		9,887			10,266


Interest expense
Certificates of deposit, $100,000 or more		136			172		271			383
Other deposits		458			686		917			1,439
Securities sold under agreements to repurchase		24			29		41			50
Interest on long-term borrowings		325			324		646			669

Total interest expense		943			1,211		1,875			2,541

Net interest income		4,034			3,706		8,012			7,725
Provision for credit losses		679			363		1,236			599

Net interest income after provision for credit losses		3,355			3,343		6,776			7,126


Noninterest income
Service charges and fees on deposits		316			306		616			573
Mortgage banking fees		15			10		17			32
Other fee income		(31	)		108		(2	)		212
Gain on sale of loans		79			41		147			83
Loss on sale of securities		0			0		0			(55	)
(Loss) gain on sale of real estate owned and repossessed assets		(22	)		16		(22	)		48
Loss on disposal of fixed assets		(1	)		0		(32	)		0

Total noninterest income		356			481		724			893


Noninterest expense
Personnel		1,714			1,723		3,475			3,507
Occupancy and equipment		424			374		845			791
Data processing		213			209		421			417
Legal and professional fees		146			179		225			325
Marketing		123			79		232			180
FDIC Insurance		135			137		281			287
Other operating expenses		461			450		780			857

Total noninterest expense		3,216			3,151		6,259			6,364

Income before income taxes		495			673		1,241			1,655
Income tax expense		169			235		406			600

Net income		326			438		835			1,055
Preferred stock dividend and discount accretion		123			120		245			241

Net income available to common shareholders	$	203		$	318	$	590		$	814

Basic earnings per common share	$	0.05		$	0.08	$	0.15		$	0.21

Basic weighted average shares		3,938,070			3,912,641		3,944,417			3,901,691

Diluted earnings per common share	$	0.05		$	0.08	$	0.14		$	0.21

Diluted weighted average shares		4,285,370			3,950,609		4,291,717			3,939,659

Annapolis Bancorp, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

and Comprehensive Income

for the Six Month Periods Ended June 30, 2011 and 2010

(unaudited)

(dollars in thousands)


	Preferred Stock		Common Stock		Warrants		Paid in Capital		Retained Earnings			Accumulated Other Comprehensive Income			Total			Comprehensive Income

Balances, December 31, 2010	$	8,063	$	39	$	234	$	11,643	$	14,499		$	296		$	34,774
Net income		0		0		0		0		835			0			835		$	835
Stock options exercised and restricted stock issued		0		0		0		14		0			0			14			0
Preferred stock dividend declared and discount accretion		41		0		0		0		(245	)		0			(204	)		0
Stock-based compensation		0		0		0		57		0			0			57			0
Employee stock purchase plan		0		0		0		3		0			0			3			0
Unrealized gain on investment securities net of taxes of $186		0		0		0		0		0			286			286			286

Balances, June 30, 2011	$	8,104	$	39	$	234	$	11,717	$	15,089		$	582		$	35,765		$	1,121


	Preferred Stock		Common Stock		Warrants		Paid in Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total			Comprehensive Income

Balances, December 31, 2009	$	7,985	$	39	$	234	$	11,501	$	13,367		($	494	)	$	32,632
Net income		0		0		0		0		1,055			0			1,055		$	1,055
Stock options exercised and restricted stock issued		0		0		0		43		0			0			43			0
Preferred stock dividend declared and discount accretion		37		0		0		0		(240	)		0			(203	)		0
Stock-based compensation		0		0		0		20		0			0			20			0
Employee stock purchase plan		0		0		0		5		0			0			5			0
Reclassification adjustment for securities losses net of taxes of $20 included in net income		0		0		0		0		0			35			35			35
Unrealized gain on investment securities net of taxes of $587		0		0		0		0		0			1,390			1,390			1,390

Balances, June 30, 2010	$	8,022	$	39	$	234	$	11,569	$	14,182		$	931		$	34,977		$	2,480

Annapolis Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

for the Six Month Periods Ended June 30, 2011 and 2010

(unaudited)

(in thousands)


	For the Six Months Ended June 30,
	2011			2010
Cash flows from operating activities
Net income	$	835		$	1,055
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		342			312
Amortization of premiums and accretions of discounts, net		152			190
Provision for credit losses		1,236			599
Origination of loans held for sale		(7,496	)		(8,830	)
Proceeds from sale of loans held for sale		9,022			10,421
Stock based compensation		57			20
Deferred income taxes		(213	)		402
Earnings on life insurance policies		(89	)		(108	)
Loss on sale of securities, available for sale		0			55
Gain on sale of loans held for sale		(147	)		(83	)
Loss (gain) on sale of real estate owned and repossessed assets		22			(48	)
Loss on disposal of fixed assets		32			0
Decrease (increase) in:
Accrued interest receivable		191			425
Prepaid FDIC insurance		270			133
Real estate owned and repossessed assets		117			0
Other assets		406			(15	)
Increase (decrease) in:
Accrued interest payable		(13	)		(15	)
Accrued income taxes, net of taxes refundable		14			(421	)
Deferred loan origination fees		(80	)		(84	)
Other liabilities		245			322

Net cash provided by operating activities		4,903			4,330

Cash flows from investing activities
Proceeds from sales and maturities of securities available for sale		14,022			46,093
Purchase of securities available for sale		(6,829	)		(21,355	)
Net increase in federal funds sold		(13,207	)		(20,453	)
Net decrease in interest bearing certificates of deposit		8,143			2,604
Net (increase) decrease in loans receivable, net		(12,360	)		2,427
Purchase of premises and equipment, net of disposals		(232	)		(74	)
Proceeds from sales of real estate owned and repossessed assets		29			447

Net cash (used in) provided by investing activities		(10,434	)		9,689

Annapolis Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows (continued)

for the Six Month Periods Ended June 30, 2011 and 2010

(unaudited)

(in thousands)

(continued)


	For the Six Months Ended June 30,
	2011			2010

Cash flows from financing activities
Net (decrease) increase in:
Time deposits		(2,027	)		(12,692	)
Other deposits		1,012			2,629
Securities sold under agreements to repurchase		1,603			221
Repayment of long-term borrowing		0			(5,000	)
Proceeds from stock options exercised		14			43
Proceeds from issuance of common stock		3			5
Payment of preferred stock dividend		(204	)		(203	)

Net cash provided by (used in) financing activities		401			(14,997	)

Net decrease in cash		(5,130	)		(978	)
Cash and cash equivalents, beginning of period		7,854			5,936

Cash and cash equivalents, end of period	$	2,724		$	4,958


Supplemental cash flow information
Interest paid, including interest credited to accounts	$	2,092		$	2,559
Income taxes paid	$	635		$	605

Non-cash investing activities
Transfers from loans to real estate owned	$	0		$	621
Transfers from loans to other assets	$	20		$	96

Annapolis Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

for the Six Month Periods Ended June 30, 2011 and 2010

(unaudited)

Note A – Basis of Presentation

The accompanying unaudited consolidated financial statements of Annapolis Bancorp, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all the information and footnotes required for complete financial statements. In the opinion of management, all adjustments and reclassifications that are normal and recurring in nature and are considered necessary for fair presentation have been included. Operating results for the six month period ended June 30, 2011 are not necessarily indicative of the results that may be expected for the year ended December 31, 2011 or any other period. These unaudited consolidated financial statements should be read in conjunction with the Company’s Form 10-K for the year ended December 31, 2010, which includes the consolidated financial statements and footnotes. Certain reclassifications have been made to amounts previously reported to conform to the classifications made in 2011.

Note B – Business

The Company was incorporated on May 26, 1988, under the laws of the State of Maryland, to serve as a bank holding company for BankAnnapolis (formerly known as Annapolis National Bank) (the “Bank”). Effective November 1, 2000, the Bank changed its charter from a national charter to a state charter and joined the State of Maryland and the Federal Reserve banking systems. Also effective November 1, 2000, the Bank changed its name from Annapolis National Bank to BankAnnapolis. The bank holding company changed its name from Annapolis National Bancorp, Inc. to Annapolis Bancorp, Inc. effective June 1, 2001. The Company (as a bank holding company) and the Bank are subject to governmental supervision, regulation, and control.

The Bank currently conducts a general commercial and retail banking business in its market area, emphasizing the banking needs of small businesses, professional concerns and individuals from its headquarters in Annapolis, its five other branches located in Anne Arundel County, Maryland and one branch located on Kent Island in Queen Anne’s County, Maryland. The Bank closed its Market House branch on May 27, 2011 and moved the corresponding deposits to its Bestgate location.

The Bank has built its reputation on exemplary customer service and outreach to the communities surrounding each of the Bank’s locations. The Bank is committed to offering products and services that focus on relationship banking and provide an alternative to the large multi-regional financial institutions that are so pervasive in the markets the Bank serves. The Bank attracts most of its customer deposits from Anne Arundel County, Maryland, and to a lesser extent, Queen Anne’s County, Maryland. The Bank’s lending operations are centered in Anne Arundel County, but extend throughout Central and Southern Maryland.

Note C – Stock Based Compensation

Stock based-compensation expense for the six month periods ended June 30, 2011 and 2010 was $57,000 and $20,000, respectively. Stock-based compensation expense recognized in the consolidated statements of income for the first and second quarters of 2011 and 2010 reflects estimated forfeitures.

For the three month period ended June 30, 2011, $19,000 of expense was recognized on the remaining outstanding options, restricted shares and restricted share units. For the three month period ended June 30, 2010, 11,000 deferred restricted share units and 6,221 options were forfeited resulting in the reversal of previously recognized expense of approximately $67,000. During the same period of 2010, $26,000 of expense was recognized on the remaining outstanding options, restricted shares and restricted share units resulting in a net reversal of expense for the three month period ended June 30, 2010 of $41,000.

During the first and second quarter of 2011 and 2010, there were no options granted to employees or directors of the Company or Bank.

Stock option activity for the six months ended June 30, 2011 and 2010 was as follows:


	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Outstanding at December 31, 2010		124,270		$	6.06
Grants		0			0.00
Exercised		(5,333	)		2.64
Forfeitures		0			0.00
Expired		(22,374	)		2.64

Outstanding as of June 30, 2011		96,563		$	7.05


Exercisable at June 30, 2011		95,721		$	7.03		3.0	$	0


Outstanding at December 31, 2009		183,819		$	5.05
Grants		0			0.00
Exercised		(17,776	)		2.42
Forfeitures		(6,221	)		7.24
Expired		(35,552	)		2.42

Outstanding as of June 30, 2010		124,270		$	6.06


Exercisable at June 30, 2010		117,378		$	5.89		3.1	$	56,000

The aggregate intrinsic value in the table above represents the total pre-tax value of the exercisable in-the-money options (that is, the difference between the closing stock price on the last trading day in the first six months of 2011 and 2010, and the exercise price of the options multiplied by the number of shares) on June 30, 2011 and June 30, 2010. This amount changes based on the fair market value of the Company’s stock. The total intrinsic value of options exercised was $8,000 for the six months ended June 30, 2011, and $33,000 for the six months ended June 30, 2010. The total fair value of options that vested during the six month period ending June 30, 2011 was $6,800 and $24,000 for the six months ended June 30, 2010.

As of June 30, 2011, $3,000 of total unrecognized costs related to unvested options is expected to be recognized over a weighted average period of 1.0 years. As of June 30, 2010, $10,000 of total unrecognized costs related to unvested options was expected to be recognized over a weighted average period of 1.2 years.

There were no restricted shares granted to employees during the second quarter of 2011 or 2010.

During the first quarter of 2011, non-employee directors of the Bank were awarded a total of 12,782 shares of restricted stock at a market value of $4.30 per share in lieu of an annual retainer. These shares vest on January 27, 2012. During the first quarter of 2010, non-employee directors of the Bank were awarded a total of 15,384 shares of restricted stock at a market value of $3.90 per share in lieu of an annual retainer. These shares vested on January 28, 2011. Non-compensation related expense of $13,750 and $15,000 was recognized for the three month periods ended June 30, 2011 and 2010, respectively and $27,500 and $30,000 for the six month periods ending June 30, 2011 and 2010, respectively, relating to the shares issued to non-employee directors.

During the first quarter of 2011, an employee of the Bank was awarded 5,000 restricted shares at a market value of $4.45 per share. One-half of the restricted shares vest on each of the employee’s first two anniversaries of employment with the Bank, with the shares being fully vested on February 28, 2013. During the same period in 2010, an employee of the Bank was awarded 3,000 restricted shares at a market value of $3.75 per share. One-third of the restricted shares vested on the employee’s first anniversary of employment with the Bank and the remaining two-thirds of the restricted shares vest one-third on each of the employee’s second and third anniversaries of employment with the Bank, with the shares being fully vested on March 15, 2013.

As of June 30, 2011, 10,000 restricted share units of the 62,282 restricted shares and restricted share units outstanding have vested; the remaining 52,282 shares will vest over a weighted average period of 2.2 years.

Restricted stock activity for the six months ended June 30, 2011 and 2010 was as follows:


	Shares			Weighted Average Grant Price
Outstanding at December 31, 2010		68,384		$	3.66
Grants		17,782			4.34
Issued		(23,884	)		3.71
Forfeitures		0			0

Outstanding as of June 30, 2011		62,282		$	3.87


Outstanding at December 31, 2009		98,005		$	3.69
Grants		18,384			3.75
Issued		(28,005	)		2.68
Forfeitures		(11,000	)		8.92

Outstanding as of June 30, 2010		77,384		$	3.36

As of June 30, 2011, $153,000 of total unrecognized costs related to unvested restricted shares and restricted share units is expected to be recognized over a weighted average period of 2.2 years. As of June 30, 2010, $187,000 of total unrecognized costs related to unvested restricted shares and restricted share units was expected to be recognized over a weighted average period of 1.3 years.

Note D – Earnings Per Share

Information regarding earnings per share is summarized as follows:

Computation of Earnings Per Share

(in thousands, except Earnings Per Share)


	For the Three Months Ended June 30,				For the Six Months Ended June 30,
	2011		2010		2011		2010
Net income available to common shareholders	$	203	$	318	$	590	$	814
Weighted average common shares outstanding		3,938		3,913		3,945		3,902
Basic Earnings Per Common Share	$	0.05	$	0.08	$	0.15	$	0.21

Net income available to common shareholders	$	203	$	318	$	590	$	814
Weighted average common shares outstanding		3,938		3,913		3,945		3,902
Effect of potential dilutive common shares		347		38		347		38
Total weighted average diluted common shares outstanding		4,285		3,951		4,292		3,940
Diluted Earnings Per Common Share	$	0.05	$	0.08	$	0.14	$	0.21

Basic earnings per common share are calculated using the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share are calculated using the weighted-average number of shares of common stock plus dilutive potential shares of common stock outstanding during the period. Potential common shares consist of stock options and restricted stock, restricted share units and warrants. For each of the three months ended June 30, 2011 and 2010, 58,969 and 385,116 shares of common stock, respectively, attributable to outstanding stock options, restricted stock, restricted share units and warrants were excluded from the calculations of diluted earnings per share because their effect was anti-dilutive. For each of the six months ended June 30, 2011 and 2010, 58,969 and 385,116 shares of common stock, respectively, attributable to outstanding stock options and warrants were excluded from the calculations of diluted earnings per share because their effect was anti-dilutive.

Note E – Investment Securities

Investment securities are summarized as follows:


(dollars in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses		Estimated Fair Value
June 30, 2011
Available for sale
U.S. Government agency	$	47,100	$	114	$	249	$	46,965
State and municipal		1,078		30		0		1,108
Residential mortgage-backed securities		39,695		1,148		106		40,737
Other equity securities		609		25		0		634

	$	88,482	$	1,317	$	355	$	89,444


	Amortized Cost		Unrealized Gains		Unrealized Losses		Estimated Fair Value
December 31, 2010
Available for sale
U.S. Government agency	$	54,062	$	209	$	510	$	53,761
State and municipal		1,079		10		0		1,089
Residential mortgage-backed securities		40,067		873		112		40,828
Other equity securities		599		18		0		617

	$	95,807	$	1,110	$	622	$	96,295

The amortized cost and estimated fair value of securities by contractual maturities at June 30, 2011 are shown below. Actual maturities of these securities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.


	June 30, 2011
	Available for Sale
	Amortized Cost		Estimated Fair Value
(dollars in thousands)
Due within one year	$	4,003	$	4,010
Due after one through five years		14,385		14,402
Due after five through ten years		24,105		24,039
Due after ten years		45,380		46,359
Equity securities		609		634

	$	88,482	$	89,444

The following table shows the level of the Company’s gross unrealized losses and the fair value of the associated securities by type and maturity for securities available for sale at June 30, 2011 and December 31, 2010.


	Less than 12 months				12 months or more				Total
June 30, 2011	Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses
(dollars in thousands)
U.S. Government agency	$	22,203	$	249	$	0	$	0	$	22,203	$	249
Residential mortgage-backed securities		3,127		3		2,114		103		5,241		106

	$	25,330	$	252	$	2,114	$	103	$	27,444	$	355


	Less than 12 months				12 months or more				Total
December 31, 2010	Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses
(dollars in thousands)
U.S. Government Agency	$	24,934	$	500	$	897	$	10	$	25,831	$	510
Residential mortgage-backed securities		3,118		10		2,401		102		5,519		112

	$	28,052	$	510	$	3,298	$	112	$	31,350	$	622

The unrealized losses that exist are the result of market changes in interest rates since the original purchase. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2011. The Company has used a variety of tools to analyze the contents of its security portfolio and at this time does not believe that the unrealized losses in the portfolio shown in the table above are other than temporary. At June 30, 2011 mortgaged-backed securities with a fair market value of $2.1 million carried bond ratings below investment grade. These securities were evaluated by an independent third-party consulting firm using an expected cash flow model that includes assumptions related to prepayment rates, default trends, and loss severity, and were deemed by management not to be other-than-temporarily impaired at June 30, 2011. At June 30, 2011, both securities were current on both principal and interest payments.

Note F – Loans, Allowance For Credit Losses And Credit Quality

Major classifications of loans are as follows:


	June 30, 2011⁽¹⁾			December 31, 2010 ⁽¹⁾
Commercial	$	51,345		$	51,359
Real estate
Commercial		106,677			94,864
Construction		34,095			33,534
One to four-family		52,317			51,581
Home equity		36,259			36,697
Consumer		9,688			10,664

		290,381			278,699


Deferred loan fees, net		(241	)		(162	)
Allowance for credit losses		(7,272	)		(6,853	)

		(7,513	)		(7,015	)

Loans, net	$	282,868		$	271,684

The maturity and rate repricing distribution of the loan portfolio is as follows:


Repricing or maturing within one year	$	113,494	$	117,574
Maturing over one to five years		112,954		102,755
Maturing over five years		63,933		58,370

	$	290,381	$	278,699

(1)	Excludes loans held for sale

The Company’s goal is to mitigate risks inherent in the loan portfolio. Commercial loans and loans secured by real estate make up the majority of the loan portfolio, accounting for 97% of the portfolio as of June 30, 2011 and 96% of the portfolio as of December 31, 2010. To mitigate risk, commercial loans are generally secured by receivables, inventories, equipment and other assets of the business. Personal guarantees of the borrowers are generally required.

Loans secured by commercial real estate properties generally involve larger principal amounts and a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks through its underwriting standards, which require such loans to be qualified on the basis of the property’s value, debt service coverage ratio, and, under certain circumstances, additional collateral. The Bank generally also requires personal guarantees on its commercial real estate loans.

Construction loans are generally considered to involve a higher degree of credit risk than long-term financing of improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the security property’s value upon completion of construction as compared to the estimated costs of construction, including interest. Also, the Bank assumes certain risks associated with the borrowers' ability to complete construction in a timely and workmanlike manner. If the estimate of value proves to be inaccurate, or if construction is not performed timely or accurately, the Bank may be faced with a project which, when completed, has a value that is insufficient to assure full repayment.

The Bank currently originates one- to four-family residential mortgage loans in amounts typically up to 80% (or higher with private mortgage insurance) of the lower of the appraised value or the selling price of the property securing the loan. The origination of adjustable-rate residential mortgage loans, as opposed to fixed-rate residential mortgage loans, helps to reduce the Bank’s exposure to increases in interest rates. However, adjustable-rate loans generally pose credit risks not inherent in fixed-rate loans, primarily because as interest rates rise, the underlying payments of the borrower rise, thereby increasing the potential for default. Periodic and lifetime caps on interest rate increases help to reduce the risks associated with the Bank’s adjustable-rate loans, but also limit the interest rate sensitivity of its adjustable-rate mortgage loans.

Specific loan reserves are established based upon credit and/or collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve allocations.

The following table shows the allowance for credit losses and recorded investment in loans receivable for the three and six month periods ended June 30, 2011:

Allowance for Credit Losses and Recorded Investment in Loans Receivable

for the Three Months Ended June 30, 2011


(Dollars in thousands)	Commercial			Commercial Real Estate		Residential			Consumer			Unallocated		Total
Allowance for credit losses
Beginning balance, March 31, 2011	$	1,886		$	3,054	$	1,434		$	518		$	0	$	6,892
Charge-offs		301			49		133			81			0		564
Recoveries		5			0		253			7			0		265
Provision		(187	)		1,072		(160	)		(46	)		0		679

Ending balance, June 30, 2011	$	1,403		$	4,077	$	1,394		$	398		$	0	$	7,272

Allowance for Credit Losses and Recorded Investment in Loans Receivable

for the Six Months Ended June 30, 2011


(Dollars in thousands)	Commercial		Commercial Real Estate		Residential		Consumer		Unallocated		Total
June 30, 2011
Allowance for credit losses:
Beginning balance, December 31, 2010	$	1,868	$	3,205	$	1,257	$	523	$	0	$	6,853
Charge-offs		772		49		133		136		0		1,090
Recoveries		10		0		253		10		0		273
Provision		297		921		17		1		0		1,236

Ending balance, June 30, 2011	$	1,403	$	4,077	$	1,394	$	398	$	0	$	7,272

Period ending amount: Individually evaluated for impairment	$	63	$	1,199	$	465	$	46	$	0	$	1,773

Period ending amount: Collectively evaluated for impairment	$	1,340	$	2,878	$	929	$	352	$	0	$	5,499

Period ending amount: Loans acquired with deteriorating credit quality	$	0	$	0	$	0	$	0	$	0	$	0

Loans individually evaluated for impairment	$	126	$	4,668	$	1,526	$	82	$	0	$	6,402

Loans collectively evaluated for impairment	$	51,219	$	136,104	$	87,050	$	9,606	$	0	$	283,979

Nonaccrual loans totaled approximately $5.7 million and $7.8 million at June 30, 2011 and December 31, 2010, respectively. There were no loans past due greater than 90 days at June 30, 2011. At December 31, 2010, there were $599,000 in loans past due greater than 90 days. As of June 30, 2011 $1.8 million of loan loss allowances were allocated to all loans classified as impaired with $1.5 million of loan loss allowances allocated to all loans classified as impaired at December 31, 2010.

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management assigns a Risk Assessment Rating (“Risk Rating”) to extensions of credit based upon the degree of risk, the likelihood of repayment and the effect on the Bank’s safety and soundness. The Risk Rating, applied consistently, enables lending personnel and bank management to monitor the loan portfolio. The Risk Rating is an integral part of the bank’s loan loss provision formulation process and, properly maintained, the Risk Rating assessment can provide an early warning signal of deterioration in a credit.

The Company uses a risk rating matrix to assign a risk grade to each loan. The Risk Ratings are divided into five general categories:

Risk Ratings 1 - 6 are assigned to “Pass” credits.

Risk Rating 7 is assigned to “Pass” credits that are also considered “Watch” credits.

Risk Rating 8 is assigned to “Criticized” credits.

Risk Ratings 9 and 10 are assigned to “Classified” credits.

Risk Rating 11 is assigned to “Loss” credits.

A general description of the characteristics of the risk ratings are described below:

•

Risk ratings 1, 2 and 3 – these ratings have the highest degree of probability of repayment. Borrowers in this category are established entities, well-positioned within their industry with a proven track record of solid financial performance. These ratings are usually reserved for the strongest customers of the Bank, who have strong capital, stable earnings and alternative sources of financing.

•

Risk ratings 4 and 5 – these ratings have a below and average degree of risk. The customers have, generally strong to adequate net worth, stable earnings trends and strong to moderate liquidity.

•

Risk rating 6 – this category represents an above average degree of risk as to repayment with minimal loss potential. Borrowers in this category generally exhibit adequate operating trends, satisfactory balance sheet trends, moderate leverage and adequate liquidity; however, there is minimal excess operating cushion.

•

Risk rating 7 – this rating includes loans on management’s “Watch” list. Borrowers in this category generally exhibit characteristics of an acceptable/adequate credit, but may be experiencing income volatility, negative operating trends, and a more highly leveraged balance sheet.

•

Risk rating 8 – this rating is for “Other Assets Especially Mentioned” in accordance with regulatory guidelines. This rating generally includes loans to borrowers with currently protected, but potentially weak assets that deserve management’s close attention.

•

Risk rating 9 – this rating is for loans considered “Substandard” in accordance with regulatory guidelines. This rating represents assets inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged. These assets have a well-defined weakness, or weaknesses, that jeopardize liquidation of the debt and are characterized by the distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.

•

Risk rating 10 – this rating is for loans considered “Doubtful” in accordance with regulatory guidelines. Borrowers in this category have all the weaknesses inherent in a “Substandard” credit with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly improbable.

•

Risk rating 11 – this rating is for loans considered “Loss” in accordance with regulatory guidelines. This category represents loans that are considered uncollectible and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but simply it is neither practical nor desirable to defer writing off all or some portion of the credit, even though partial recovery may be effected in the future.

The following table presents credit quality indicators:

Credit Quality Indicators

as of June 30, 2011

(Dollars in thousands)


			Commercial Real Estate
	Commercial		Construction		Other
	2011		2011		2011
Risk Rating:
Other Assets Especially Mentioned	$	4,407	$	1,669	$	8,499
Substandard		3,945		4,607		3,515
Doubtful		0		1,152		0
Loss		0		0		0

	$	8,352	$	7,428	$	12,014


	Residential		Consumer Installment
	2011		2011
Risk Rating:
Other Assets Especially Mentioned	$	2,499	$	120
Substandard		1,995		371
Doubtful		1,382		82
Loss		0		0

	$	5,876	$	573

Credit Quality Indicators

as of December 31, 2010

(Dollars in thousands)


			Commercial Real Estate
	Commercial		Construction		Other
	2010		2010		2010
Risk Rating:
Other Assets Especially Mentioned	$	7,358	$	1,671	$	8,938
Substandard		2,048		7,010		2,438
Doubtful		600		0		0
Loss		0		0		0

	$	10,006	$	8,681	$	11,376


	Residential		Consumer Installment
	2010		2010
Risk Rating:
Other Assets Especially Mentioned	$	1,517	$	123
Substandard		3,868		575
Doubtful		0		0
Loss		0		0

	$	5,385	$	698

The following table presents an age analysis of past due loans receivable:

Age Analysis of Past Due Loans Receivable

As of June 30, 2011

(Dollars in thousands)


	30-59 Days Past Due		59-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment 90 Days and Accruing
2011
Commercial	$	11	$	100	$	760	$	871	$	50,474	$	51,345	$	0
Commercial Real Estate
Construction		0		0		1,152		1,152		32,943		34,095		0
Other		3,515		0		0		3,515		103,162		106,677		0
Residential		845		352		1,450		2,647		85,929		88,576		0
Consumer		276		259		446		981		8,707		9,688		0

	$	4,647	$	711	$	3,808	$	9,166	$	281,215	$	290,381	$	0

Age Analysis of Past Due Loans Receivable

As of December 31, 2010

(Dollars in thousands)


	30-59 Days Past Due		59-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment 90 Days and Accruing
2010
Commercial	$	191	$	691	$	2,079	$	2,961	$	48,398	$	51,359	$	0
Commercial Real Estate
Construction		3,515		0		1,585		5,100		28,434		33,534		180
Other		488		239		1,449		2,176		92,688		94,864		419
Residential		1,669		596		1,795		4,060		84,218		88,278		0
Consumer		189		108		187		484		10,180		10,664		0

	$	6,052	$	1,634	$	7,095	$	14,781	$	263,918	$	278,699	$	599

Total past due loans at June 30, 2011 decreased $5.6 million to $9.2 million from $14.8 million as of December 31, 2010 primarily due to payments received including payoffs and pay-downs totaling approximately $2.4 million, charge-offs of loans deemed uncollectable of approximately $1.1 million, and the return of loans to performing of $2.8 million. Additions to past due as of June 30, 2011 compared to December 31, 2010 totaled approximately $663,000.

Loans are considered impaired when, based on current information it is probable that the Bank will not collect all principal and interest payments according to contractual terms. Generally, loans are considered impaired once principal and interest payments are past due and they are placed on non-accrual. Management also considers the financial condition of the borrower, cash flows of the loan and the value of the related collateral. Impaired loans do not include large groups of smaller balance homogeneous credits such as residential real estate and consumer installment loans, which are evaluated collectively for impairment. Loans specifically reviewed for impairment are not considered impaired during periods of “minimal delay” in payment (usually ninety days or less) provided eventual collection of all amounts due is expected. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, the Bank may measure impairment based on a loan’s observable market price or the fair value of the collateral, if the loan is collateral dependent. Interest payments on impaired loans are typically applied to principal unless collectability is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans or portions thereof, are charged-off when deemed uncollectible.

The Company’s policy states that when the probability for full repayment of a loan is unlikely, the Bank will initiate a full charge-off or a partial write-down of the asset based upon the status of the loan.

Consumer loans less than $25,000 for which payments of principal and/or interest are past due ninety (90) days are charged-off and referred for collection. Consumer loans of $25,000 or more are evaluated for charge-off or partial write-down at the discretion of Bank management.

Any other loan over 120 days past due is evaluated for charge-off or partial write-down at the discretion of Bank management.

Generally, real estate secured loans are charged-off on a deficiency basis after liquidation of the collateral. Bank management may determine that when the full loan balance is clearly uncollectible and some loss is anticipated a charge-off or write-down is appropriate prior to liquidation of the collateral. An updated evaluation or appraisal of the property may be required to determine the appropriate level of charge-off or write-down.

The following tables presents a summary of impaired loans as of and for the six months ended June 30, 2011 and as of December 31, 2010 and for the year then ended:

Impaired Loans

as of and for the Six Month Period Ended June 30, 2011


(Dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial	$	944	$	944	$	0	$	600	$	36
Commercial real estate		0		0		0		429		30
Residential real estate		1,539		1,539		0		733		34
Consumer		312		312		0		105		11

		2,795		2,795		0		1,867		111

With an allowance recorded
Commercial		126		126		63		346		1
Commercial real estate		4,667		4,667		1,199		931		0
Residential real estate		1,527		1,527		465		779		12
Consumer		82		82		46		105		3

		6,402		6,402		1,773		2,161		16

Total
Commercial		1,070		1,070		63		946		37
Commercial real estate		4,667		4,667		1,199		1,360		30
Residential real estate		3,066		3,066		465		1,512		46
Consumer		394		394		46		210		14

	$	9,197	$	9,197	$	1,773	$	4,028	$	127

Impaired Loans

as of and for the Year Ended December 31, 2010


(Dollars in thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial	$	1,009	$	1,009	$	0	$	539	$	43
Commercial real estate		1,628		1,628		0		1,940		0
Residential real estate		1,478		1,478		0		1,060		73
Consumer		181		181		0		439		14

		4,296		4,296		0		3,978	$	130

With an allowance recorded
Commercial	$	1,098	$	1,098	$	545	$	2,293	$	3
Commercial real estate		1,405		1,405		351		3,371		24
Residential real estate		1,341		1,341		416		1,347		21
Consumer		249		249		150		241		19

		4,093		4,093		1,462		7,252		67

Total
Commercial	$	2,107	$	2,107	$	545	$	2,832	$	46
Commercial real estate		3,033		3,033		351		5,311		24
Residential real estate		2,819		2,819		416		2,407		94
Consumer		430		430		150		680		33

	$	8,389	$	8,389	$	1,462	$	11,230	$	197

Note G – Fair Value Measurements

Fair Value Hierarchy

The Company follows FASB’s guidance on “Fair Value Measurements.” The guidance defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The guidance applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the guidance establishes a fair value hierarchy that prioritizes the information used to develop those assumptions.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value all other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

The guidance establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy is as follows:

Level 1 inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. Fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the assets credit rating, prepayment assumptions and other factors such as credit loss assumptions

An asset or liability’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Management reviews and updates the fair value hierarchy classifications of the Company’s assets and liabilities on a quarterly basis. During the six months ended June 30, 2011, there were no transfers made between Level 1, 2, and 3 inputs.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents information about the Company’s assets measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value.


(in thousands)			Fair Value Measurements at June 30, 2011 Using
Description	Fair Value June 30, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Changes in Fair Values Included in Period Earnings

Investment Securities Available for Sale – Debt Securities
Issued by the U.S. Treasury and Government agencies	$	46,965	$	0	$	46,965	$	0	$	0
Issued by State and municipal		1,108		0		1,108		0		0
Mortgage-backed securities issued by Government agencies		38,600		0		38,600		0		0
Other debt securities		2,137		0		23		2,114		0

Total Debt Securities		88,810		0		86,696		2,114		0


Investment Securities Available for Sale – Equity Securities
Mutual funds		634		0		634		0		0

Total Equity Securities		634		0		634		0		0


Total Assets Measured at Fair Value on a Recurring Basis	$	89,444	$	0	$	87,330	$	2,114	$	0


(in thousands)			Fair Value Measurements at December 31, 2010 Using
Description	Fair Value December 31, 2010		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Changes in Fair Values Included in Period Earnings

Investment Securities Available for Sale – Debt Securities
Issued by the U.S. Treasury and Government agencies	$	53,761	$	0	$	53,761	$	0	$	0
Issued by State and municipal		1,089		0		1,089		0		0
Mortgage-backed securities issued by Government agencies		37,737		0		37,737		0		0
Other debt securities		3,091		0		690		2,401		0

Total Debt Securities		95,678		0		93,277		2,401		0


Investment Securities Available for Sale – Equity Securities
Mutual funds		617		0		617		0		0

Total Equity Securities		617		0		617		0		0


Total Assets Measured at Fair Value on a Recurring Basis	$	96,295	$	0	$	93,894	$	2,401	$	0


Fair Value Measurements Using Significant Unobservable Inputs (Level 3) – Roll Forward at June 30, 2011

Investment Securities Available for Sale – Debt Securities
Beginning Balance	$	2,401
Transfers in to Level 3		0
Transfers out of Level 3		0
Unrealized losses		(4	)
Repayments		(283	)

Ending Balance	$	2,114

Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include securities below investment grade and asset-backed securities in illiquid markets. Level 3 securities include two private-label residential one to-four family mortgage backed securities. These 2005 senior tranches in a securitization trust were rated “Aa1 and Aaa” by Moody’s when purchased in 2005 and are currently rated “B3”. The Company engages the service of independent third party valuation professionals to estimate the fair value of these securities. The valuation is meant to be “Level 3” pursuant to FASB ASC Topic 820 – Fair Value Measurements and Disclosures. The valuation uses an expected cash flow model that includes assumptions related to prepayment rates, default trends, and loss severity. At June 30, 2011, both securities were current on both principal and interest payments, and had a fixed weighted average coupon of 5.50%. One security had a weighted average remaining life of less than one year and the other had a weighted average remaining life of just over two years.

The following table details the Level 3 securities:

Remaining

Current Rating

(in thousands)

Class

Coupon

Par Value

Moody’s

Fitch

CWHL 2005-21

A13

5.5% Fixed

424

WFMBS 2005-14

IA7

5.5% Fixed

1,791

We calculated fair value for the two securities by using a present value of future cash flows model, which incorporated assumptions as follows as of June 30, 2011:

Weighted

Cumulative

Average

Modified

Default (1)

Life (2)

Duration (3)

Yield (4)

CWHL 2005-21

4.65

0.89 years

0.80 years

8.00

WFMBS 2005-14

2.52

2.39 years

2.03 years

8.00

(1)	The anticipated level of total defaults from the issuer within the pool of performing collateral as of June 30, 2011.

(2)	The average number of years that each dollar of principal remains outstanding.

(3)	The weighted average of present values for a series of cash flows which accurately indicates the average time until the cash flows are received.

(4)	The discount rate obtained from taking a sequence of cash flows and an estimated price.

The Company may be required from time to time, to measure certain assets at fair value on a non-recurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis are included in the following tables.


(in thousands)			Fair Value Measurements at June 30, 2011 Using
Description	Fair Value June 30, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Trading Gains and (Losses)		Total Changes in Fair Values Included in Period Earnings

Loans
Commercial	$	1,007	$	0	$	1,007	$	0	$	0	$	0
Commercial real estate		353		0		353		0		0		0
Residential real estate		2,238		0		2,238		0		0		0
Construction		813		0		813		0		0		0
Consumer		358		0		358		0		0		0

Total loans		4,769		0		4,769		0		0		0
Real estate owned		1,540		0		1,540		0		0		0
Other assets (repossessed assets)		65		0		65		0		0		0

Total Assets Measured at Fair Value on a Nonrecurring Basis	$	6,374	$	0	$	6,374	$	0	$	0	$	0


(in thousands)			Fair Value Measurements at December 31, 2010 Using
Description	Fair Value December 31, 2010		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Trading Gains and (Losses)		Total Changes in Fair Values Included in Period Earnings

Loans
Commercial	$	1,562	$	0	$	1,562	$	0	$	0	$	0
Commercial real estate		1,449		0		1,449		0		0		0
Residential real estate		2,402		0		2,402		0		0		0
Construction		1,234		0		1,234		0		0		0
Consumer		280		0		280		0		0		0

Total loans		6,927		0		6,927		0		0		0
Real estate owned		1,608		0		1,608		0		0		0
Other assets (repossessed assets)		145		0		145		0		0		0

Total Assets Measured at Fair Value on a Nonrecurring Basis	$	8,680	$	0	$	8,680	$	0	$	0	$	0

Loans for which it is probable that the Company will not collect all of principal and interest due according to contractual terms are measured for impairment in accordance with FASB guidance on Accounting by Creditors for Impairment of a Loan. Allowable methods for estimating fair value include using the fair value of the collateral for collateral dependent loans or, where a loan is determined not to be collateral dependent, using the discounted cash flow method. In our determination of fair value, we have categorized both methods of valuation as estimates based on Level 2 inputs.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal or utilizing some other method of valuation for the collateral and applying a discount factor to the value based on our loan review policy and procedures.

If the impaired loan is determined not to be collateral dependent, then the discounted cash flow method is used. This method requires the impaired loan to be recorded at the present value of expected future cash flow’s discounted at the loan’s effective interest rate. The effective interest rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premiums, or discounts existing at origination or acquisition of the loan.

Management establishes a specific reserve for loans that have an estimated fair value below the carrying value. Nonperforming loans had a carrying value of $5.7 million as of June 30, 2011. Of the $5.7 million of nonperforming loans, $2.9 million had specific reserves of $913,000.

When there is little prospect of collecting principal or interest, loans, or portions of loans, may be charged-off to the allowance for credit losses. Losses are recognized in the period an obligation becomes uncollectible. The recognition of a loss does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the loan even though a partial recovery may occur in the future. During the six months ended June 30, 2011 the Company charged-off $1.1 million of impaired loans to the allowance for credit losses.

Property acquired by the Company as a result of foreclosure on a mortgage loan will be classified as “real estate owned.” Personal property acquired through repossession will be classified as “repossessed assets.” Property acquired will be recorded at the lower of the unpaid principal balance or fair value at the date of acquisition and subsequently carried at the lower of cost or net realizable value. Any required write-down of the loan to its net realizable value will be charged against the allowance for credit losses. As of June 30, 2011 the Company held $1.5 million in real estate owned as a result of foreclosure. Real estate owned carried at appraised value is considered to be using Level 2 inputs. The Company held $1.6 million in real estate owned as a result of foreclosure as of December 31, 2010.

The Company records repossessed assets such as boats, automobiles or equipment at the lower of cost or estimated fair value on the acquisition date and at the lower of such initial amount or estimated fair value less selling costs thereafter. Estimated fair value is generally based upon independent values of the collateral obtained through valuation or listing services specifically used for the type of asset repossessed. We consider these collateral values to be estimated using Level 2 inputs. Repossessed assets totaled $65,000 at June 30, 2011 and $145,000 at December 31, 2010.

The estimated fair values of the Company’s financial instruments are summarized below. The fair values of a significant portion of these financial instruments are estimates derived using present value techniques and may not be indicative of the net realizable or liquidation values. Also, the calculation of estimated fair values is based on market conditions at a specific point in time and may not reflect current or future fair values.


	June 30, 2011				December 31, 2010
(dollars in thousands)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets
Cash and due from banks	$	2,724	$	2,724	$	7,854	$	7,854
Interest bearing balances with banks		8,713		8,713		16,856		16,856
Federal funds sold		25,191		25,191		11,984		11,984
Investment securities		89,444		89,444		96,295		96,295
Federal Reserve and Federal Home Loan Bank stock		3,013		3,013		3,035		3,035
Loans and loans held for sale, net		282,868		283,987		273,063		273,454
Accrued interest receivable		1,376		1,376		1,567		1,567
Bank owned life insurance		5,531		5,531		5,442		5,442
Real estate owned		1,540		1,540		1,608		1,608
Financial liabilities
Noninterest bearing deposits	$	48,774	$	48,774	$	45,514	$	45,514
Interest bearing deposits		291,125		295,684		295,400		299,239
Securities sold under agreements to repurchase		16,161		16,161		14,558		14,558
Long-term borrowings		35,000		32,267		35,000		32,483
Junior subordinated debt		5,000		5,000		5,000		5,000
Accrued interest payable		174		174		187		187

The carrying amount of cash and due from banks, federal funds sold and interest bearing balances with banks approximates fair value.

The fair values of U.S. Treasury and Government agency securities and mortgage backed securities are determined using market quotations.

The carrying amount of Federal Reserve stock and Federal Home Loan Bank stock approximates fair value.

The fair value of fixed-rate loans is estimated to be the present value of scheduled payments discounted using interest rates currently in effect. The fair value of variable-rate loans, including loans with a demand feature, is estimated to equal the carrying amount. The valuation of loans is adjusted for possible credit losses. The fair value of loans held for sale are at the carrying value (lower of cost or market) since such loans are typically committed to be sold (servicing released) at a profit.

The carrying amount of accrued interest receivable approximates fair value.

The fair value of bank owned life insurance is the current cash surrender value which is the carrying value.

The carrying value of real estate owned approximates fair value at the reporting date.

The fair value of noninterest bearing deposits is the amount payable on demand at the reporting date, since generally accepted accounting standards does not permit an assumption of core deposit value.

The fair value of interest bearing transaction, savings, and money market deposits with no defined maturity is the amount payable on demand at the reporting date, since generally accepted accounting standards does not permit an assumption of core deposit value.

The fair value of certificates of deposit is estimated by discounting the future cash flows using the current rates at which similar deposits would be accepted.

The carrying amount for customer repurchase agreements and variable rate borrowings approximate the fair values at the reporting date. The fair value of fixed rate Federal Home Loan Bank advances is estimated by computing the discounted value of contractual cash flows payable at current interest rates for obligations with similar remaining terms. The fair value of variable rate Federal Home Loan Bank advances is estimated to be carrying value since these liabilities are based on a spread to a current pricing index.

The carrying amount of junior subordinated debentures approximate the fair values at the reporting date.

The carrying amount of accrued interest payable approximates fair value.

Management has reviewed the unfunded portion of commitments to extend credit, as well as standby and other letters of credit, and has determined that the fair value of such instruments is equal to the fee, if any, collected and unamortized for the commitment made.

Note H – Preferred Stock

The Company is authorized to issue up to 5,000,000 shares of preferred stock with a par value of $.01 per share. On January 30, 2009 the Company completed a transaction to participate in the Government sponsored Troubled Asset Relief Program which resulted in the Treasury purchasing 8,152 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) at a value of $8.2 million. The Series A Preferred Stock qualifies as Tier 1 Capital. The Series A Preferred Stock pays a dividend of 5% per annum; payable quarterly for five years then pays a dividend of 9% per annum thereafter. Dividends declared for each of the six months ended June 31, 2011 and 2010 was $203,800.

The warrant is exercisable at $4.08 per share at any time on or before January 30, 2019. The number of shares of common stock issuable upon exercise of the warrant and the exercise price per share will be adjusted if specific events occur.

Note I – New Accounting Pronouncements

All pending but not yet effective Accounting Standards Updates (“ASU”) were evaluated and only those listed below could have a material impact on the Company’s financial condition or results of operation.

In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures About Fair Value Measurement,” which provided guidance on disclosure requirements about transfers into and out of Levels 1, 2, and 3, clarified existing fair value disclosure requirements about the appropriate level of disaggregation, and clarified that a description of the valuation technique (e.g., market approach, income approach, or cost approach) and inputs used to measure fair value was required for recurring, nonrecurring, and Level 2 and 3 fair value measurements. The guidance is effective for the Company’s interim and annual reporting periods beginning after December 15, 2009 except for gross basis presentation for Level 3 reconciliation, which is effective for interim and annual periods beginning after December 15, 2010. The disclosure did not have a material impact on our financial condition or results of operations.

In the second quarter 2010, additional guidance was issued under ASU No. 2010-20, “Receivables (Topic 310) - Disclosures about Credit Quality of Financing Receivables and the Allowance for Credit Losses.” ASU 2010-20 requires additional disclosures related to the Allowance for Credit Losses with the objective of providing financial statement users with greater transparency about an entity’s loan loss reserves and overall credit quality. Additional disclosures include showing on a disaggregated basis the aging of receivables, credit quality indicators and troubled debt restructuring with its effect on the Allowance for Credit Losses. The provisions of this standard became effective for interim annual periods ending on or after December 15, 2010. The adoption of this standard did not have a material impact on our financial condition or results of operations but did increase the amount of disclosures in the notes to the financial statements.

ASU 2011-01, “Receivables (Topic 310) - Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20,” temporarily deferred the effective date for disclosures related to troubled debt restructurings to coincide with the effective date of the then proposed ASU 2011-02, “Receivables (Topic 310) - A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring,” which is further discussed below.

In April 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” ASU No. 2011-02 provides additional guidance and clarification to help creditors in determining whether a creditor has granted a concession and whether a debtor is

experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The provisions of ASU No. 2011-02 will be effective for the Company’s reporting period ended September 30, 2011 and will be applied retrospectively to January 1, 2011. As a result of the retrospective application, the Company may identify loans that are newly considered impaired. The adoption of this ASU is not expected to have a material impact on the Company’s statements of operations and financial condition

In April, 2011, the FASB issued ASU No. 2011-03, “Reconsideration of Effective Control for Repurchase Agreements.” ASU No. 2011-03 affects all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The amendments in ASU No. 2011-03 remove from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU No. 2011-03 also eliminates the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. The guidance is effective for the Company’s reporting period ended March 31, 2012. The guidance will be applied prospectively to transactions or modifications of existing transaction that occur on or after January 1, 2012.

In May, 2011, FASB issued ASU No. 2011-04, “ASU No. 2011-04; Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The Company will adopt the methodologies prescribed by this ASU by the date required, and does not anticipate that the ASU will have a material impact on its financial condition or results of operations.

In June, 2011, FASB issued ASU No. 2011-05, “ASU No. 2011-05; Amendments to Topic 220, Comprehensive Income.” Under the amendments in this ASU an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.

The amendments in ASU 2011-05 should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The provisions of ASU 2011-05 are effective for the

Company’s first reporting period beginning on January 1, 2012, with early adoption permitted, The Company is in the process of evaluating the impact of adoption of ASU 2011-05 and does not expect it to have a material impact on the Company’s future financial statements.

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 2010 consolidated financial statements which can be found in 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 Bank’s allowance for credit losses is established through a provision for loan losses based on management’s evaluation of the risks inherent in its loan portfolio and the general economy. The allowance for credit losses is maintained at an amount management considers adequate to cover estimated losses in loans receivable which are deemed probable and estimable based on information currently known to management. The Bank estimates an acceptable allowance for credit loss with the objective of quantifying portfolio risk into a dollar figure of inherent losses, thereby translating the subjective risk value into an objective number. Emphasis is placed on independent external loan reviews and regular internal reviews. The determination of the allowance for loan losses is based on a combination of the higher of the Bank’s historical loss experience or the peer group average historical loss experience and ten (10) qualitative factors for specific categories and types of loans. The combination of the loss experience factor and the total qualitative factors (“Total ALLL Factor”) is expressed as a percentage of the portfolio for specific categories and types of loans to create the inherent loss index for each loan portfolio. Individual loans deemed impaired are separated from the respective loan portfolios and a specific reserve allocation is assigned based upon Bank management’s best estimate as to the loss exposure for each loan. Each Total ALLL Factor is assigned a percentage weight and that total weight is applied to each loan category. The Total ALLL Factor is different for each loan type and for each risk assessment category within each loan type.

•

The Bank’s historical loss experience is calculated by aggregating the actual loan losses by category for the previous eight quarters and converting that total into a percentage for each loan category.

•

Peer Group average loss experience is calculated by averaging the industry loss experience by loan category over the last three full years and the current year to date. (Based upon the current economic and industry conditions, Bank management has shortened the “look back” at peer group loss experience to include an annualized average of the last eight “rolling” quarters).

•

Qualitative factors include: levels and trends in delinquencies and non-accruals; trends in volumes and terms of loans; effects of any changes in lending policies; the experience, ability and depth of management; national and local economic trends and conditions; concentrations of credit; quality of the bank’s loan review system; and, external factors, such as competition, legal and regulatory requirements.

The total allowance for credit losses changes as the percentage weight assigned to each Total ALLL Factor is increased or decreased due to its particular circumstance, as the various types and categories of loans change as a percentage of total loans and as the aggregate of specific allowances is adjusted due to an increase or decrease in impaired loans.

Management believes this approach effectively measures the risk associated with any particular loan or group of loans. The Bank’s Board of Directors engages an independent loan review consultant to evaluate the adequacy of the Bank’s allowance for credit losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for credit losses. Such agencies may require the Bank to make additional provisions for estimated credit losses based upon judgments different from those of management. The Bank recorded a total provision for credit losses of $679,000 for the three month period ended June 30, 2011 and $363,000 for the same period

in 2010. For the six month periods ended June 30, 2011 and 2010 the Bank recorded provisions of $1.2 million and $599,000, respectively. The aggregate provision was based upon the results of quarterly evaluations using a combination of factors including the level of nonperforming loans, the Bank’s growth in total gross loans and the Bank’s net credit loss experience. Total gross loans, including loans held for sale, increased by $10.2 million for the six months ended June 30, 2011. For the same period, the Bank recorded charge-offs of $1.1 million and recovered $273,000 on previously charged-off loans. As of June 30, 2011, the Bank’s allowance for credit losses was $7.3 million or 2.51% of total loans and 128.0% of nonperforming loans as compared to $6.9 million, or 2.45% of total loans and 81.7% of nonperforming loans as of December 31, 2010.

The Bank continues to monitor and modify its allowance for credit losses as conditions dictate. While management believes that, based on information currently available, the Bank’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 Bank’s level of allowance for credit losses will be sufficient to cover future loan losses incurred by the Bank 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.

Activity in the allowance for credit losses for the six months ended June 30, 2011 and 2010 is shown below:


(dollars in thousands)	For the Six Months Ended June 30,
	2011			2010
Total loans outstanding - at June 30⁽¹⁾	$	290,140		$	276,363
Average loans outstanding year-to-date		285,091			276,724

Allowance for credit losses at beginning of period	$	6,853		$	7,926

Provision charged to expense		1,236			599

Chargeoffs:
Commercial loans		772			1,242
Real estate and construction loans		182			199
Consumer and other loans		136			327

Total		1,090			1,768

Recoveries:
Commercial loans		10			0
Real estate and construction loans		253			2
Consumer and other loans		10			22

Total		273			24


Net chargeoffs		817			1,744

Allowance for credit losses at end of period	$	7,272		$	6,781


Allowance for credit losses as a percent of total loans		2.51	%		2.45	%
Net chargeoffs (recoveries) as a percent of average loans		0.29	%		0.63	%

⁽¹⁾	Includes loans held for sale.

The Bank’s nonperforming assets, which are comprised of loans delinquent 90 days or more, non-accrual loans, loans with repossessed collateral and repossessed assets, totaled $7.3 million at June 30, 2011, compared to $10.1 million at December 31, 2010, a decrease in nonperforming assets of $2.8 million or 28.2%. The percentage of nonperforming assets to total assets was 1.68% at June 30, 2011, compared to 2.35% at December 31, 2010. The

decrease in nonperforming assets was principally attributable to sales, payoffs and pay-downs of nonperforming assets of $2.4 million, the charge-off of $1.1 million of loans previously classified as nonperforming, the return to performing of $285,000 of loans and additional write-downs taken on REO and repossessed assets of $117,000. Offsetting these decreases was the addition to nonperforming of net new totaling $1.3 million.

The $7.3 million in nonperforming assets at June 30, 2011 included $5.7 million in nonaccrual loans, and $1.6 million in other assets. Of the $5.7 million in nonaccrual loans at June 30, 2011, $4.2 million were secured by real estate, $1.1 million were commercial loans and $393,000 were consumer and other loans. At December 31, 2010, assets classified as nonperforming totaled $10.1 million and consisted of $8.4 million in nonaccrual loans and loans delinquent 90 days or more and $1.7 million in other assets. Included in the $8.4 million of nonaccrual and loans delinquent 90 days or more was $5.7 million of loans secured by real estate, $2.1 million of commercial and $630,000 of consumer and other loans.

Comparison of Financial Condition at June 30, 2011 and December 31, 2010

Total assets of $434.0 million at June 30, 2011 increased 0.42% or $1.9 million compared to $432.1 million at December 31, 2010. Loan demand improved in the first six months of 2011, with $290.3 million of gross loans as of June 30, 2011, an increase of $10.2 million from $280.1 million at December 31, 2010. The increase resulted primarily from the origination, net of payments of approximately $12.6 million in real estate secured loans offset by charge-offs of $1.1 million and the net sale of $1.4 million of loans held for sale. Investment securities decreased $6.9 million or 7.1% compared to December 31, 2010 while federal funds sold as of June 30, 2011 increased $13.2 million or 110.2% from December 31, 2010. The movement of balances allowed the Company to maintain sufficient liquidity for future loan generation while maximizing the yield on funds not specifically earmarked for growth or expansion.

Deposits of $339.9 million at June 30, 2011 decreased $1.0 million or 0.3% from December 31, 2010 deposits of $340.9 million. Savings balances decreased $3.5 million in total, due in part to a $3.0 million transfer into a certificate of deposit. Certificate of deposit balances, however, excluding the $3.0 million transfer decreased $4.7 million due to higher rate certificates of deposit maturing. Money market balances increased $2.0 million.

Comparison of Operating Results for the Six Months Ended June 30, 2011 and 2010.

General. The Company recorded net income of $835,000 for the six months ended June 30, 2011; a decrease of $265,000, compared to net income of $1.1 million for the six months ended June 30, 2010. Net income available to common shareholders for the six months ended June 30, 2011 was $590,000 or $0.15 per basic and $0.14 per diluted common shares compared to net income available to common shareholders of $814,000 or $0.21 per basic and diluted shares for the six months ended June 30, 2010. Net interest income increased by $287,000 or 3.7% for the six months ended June 30, 2011 compared to the same period in 2010. The provision for credit losses increased $637,000 to $1.2 million for the six months ended June 30, 2011 compared to $599,000 for the six month period ended June 30, 2010.

Interest Income. Total interest income decreased $379,000 or 3.7% for the six months ended June 30, 2011 compared to the same period in 2010 as a result of lower yields on investment securities. Interest income on investments decreased $827,000. The yield on the investment portfolio decreased to 3.01% from 4.01% on balances $18.4 million lower on average over the same period in 2010. Income on the loan portfolio increased $453,000 for the six months ended June 30, 2011 to $8.5 million from $8.0 million for the six months ended June 30, 2010 due to an increase in average loan balances of $8.4 million and the recognition of $180,000 as income, from a paid-off loan previously classified as nonaccrual. The yield on the loan portfolio increased to 5.98% for the six months ended June 30, 2011 from 5.83% for the six months ended June 30, 2010.

Interest Expense. Total interest expense decreased by $666,000 or 26.2% for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The decrease was due to reducing the yields on the Company’s “Superior Savings” product and other interest bearing accounts. The Company’s savings product had an average balance of $139.9 million for the six months ended June 30, 2011 and a yield of 0.73% compared to an average balance of $142.2 million and a yield of 1.09% for the six months ended June 30, 2010. Contributing to the decrease in interest expense were the lower yields on all other deposit products, primarily money market accounts and certificates of deposit and the lower yields on repurchase agreements. The average rate of interest paid on all interest bearing liabilities was 1.08% for the six months ended June 30, 2011 compared to 1.42% for the six months ended June 30, 2010. Interest expense on long-term borrowings and junior subordinated debentures was $646,000 for the six months ended June 30, 2011 compared to $669,000 for the six months ended June 30, 2010, a decrease of $23,000. The decrease in expense was a result of average Federal Home Bank advances decreasing to $35.0 million for the six months ended June 30, 2011 compared to $37.1 million on average for the same period in 2010.

Net Interest Income. Net interest income increased by $287,000 million or 3.7% for the six months ended June 30, 2011 compared to the six months ended June 30, 2010. The increase was primarily the result of the lower overall cost of deposits. The Company’s cost of funds decreased to 0.96% for the six months ended June 30, 2011 compared to 1.27% for the six months ended June 30, 2010.

For the six months ended June 30, 2011, the net interest margin increased to 3.95% compared to 3.71% for the six months ended June 30, 2010. The increase in net interest margin was primarily the result of the decrease in the yield paid on interest bearing liabilities to 1.08% from 1.42%. The yield on earning assets decreased to 4.87% for the six months ended June 30, 2011 from 4.93% for the same period in 2010. Income of approximately $180,000 on a loan previously categorized as nonaccrual was recognized during the six month period ended June 30, 2011 compared to income of $280,000 recognized on loans categorized as nonaccrual for the six months ended June 30, 2010.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $1.2 million for the six months ended June 30, 2011 compared to $599,000 for the same period in 2010. The provision was based on the composition and credit quality of the loan portfolio as of June 30, 2011 and reflected 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 gross loans increased by $10.2 million for the six month period ended June 30, 2011 compared to December 31, 2010. The Bank recorded net charge-offs on loans deemed uncollectible of $817,000 for the six months ended June 30, 2011 compared to $1.7 million for the same period in 2010.

Noninterest Income. Total noninterest income decreased by $169,000 or 18.9% to $724,000 for the six months ended June 30, 2011 from $893,000 for the same period in 2010. The decrease in noninterest income was due to lower fee income from mortgage banking activity and loans held for sale, losses recognized on the disposal of fixed assets related to the May 27, 2011 closure of the Bank’s Market House branch and losses on the sale of repossessed assets. Offsetting the decreases in income was the absence of losses on the sale of investment securities which totaled $55,000 for the six months ended June 30, 2010 compared to zero for the six months ended June 30, 2011.

Noninterest Expense. Total noninterest expense decreased by $105,000 or 1.6% for the six months ended June 30, 2011 compared to the same period in 2010. The decrease in total noninterest expense during the first six months of 2011 compared with the same period in 2010 resulted from decreased legal collection expenses of $94,000 and lower costs associated with originating and processing loans held for sale. Other expense, that includes costs associated with managing real estate owned and repossessed assets, increased by $74,000 over the same period in 2010. The reduction in legal fees was the result, of receiving reimbursement of $44,000 of legal costs from the payoff of a loan previously classified as nonperforming. The remaining decrease in legal expenses was the result of lower collection related expenses. The costs to maintain repossessed assets increased $18,000 for the six months ended June 30, 2011 as additional write-downs were taken on foreclosures and repossessions. The decrease in costs for loans held for sale was volume related. Offsetting the decreases in noninterest expense was an increase in occupancy and equipment expense related to the acceleration of the amortization of leasehold improvements at the Bank’s Market House branch that closed on May 27, 2011.

Income Tax Expense. The Company recorded income tax expense for the six-month period ended June 30, 2011 of $406,000 compared to $600,000 for the six months ended June 30, 2010. The Company’s combined effective federal and state income tax rate was approximately 32.7% for the six months ended June 30, 2011 versus 36.3% for the six months ended June 30, 2010.

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)	Six Months Ended June 30, 2011 vs. 2010
				Due to Change in
	Increase or (Decrease)			Volume			Rate			Rate/ Volume
Interest income on:
Loans	$	453		$	242		$	205		$	6
Investment securities		(828	)		(365	)		(553	)		90
Interest bearing deposits in other banks		(5	)		0			(5	)		0
Federal funds sold and other overnight investments		1			(1	)		2			0

Total interest income		(379	)		(124	)		(351	)		96

Interest expense on:
NOW accounts		(3	)		3			(5	)		(1	)
Money market accounts		(54	)		(2	)		(53	)		1
Savings accounts		(265	)		(12	)		(257	)		4
Certificates of deposit		(312	)		(124	)		(219	)		31
Repurchase agreements		(9	)		7			(14	)		(2	)
Long-term borrowing		(24	)		(34	)		10			0
Junior subordinated debt		1			0			1			0

Total interest expense		(666	)		(162	)		(537	)		33


Net interest income	$	287		$	38		$	186		$	63

Consolidated Average Balances, Yields and Rates


(dollars in thousands)	Six Month Periods Ended
	June 30, 2011							June 30, 2010
	Average Balance		Interest (1)		Yield/ Rate			Average Balance		Interest (1)		Yield/ Rate
Assets
Interest earning assets
Federal funds sold and other overnight investments	$	13,795	$	15		0.22	%	$	15,069	$	15		0.20	%
Interest bearing balances with banks		16,350		9		0.11	%		15,918		14		0.18	%
Investment securities (1)		93,908		1,404		3.01	%		112,278		2,231		4.01	%
Loans (2)		285,091		8,459		5.98	%		276,724		8,006		5.83	%

Total interest earning assets		409,144		9,887		4.87	%		419,989		10,266		4.93	%
Noninterest earning assets
Cash and due from banks		7,785							2,438
Other assets		15,663							15,326

Total Assets	$	432,592						$	437,753


Liabilities and Stockholders’ Equity
Interest bearing deposits
NOW accounts	$	33,308	$	22		0.13	%	$	29,586	$	25		0.17	%
Money market accounts		42,474		105		0.50	%		43,097		159		0.74	%
Savings accounts		139,910		505		0.73	%		142,188		770		1.09	%
Certificates of deposit		77,075		556		1.45	%		89,918		868		1.95	%
Repurchase agreements		15,814		41		0.52	%		13,903		50		0.73	%
Long-term borrowings		35,000		559		3.22	%		37,147		583		3.16	%
Junior subordinated debt		5,000		87		3.51	%		5,000		86		3.47	%

Total interest bearing liabilities		348,581		1,875		1.08	%		360,839		2,541		1.42	%

Noninterest bearing Liabilities
Demand deposit accounts		46,679							41,061
Other liabilities		2,041							1,723
Stockholders’ Equity		35,291							34,130

Total Liabilities and Stockholders’ Equity	$	432,592						$	437,753


Interest rate spread						3.79	%						3.51	%
Ratio of interest earning assets to interest bearing liabilities						117.37	%						116.39	%
Net interest income and net interest margin			$	8,012		3.95	%			$	7,725		3.71	%

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

(2)	Includes nonaccrual loans

Comparison of Operating Results for the Three Months Ended June 30, 2011 and 2010.

General. The Company recorded net income for the three months ended June 30, 2011 of $326,000, a decrease of $112,000, compared to a net income of $438,000 for the three months ended June 30, 2010. Net income available to common shareholders was $203,000 or $0.05 per basic and diluted common share, compared to net income available to common shareholders of $318,000 or $0.08 per basic and diluted common share for the three months ended June 30, 2010. Net interest income improved to $4.0 million from $3.7 million, an increase of $328,000 or 8.9% for the three months ended June 30, 2011 compared to the same period in 2010. The Bank recorded $679,000 in provision for credit losses during the three months ended June 30, 2011, compared to $363,000 in provision for credit losses during the same period in 2010.

Interest Income. Interest income increased $60,000 or 1.2% for the quarter ended June 30, 2011 compared to the same quarter in 2010. The improvement is a result of an increase in average loan balances of $11.9 million and an increase in yield on the loan portfolio to 5.94% from 5.64% for the three months ended June 30, 2011 compared to June 30,

2010. Income on the investment portfolio decreased $318,000 for the quarter ended June 30, 2011 compared to the same period in 2010 due to a decrease in volume as average investment security balances decreased by $16.2 million and the yield decreased to 3.02% from 3.74% for the same period in 2010.

Interest Expense. Interest expense decreased by $268,000 or 22.1% for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 while average interest bearing deposit balances decreased $7.2 million. Interest expense on interest bearing deposits for the quarter ended June 30, 2011 was $594,000 compared to $858,000 for the same period in 2010, a 30.8% decrease. The decrease in interest expense was due to the lower cost of all interest bearing deposit types with the yield dropping to 0.81% for the three months ended June 30, 2011 compared to 1.14% for the three months ended June 30, 2010. Decreases in the Company’s cost of savings accounts to 0.73% from 1.05%, in the cost of the Company’s indexed money market account to 0.49% from 0.73% and a decrease to 1.44% from 1.83% in the cost of the Company’s certificates of deposit contributed to the reduction in interest expense. The total cost of interest bearing liabilities decreased for the quarter ended June 30, 2011 to 1.07% from 1.36% for the quarter ended June 30, 2010. The Company’s overall cost of funds decreased to 0.94% from 1.22% for the same periods. Interest expense on long-term borrowings and junior subordinated debentures remained at $324,000 with a yield of 3.25% for each of the three months ended June 30, 2011 and June 30, 2010.

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.

Net interest income improved by $328,000 or 8.9% for the three months ended June 30, 2011 compared to the three months ended June 30, 2010. The improvement was due primarily to an increase in the yield on the loan portfolio and a decrease in interest expense offset by a decrease in the yield on, and volume of investment securities.

For the three months ended June 30, 2011, the net interest margin improved to 3.90% from 3.55% for the three months ended June 30, 2010, with the interest rate spread for the same period increasing to 3.74% in the second quarter of 2011 from 3.35% in the same quarter in 2010. The increase in the net interest margin was the result of a decrease in the yield paid on interest bearing liabilities to 1.07% from 1.36% and improvement to 5.94% from 5.64% in the yield on loans. The yields on federal funds sold and other overnight investments, interest bearing balances with banks, and the overall investment portfolio were negatively impacted by the lower rate environment as re-investment rates continued to fall quarter over quarter.

Provision for Credit Losses. The Bank recorded a provision for credit losses of $679,000 for the three months ended June 30, 2011 compared to $363,000 for the same period in 2010. The increase in provision was due in part to higher loss experience on several segments of the loan portfolio as well as an increase in total loans outstanding. The Bank recorded net charge-offs of $298,000 for the quarter ended June 30, 2011 compared to net charge-offs of $1.3 million for the three months ended June 30, 2010. Nonperforming assets totaling $7.3 million at quarter-end were comprised of $5.7 million of nonaccrual loans and $1.6 million in other assets.

Noninterest Income. Noninterest income decreased by $125,000 or 26.0% to $356,000 for the three months ended June 30, 2011 from $481,000 for the same period of 2010. Non interest income decreased for the three months ended June 30, 2011 in part due to losses on the sale of repossessed assets as well as lower income from mortgage banking activities.

Noninterest Expense. Noninterest expense increased by $65,000 or 2.1% for the three months ended June 30, 2011 compared to the same quarter in 2010. The increase in noninterest expense was due to increased occupancy expense. The increase was the result of the acceleration of the amortization of leasehold improvements when the Bank closed its Market House location. Also contributing to the increase in noninterest expense were additional marketing costs as well as costs to maintain real estate owned and repossessed assets. Offsetting these expense increases was a decrease in and reimbursement of legal expenses for loan collection.

Income Tax Expense. The Company recorded tax expense of $169,000 for the three-month period ended June 30, 2011. The Company’s combined effective federal and state income tax rate was approximately 34.1% for the three months ended June 30, 2011 versus 34.9% for the three months ended June 30, 2010.

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 June 30, 2011, total deposits were $339.9 million. Core deposits, considered to be stable funding sources and defined as all deposits except time deposits totaled $264.3 million or 77.8% 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 June 30, 2011, interest bearing deposits with banks, federal funds sold and other overnight investments totaled $33.9 million while investment securities available-for-sale totaled $89.4 million.

In addition, the Bank has external sources of funds, which can be used as needed. The FHLB is the primary source of this external liquidity. The FHLB has established credit availability for banks up to 40% of the bank’s total assets. The Bank currently has an approved line of credit with the FHLB of 25% of total assets with the ability to request an increase in the line if necessary. Total assets are based on the most recent quarterly financial information submitted by the Bank to the appropriate regulatory agency. The ability to borrow funds is subject to the Bank’s continued creditworthiness, compliance with the terms and conditions of the FHLB’s Advance Applications and the pledging of sufficient eligible collateral to secure advances. At June 30, 2011, the Bank had a $108.5 million credit limit with the FHLB with advances outstanding of $35.0 million. The Bank had loans currently

pledged as collateral sufficient to borrow up to $9.8 million of the remaining $73.5 million availability from the FHLB. The Bank also has the ability to borrow from the Federal Reserve Bank’s discount window. Additional collateral including cash, investment securities and home-equity loans are available for pledging purposes in the event the Bank would need to draw on the unused portion of the line of credit. Additionally, at June 30, 2011, the Bank had available credit with its correspondent banks of $19.2 million.

Capital Resources

Total stockholders’ equity was $35.8 million at June 30, 2011, representing an increase of $991,000 or 2.9% from December 31, 2010. The growth of stockholders’ equity in the first six months of 2011 was attributable to income of $835,000, stock based compensation of $57,000, stock purchases through the Company’s Employee Stock Purchase Plan of $3,000, the exercise of options totaling $14,000, and an increase in accumulated other comprehensive income of $286,000 resulting from higher market values of securities available-for-sale. Offsetting these increases was a decrease in stockholder’s equity from the declaration of $204,000 in preferred stock dividends.

During the first quarter of 2009 the Company received an infusion of capital under TARP. Under TARP, the U. S. Treasury created the CPP, pursuant to which it provides access to capital that will serve as Tier 1 capital to financial institutions through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions. 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 Treasury under the CPP for a total purchase price of $8,152,000.

The Company currently has $5.0 million of junior subordinated debt issued in the form of trust preferred securities. Trust preferred securities are considered regulatory capital for purposes of determining the Company’s Tier 1 capital ratios. Regulatory guidance was issued by the Board of Governors of the Federal Reserve System ruled that banks could continue to include trust preferred securities in regulatory capital.

The following table summarizes the Company’s risk-based capital ratios:

Annapolis Bancorp, Inc.


	June 30, 2011			December 31, 2010			Minimum Regulatory Requirements			Well-Capitalized Regulatory Requirements
Risk Based Capital Ratios:
Tier 1 Capital		12.8	%		12.8	%		4.0	%		6.0	%
Total Capital		14.0	%		14.1	%		8.0	%		10.0	%
Tier 1 Leverage Ratio		9.2	%		9.1	%		4.0	%		5.0	%

As of June 30, 2011, both the Company and the Bank met the criteria for classification as a “well-capitalized” institution. Designation as a well-capitalized institution under these regulations is not a recommendation or endorsement of the Company or the Bank by federal bank regulators.

Risk Management

The Board of Directors is the foundation for effective corporate governance and risk management. The Board demands accountability of management, keeps stockholders’ and other constituencies’ interests in focus, advocates the upholding of the Company’s code of ethics, and fosters a strong internal control environment. Through its Audit Committee, the Board actively reviews critical risk positions, including market, credit, liquidity, and operational risk. The Company’s goal in managing risk is to reduce earnings volatility, control exposure to unnecessary risk, and ensure appropriate returns for risk assumed. Senior management manages risk at the business line level, supplemented with corporate-level oversight through the Asset Liability Committee, internal audit and quality control functions.

Dodd-Frank Wall Street Reform and Consumer Protection Act

As a result of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) banks are no longer prohibited from paying interest on demand deposit accounts, including those from businesses, effective July 21, 2011. It is not clear what affect the elimination of this prohibition will have on the Bank’s interest expense, allocation of deposits, deposit pricing, loan pricing, net interest margin, ability to compete, ability to establish and maintain customer relationships, or profitability.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

Item 4. Controls and Procedures

As of the end of the period covered by this report, based on an evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15(d)-15(e) under the Exchange Act), each of the chief executive officer and the chief financial officer of the Company has concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in its Exchange Act reports is recorded, processed, summarized and reported within the applicable time periods specified by the Securities and Exchange Commission’s rules and forms.

There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1 – Legal Proceedings

Neither the Company nor the Bank is involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business which involve amounts in the aggregate believed by management to be immaterial to the financial condition of the Company and the Bank.

Item 1A – Risk Factors

Not applicable.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3 – Defaults Upon Senior Securities

None.

Item 4 – Reserved

Item 5 – Other Information

None.

Item 6 – Exhibits

The following exhibits are filed as part of this report.



3.1		Articles of Incorporation of Annapolis Bancorp, Inc.*

3.2		Amended and Restated Bylaws of Annapolis Bancorp, Inc.**

3.3		Articles of Incorporation of BankAnnapolis***

3.4		Bylaws of BankAnnapolis***

4.0		Stock Certificate of Annapolis National Bancorp, Inc.*

4.1		Form of Stock Certificate for the Fixed Rate Cumulative Preferred Stock, Series A. *******

4.2		Warrant To Purchase 299,706 Shares of Common Stock Of Annapolis Bancorp, Inc. *******

10.1		Annapolis National Bancorp, Inc. Employee Stock Option Plan*+

10.2		Annapolis National Bancorp, Inc. 2000 Employee Stock Option Plan****

10.3		Annapolis Bancorp, Inc. 2006 Stock Incentive Plan*****

10.4		Form of Stock Option Award Agreement*****

10.5		Form of Restricted Share Award Agreement*****

10.6		Form of Deferral Election Agreement for Deferred Share Units*****

10.7		Annapolis Bancorp, Inc. 2007 Employee Stock Purchase Plan ******

10.8		Securities Purchase Agreement by and between the United States Department of the Treasury and Annapolis Bancorp, Inc. dated January 30, 2009*******

31.1		Certification Pursuant to Rules 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934, as amended (filed herewith)

31.2		Certification Pursuant to Rules 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934, as amended (filed herewith)

32.1		Certification Pursuant to 18 U.S.C. Section 1350 (filed herewith)

32.2		Certification Pursuant to 18 U.S.C. Section 1350 (filed herewith)


+		Management contract or compensatory plan or arrangement.
*		Incorporated herein by reference to the Company’s Registration Statement on Form SB-2, as amended, Commission File Number 333-29841, filed with the Securities and Exchange Commission on June 23, 1997.
**		Incorporated herein by reference to the Company’s Report on Form 8-K, filed with the Securities and Exchange Commission on October 23, 2007.
***		Incorporated herein by reference to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000, filed with the Securities and Exchange Commission on March 28, 2001.
****		Incorporated herein by reference to the Company’s Definitive Proxy Statement for the 2000 annual meeting, filed with the Securities and Exchange Commission on April 5, 2000.
*****		Incorporated herein by reference to the Company’s Registration Statement on Form S-8, Commission File Number 333-136382, filed with the Securities and Exchange Commission on August 8, 2006.
******		Incorporated herein by reference to the Company’s Definitive Proxy Statement for the 2007 annual meeting, filed with the Securities and Exchange Commission on April 13, 2007.
*******		Incorporated herein by reference to the Company’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on February 2, 2009.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


				ANNAPOLIS BANCORP, INC.
				(Registrant)

Date: August 12, 2011				/s/ Richard M. Lerner
				Richard M. Lerner
				Chief Executive Officer

Date: August 12, 2011				/s/ Edward J. Schneider
				Edward J. Schneider
				Chief Financial Officer

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller Reporting Company