UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

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

For the transition period from to

Commission File No.: 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

I.D. No.)


1000 Bestgate Road, Suite 400, Annapolis, Maryland		21401
(Address of principal executive offices)		(Zip Code)

Registrant’s Telephone Number, including area code:

(410) 224-4455

Securities registered pursuant to Section 12(b) of the Exchange Act:

None

Securities registered pursuant to Section 12(g) of the Exchange Act:


Common Stock $0.01 par value		NASDAQ Capital Market
(Title of class)		(Exchange on which registered)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes: ¨ No: x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes: ¨ No: x

Indicate by check mark whether the registrant (1) has 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨

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

The aggregate market value of the outstanding Common Stock held by nonaffiliates was $9,967,182 as of June 30, 2012 based on a sales price of $6.80 per share of Common Stock.

The number of shares outstanding of the registrant’s Common Stock was 4,059,802 as of March 1, 2013.

INDEX


			PAGE
PART I

	Item 1.	Description of Business		1-10
	Item 1A.	Risk Factors		10
	Item 1B.	Unresolved Staff Comments		10
	Item 2.	Properties		11
	Item 3.	Legal Proceedings		11
	Item 4.	Mine Safety Disclosures		11

PART II

	Item 5.	Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		12-13
	Item 6.	Selected Financial Data		13
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14-29
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		29
	Item 8.	Financial Statements and Supplementary Data		29-66
	Item 9.	Changes In and Disagreements with Accountants on Accounting and Financial Disclosure		66
	Item 9A.	Controls and Procedures		66-67
	Item 9B.	Other Information		67

PART III

	Item 10.	Directors, Executive Officers and Corporate Governance		67-71
	Item 11.	Executive Compensation		72-75
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		76-79
	Item 13.	Certain Relationships and Related Transactions and Director Independence		79-81
	Item 14.	Principal Accountant Fees and Services		82

PART IV

	Item 15.	Exhibits, Financial Statement Schedules		83-84

PART I

ITEM 1. BUSINESS

Annapolis Bancorp, Inc. (the “Company”), formerly Annapolis National Bancorp, Inc. and Maryland Publick Banks, Inc., is a bank holding company, incorporated under the laws of Maryland in May 1988 for the purpose of acquiring and holding all of the outstanding stock of BankAnnapolis (the “Bank”). In November 1997 the Company went public and joined the NASDAQ Stock Market using the ticker symbol ANNB. Effective June 1, 2001 the Company changed its name to Annapolis Bancorp, Inc.

The Company and later the Bank were formed by a group of businessmen who at the time the Company was organized were dissatisfied with the banking opportunities available in the Annapolis area. The Bank grew based upon a real desire to serve people and business in the Annapolis region. Throughout the Company’s history the Board of Directors has attempted to and succeeded in hiring talented and competent community bankers to lead the Company and Bank as its Senior Management Team.

On October 22, 2012, the Company and F.N.B. Corporation (“FNB”), the parent company of First National Bank of Pennsylvania (“FNB Bank”), entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which the Company will merge with and into FNB, with FNB surviving the merger (the “Merger”). As a result of the Merger, the Company will cease to exist as a separate legal entity and its business will be combined with that of FNB’s. As soon as practicable after the completion of the Merger, the Bank will merge with and into FNB Bank, with FNB Bank as the surviving entity. Our Board of Directors and the Board of Directors of FNB, have approved the Merger and the Merger Agreement.

Consummation of the Merger is subject to certain conditions, including, among others, approval by shareholders of the Company, of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Comptroller of the Currency (the “OCC”). See “Pending Merger with FNB” for a further description of the Merger. The information presented in this Annual Report on Form 10-K does not give effect to the Merger.

BankAnnapolis

The Bank is a federally insured community-oriented bank and is the only commercial bank headquartered in Annapolis, Maryland. 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 Company (as a bank holding company) and the Bank are subject to governmental supervision, regulation, and control.

The Bank currently operates as a full service commercial bank from its headquarters in Annapolis, its six other branches located in Anne Arundel County, Maryland and one branch located on Kent Island in Queen Anne’s County, Maryland. 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 also created a Private Business Banking Division to provide local businesses with an unprecedented level of service and attention, as well as easy access to an exclusive set of financial products and services and the professional guidance and support to take advantage of them.

The Bank competes with numerous other financial intermediaries, commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other financial institutions operating in Anne Arundel County and elsewhere. The Bank continually evaluates new products, and implements such new products as deemed appropriate by management.

The Bank conducts a general commercial and retail banking business in its market area, emphasizing the banking needs of small businesses, professional concerns and individuals. 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 Maryland. On October 15, 2012, the Bank opened its Waugh Chapel branch in Gambrills, Maryland.

The Bank’s principal business consists of originating loans and attracting deposits. The Bank originates commercial loans, commercial real estate loans, construction loans, one- to four-family real estate loans, home equity loans and consumer loans. The

Bank also invests in U.S. Treasury and U.S. Government agency securities and other securities including mortgage backed securities issued or guaranteed by the federal government.

Pending Merger with FNB

On October 22, 2012, the Company and F.N.B. entered into the Merger Agreement, pursuant to which the Company will merge with and into FNB, with FNB surviving the merger. As a result of the Merger, the Company will cease to exist as a separate legal entity and its business will be combined with that of FNB’s. As soon as practicable after the completion of the Merger, the Bank will merge with and into FNB Bank, with FNB Bank as the surviving entity.

Under the terms of the Merger Agreement, shareholders of the Company will be entitled to receive, subject to possible adjustment, as provided in the Merger Agreement, 1.143 shares of FNB’s common stock for each share of the Company’s common stock they own and if, prior to the effective time of the Merger, the Company is able to collect in cash part or all of the amounts due on a particular loan in the amount of approximately $4.6 million, up to $0.36 in cash per share of the Company’s common stock they own. The Merger is intended to qualify for United States federal income tax purposes as a reorganization under Section 368(a) of the Internal Revenue Code of 1986, as amended.

The Merger Agreement contains (a) customary representations and warranties of the Company and FNB, including, among others, with respect to corporate organization, capitalization, corporate authority, third party and governmental consents and approvals, financial statements, and compliance with applicable laws, (b) covenants of the Company and FNB to conduct their respective business in the ordinary course until the Merger is completed; and (c) covenants of the Company and FNB not to take certain actions during such period. The Company has also agreed not to (i) solicit proposals relating to alternative business combination transactions or (ii) subject to certain exceptions, enter into discussions concerning, or provide confidential information in connection with, any proposals for alternative business combination transactions.

FNB and the Company expect to complete the transaction in April 2013. Completion of the Merger depends on the satisfaction of customary closing conditions, including approval of the shareholders of the Company, of the Federal Reserve and of the OCC.

The Merger Agreement provides that upon completion of the Merger, each outstanding option or similar right to acquire the Company’s common stock granted under any Company’s equity plan, except for options under the Annapolis Bancorp, Inc. 2007 Employee Stock Purchase Plan (which was terminated effective October 31, 2012), will convert automatically into an option to purchase a number of shares of FNB common stock equal to the numbers of shares of the Company’s common stock underlying such Company’s stock option or similar right multiplied by the exchange ratio, with an exercise price that equals the exercise price of such Company’s stock option or similar right immediately prior to the Merger divided by the exchange ratio and otherwise on the same terms and conditions as were in effect immediately prior to the completion of the Merger. The outstanding warrant to purchase Company’s common stock, which was issued on January 30, 2009 to the U.S. Treasury, or the Company’s TARP Warrant, will be converted into a warrant to purchase FNB common stock, subject to appropriate adjustments to reflect the exchange ratio. FNB may elect to have the Company’s TARP Warrant purchased or redeemed, but has no obligation to do so.

The parties can agree to terminate the Merger Agreement at any time prior to completion of the Merger, and either the Company or FNB can terminate the Merger Agreement if, among other reasons, any of the following occurs:

•

The approval of a governmental entity, which is required for completion of the Merger, is denied by final and non-appealable action;

•

The Merger has not been completed by June 30, 2013;

•

The other party commits a breach of the Merger Agreement which would cause the failure of the closing conditions set forth in the Merger Agreement and such breach is not or cannot be cured within the timeframes given in the Merger Agreement;

•

The requisite stockholder vote to adopt and approve the Merger Agreement and the Merger is not obtained;

•

A significant reduction in the market value of FNB common stock prior to the closing;

Subject to certain conditions, the Company may also terminate the Merger Agreement in order to enter into an agreement with respect to an unsolicited acquisition proposal that the company’s board of directors concluded is a superior proposal, provided that the Company pays the Break-up Fee, as defined below, to FNB.

If the Merger is not consummated under certain circumstances, the Company has agreed to pay FNB a termination fee of $2.5 million (the “Break-up Fee”) and up to $500,000 of FNB’s expenses incurred in connection with the Merger.

This description of the Merger Agreement does not purport to be complete and it is qualified in its entirety by reference to the Merger Agreement, which is filed as Exhibit 10.9 hereto and incorporated by reference herein.

In connection with the Merger, FNB has filed a registration statement on Form S-4 with the SEC that includes a proxy statement/prospectus and other documents relevant to the Merger. On February 25, 2013, FNB filed Amendment No. 1 to the Form S-4. The registration statement was declared effective by the SEC on February 27, 2013. On February 27, 2013, the Company filed a definitive proxy statement with the SEC. A definitive proxy statement was first mailed to the shareholders of the Company on or about March 1, 2013.

Bank Services

The Bank’s Anne Arundel County service area is a highly concentrated, highly branched banking market. Competition in Anne Arundel County for loans to small businesses and professionals, the Bank’s target market, is intense and pricing, service and access to decision-makers are important. Deposit competition among institutions in Anne Arundel County also is strong.

The Bank is a full service commercial bank and offers a variety of products and services to both commercial and retail customers. Commercial services offered by the Bank include a variety of lending products including commercial real estate and commercial business loans, cash management services and letters of credit. Commercial business loans are typically made on a secured basis to corporations, partnerships and individual businesses. On the deposit side commercial customers are offered cash management services including account analysis, remote deposit capture, merchant services and a wide array of deposit products. To a lesser extent, the Bank offers consumer loans to its retail customers, including mortgages, home equity loans and lines of credit and new and used car and boat loans. The Bank’s retail banking services also include a variety of deposit products including transaction accounts, a high yielding savings account, money market accounts, certificates of deposit and individual retirement accounts. The Bank also participates in the Certificate of Deposit Account Registry Service^® known as CDARS^® that allows the Bank to offer FDIC insured deposits of $50 million or more to its customers.

Lending Activities

The Bank’s primary business is to make loans. Outstanding loan balances account for 63.0% of total assets at December 31, 2012. The Bank offers a wide selection of consumer loans to individuals primarily through its branch network. The Bank does a majority of its consumer lending on a secured basis with the highest percentage of loans secured by first and second liens on one- to four-family owner occupied residences. The Bank will originate and maintain servicing rights on some loans and broker fixed rate loans to other financial institutions. In addition to consumer mortgage loans the Bank offers a variety of home equity products including fixed rate amortizing term loans and revolving lines of credit. The Bank generally requires that the loan to value for such loans be below 80%. The Bank also offers new and used auto loans and to a lesser extent boat loans.

The Bank provides numerous commercial lending products and services to businesses operating in the Bank’s primary market area. These loans consist of lines of credit, which may require an annual repayment, adjustable-rate loans with terms of five to seven years, and fixed-rate loans with terms of up to five years. Such loans are generally secured by receivables, inventories, equipment and other assets of the business. The Bank generally requires personal guarantees on its commercial loans. The Bank also offers unsecured commercial loans to businesses on a selective basis. These types of loans are made to existing customers and are of a short duration, generally one year or less. The Bank also originates commercial loans which are guaranteed by the Small Business Administration. The Bank has been a participant in a variety of SBA loan programs. Refer to pages 21 to 24 for a more detailed discussion on the Bank’s lending activities.

Investment Activities

The Bank’s second largest asset is its investment portfolio, accounting for 24.4% of total assets at December 31, 2012. The investment portfolio generally consists of U.S. Government and Agency notes, and government guaranteed mortgage backed securities. Management invests excess liquidity following specific policies and procedures that limit the Bank’s exposure to any one type of investment. The Bank’s policy generally requires that each new investment be rated “A” or better. All investments are made with the intent to preserve and protect the capital of the Bank.

Investment targets such as total investment securities, the mix of investment products and the average life of the investment are derived from the Bank’s strategic plan and expected liquidity requirements. Strategies to achieve these targets are the responsibility of the Bank’s Asset and Liability Committee. For a further discussion on the Bank’s investment activities refer to page 21.

Employees

At December 31, 2012, the Bank employed 87 full-time and 12 part-time individuals. Five of these individuals are executive officers of the Bank. None of the employees are employees of the Company. The Bank provides both full- and part-time individuals with a comprehensive benefit program that includes health and dental insurance, Bank paid life and short-and long-term disability insurance, access to vision and catastrophic health insurance and a 401(k) plan.

Regulation and Supervision

General

The supervision and regulation of the Company and the Bank by the banking agencies is intended primarily for the protection of depositors, the Deposit Insurance Fund of the FDIC, and the banking system as a whole, and not for the protection of shareholders or creditors. The banking agencies have broad enforcement power over bank holding companies and banks, including the power to impose substantial fines and other penalties for violations of laws and regulations.

The following description summarizes some of the laws to which the Company and the Bank are subject. References in the following description to applicable statutes and regulations are brief summaries of these statutes and regulations, do not purport to be complete, and are qualified in their entirety by reference to such statutes and regulations.

The Company

The Company, by virtue of its control of the Bank, is a registered bank holding company as defined under the Bank Holding Company Act of 1956 (“the Act”). As a bank holding company, the Company is required to file certain reports with, and otherwise comply with the rules and regulations of, the Federal Reserve Board (“FRB”) under the Act.

Dodd-Frank Wall Street Reform and Consumer Protection Act. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law with the intent to effect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act created the Financial Stability Oversight Council to identify threats to the financial stability of the United States; promote market discipline; and respond to emerging risks to the stability of the United States financial system. The Dodd-Frank Act additionally created a new independent federal regulator to administer federal consumer protection laws, the Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act is expected to have a significant impact on the Company’s business operations as its provisions take effect.

The Company may be affected by the following provisions of the Dodd-Frank Act:

•

Holding Company Capital Requirements – The Dodd-Frank Act requires the Federal Reserve to apply consolidated capital requirements to depository holding companies that are no less stringent than those that apply to depository institutions. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. Effective July 21, 2011, the Dodd-Frank Act amended the BHC Act, to provide specific authorization for the Federal Reserve to issue orders and regulations relating to the capital requirements of depository holding companies. In establishing these rules, the Federal Reserve must seek to make the capital requirements countercyclical, so that the amount of capital required to be maintained by the company increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the company. The Company’s trust preferred securities were issued prior to May 19, 2010 and will not need to be excluded from Tier 1 capital.

•

Deposit Insurance – The Dodd-Frank Act made permanent the $250,000 deposit insurance limit for insured deposits and provided unlimited federal deposit insurance until January 1, 2013, for noninterest-bearing demand transaction accounts at all depository institutions. As of January 1, 2013, noninterest-bearing demand transaction accounts are insured up to the standard maximum deposit insurance coverage amount of $250,000 per depositor under the FDIC’s general deposit insurance rules. Amendments to the Federal Deposit Insurance Act also revise the assessment base against which an insured depository institution’s deposit insurance premium paid to the Deposit Insurance Fund (“DIF”) will be calculated. Under the amendments, the assessment base is no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period. Additionally, the Dodd-Frank Act made changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount total insured deposits and eliminating the requirement that the FDIC pays dividends to depository institutions when the reserve ratio exceeds certain threshold. The Dodd-Frank Act also eliminated the federal statutory prohibitions against the payment of interest on business transaction and other accounts.

•

Corporate Governance – As of January 21, 2011, all domestic publicly traded companies are required to give stockholders a non-binding “Say on Pay” vote to approve executive compensation disclosed in the proxy statement on at least a triennial basis. As of April 25, 2011, domestic public companies must include a non-binding “Say on Golden Parachutes” vote in a proxy statement seeking shareholder approval for a merger or similar corporate transaction, together with disclosure regarding any compensation arrangement that the issuer has with the named executive officers or those of the other party in the corporate transactions and acquisitions unless previously voted on by shareholders. On June 20, 2012, the SEC adopted Rule 10C-1 directing the national securities exchanges to adopt certain listing standards related to the independence of the compensation committee. The rule also provides six criteria the compensation committee should consider when evaluating the independence of compensation committee advisers. As of July 1, 2013, the compensation committee of a NASDAQ Company may no longer select, or receive advice from, an adviser unless it has conducted the six-factor independence assessment as the new NASDAQ Rules require. The Dodd Frank Act directs adopting incentive based clawback policies for executive officers. The legislation also authorized the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials. As a result, the SEC adopted Rule 14a-11, which was vacated by the United States Court of Appeals for the District of Columbia Circle and therefore is not effective. Additionally, the Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1 billion, regardless of whether the company is publicly traded or not. The Dodd-Frank Act gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

•

Prohibition Against Charter Conversions of Troubled Institutions – Effective July 21, 2011, the Dodd-Frank Act prohibits a depository institution from converting from a state to federal charter or vice versa while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state authority that issued the enforcement action and that agency does not object within 30 days. The notice must include a plan to address the significant supervisory matter. The converting institution must also file a copy of the conversion application with its current federal regulator which must notify the resulting federal regulator of any ongoing supervisory or investigative proceedings that are likely to result in an enforcement action and provide access to all supervisory and investigative information relating hereto.

•

Interstate Branching – The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will be able to enter new markets more freely. The Dodd-Frank Act restricts the preemption of state law by federal law and disallows subsidiaries and affiliates of federally regulated banks from availing themselves of such preemptions.

•

Limits on Derivatives – Effective 18 months after the transfer date of the Dodd-Frank Act, in the first half of 2013, the Dodd-Frank Act prohibits state-chartered banks from engaging in derivatives transactions unless the lending limit law of the state in which the bank is chartered takes into considerations credit exposure to derivative transactions. For this purpose, derivative transactions includes any contract, agreement, swap, warrant note or option that is based in whole or in part on the value of, any interest in, or any quantitative measure of occurrence of any event relating to, one or more commodities securities, currencies, interest or other rates indices or other assets.

•

Transactions with Affiliates or Insiders – Effective July 21, 2011, the Dodd-Frank Act expanded the definition of affiliate for purposes of quantitative and qualitative limitations of Section 23A of the Federal Reserve Act to include mutual funds advised by a depository institution and its affiliates. The Dodd-Frank Act apples Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transaction that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The exemption from Section 23A for transactions with financial subsidiaries was eliminated. The Dodd-Frank Act imposes further restrictions on transactions with affiliates and extensions of credit to executive officers, director and principal shareholders, by, among other things, expanding covered transactions to include securities lending, repurchase agreement and derivatives activities with affiliates. These changes became effective on July 21, 2012. The Dodd-Frank Act prohibits an insured depository institution from purchasing an asset from, or selling an asset to, an executive officer, director or principal shareholder of the institution, or any related interest of that person unless the transaction is on market terms. If the transaction represents more than 10% of the capital stock and surplus of the institution, the transaction must be approved in advance by a majority of the disinterested directors.

•

Debit Card Interchange Fees – Effective July 21, 2011, the Dodd-Frank Act requires that the amount of any interchange fee charged by a debit card issuer with respect to a debit card transaction must be reasonable and proportional to the cost incurred by the issuer. Effective October 2011, interchange fees on debit card transactions are limited to a maximum of 21 cents per transaction plus 5 basis points of the transaction amount. A debit card issuer may recover an additional one cent per transaction for fraud prevention purposes if the issuer complies with certain fraud related requirements prescribed by the FRB. The restrictions on interchange fees, however, do not apply to banks, that, together with their affiliates, have assets of

less than $10 billion as of the end of the calendar year preceding the date of the electronic debit transaction for which the interchange fee is charged or received. Under the rules, where an exempt issuer ceases to be a legal entity after acquisition, the acquiring entity becomes the issuer of the previously exempt debit cards.

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Consumer Financial Protection Bureau – The Dodd-Frank Act created the Consumer Financial Protection Bureau (“CFPB”), in order to regulate consumer financial products and services, as well as providers of such products and services. The CFPB authority to enforce existing consumer protection laws was transferred to it on July 21, 2011. In January of 2012, President Obama appointed Rich Cordray to be the first Director of the CFPB. The CFPB supervises and examines, with respect to Federal consumer financial laws, banks, savings associations and credit unions with assets in excess of $10 billion. Smaller institutions will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorized the CFPB to establish certain minimum standards for the origination of residential mortgages including determination of the borrower’s ability to repay.

Regulation of Mortgage Origination and Servicing. In January 2013, the CFPB issued a series of final rules related to mortgage loan origination and mortgage loan servicing. We are still evaluating the recently issued rules to determine if they will have any long-term impact or our mortgage loan origination and servicing activities.

On January 10, 2013, the CFPB issued a final rule concerning lenders’ assessments of consumers’ ability to repay home loans. Currently, Regulation Z prohibits creditors from extending higher-priced mortgage loans without regard for the consumer’s ability to repay. The rule extends application of this requirement to all loans secured by dwellings, not just higher-priced mortgages. Creditors must, at a minimum, consider eight specified factors while making a reasonable and good faith determination that the consumer has a reasonable ability to repay the loan before entering any consumer credit transaction secured by virtually any dwelling. The factors include information such as the consumer’s income, debt obligations, credit history, and monthly payments on the loan. The rule also establishes a safe harbor and presumption of compliance with the ability-to-repay requirement for so-called “qualified mortgages,” restricts the application of prepayment penalties, and requires the retention of evidence of compliance with the ability-to-repay requirement for three years. The final rule becomes effective January 10, 2014.

Additionally, on January 10, 2013, the CFPB issued a final rule to expand the types of mortgage loans that are subject to the protections of the Home Ownership and Equity Protections Act of 1994, or HOEPA. Loans that meet HOEPA’s high-cost coverage tests are subject to special disclosure requirements and restrictions on loan terms, and borrowers in high-cost mortgages have enhanced remedies for violations of the law. The rule revises and expands the tests for coverage under HOEPA and imposes additional restrictions on mortgages that are covered by HOEPA, including a pre-loan counseling requirement. The rule becomes effective January 10, 2014.

On January 17, 2013, the CFPB issued final rules concerning mortgage servicing standards, which amend both Regulation X and Regulation Z. The Regulation X rule requires servicers to provide certain information to borrows, to establish policies and procedures to achieve certain delineated objectives, to correct errors asserted by borrowers, and to evaluate borrowers’ applications for available loss mitigation options. The Regulation Z rule requires creditors, assignees and servicers to provide interest rate adjustment notices for adjustable-rate mortgages, periodic statements for residential mortgage loans, prompt crediting of mortgage payments, and responses to requests for payoff amounts. Both rules become effective January 10, 2014.

On January 20, 2013, the CFPB issued a final rule with multiple effective dates implementing requirements and restrictions imposed by the Reform Act concerning, among other things, qualifications of individual loan originators and the compensation practices with respect to such persons. The rule prohibits loan origination organizations from basing compensation for themselves or individual loan originators on any of the origination transaction’s terms or conditions and prohibits such persons from receiving compensation from another person in connection with the same transaction. The rule also imposes duties on loan originator organizations to ensure that their individual loan originators meet certain licensing or qualification standards and extends existing recordkeeping requirements. In addition, effective June 1, 2013, the rule prohibits the inclusion of certain provisions in residential mortgage loan agreements that could restrict legal recourse by a consumer against the loan origination organization and prohibits the financing of single-premium credit insurance. All other provisions of the final rule become effective January 10, 2014.

The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

In late 2012, a Community Bank Advisory Council was formed. Representatives were drawn from small-to-medium-sized community banks to engage in discussions on how smaller institutions help level the playing field for consumers experiencing difficulty in managing their money and what opportunities and challenges exist in mortgage lending for small institutions. The CFPB has developed prototype designs for various disclosures and agreements and invited the public and financial industry to review and comment on what works. Their website (www.consumerfinance.gov) serves as a public information resource laws and regulations, assistance with financial questions, participation with projects or initiatives, and submission of complaints. The CFPB has positioned itself to serve as a resource for submission of complaints and to provide help to consumers with complaints regarding credit cards, mortgages, student loans, checking accounts, savings accounts, credit reporting, bank services, and other consumer loans. Guidance and consumer tips on various financial topics were issued throughout 2012 in a Blog on the CFPB’s website.

•

Financial Stability Oversight Council – The Dodd-Frank Act created the Financial Oversight Stability Council, which, among other things, will recommend to the Federal Reserve Board increasingly strict rules for capital, leverage, liquidity, development of resolution plans, mandatory stress tests, risk management and other requirements as companies grow in size and complexity.

Mortgage Reform – The Dodd-Frank Act provides mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions.

Appraisal Rules. In January 2013, pursuant to the Dodd-Frank Act, the federal banking regulatory agencies issued final rules on appraisal requirements for higher-priced mortgage loans. For mortgage loans with an annual percentage rate that exceeds a certain threshold, lenders must obtain an appraisal using a licensed or certified appraiser. The appraiser must prepare a written appraisal report based on a physical inspection of the interior of the property. Lenders must also then disclose to applicants information about the purpose of the appraisal and provide them with a free copy of the appraisal report. Qualified mortgages, as defined by Section 1026.43(e) of the CFPB’s final rule implementing the Dodd-Frank Act’s ability-to-repay requirements, are exempt from the appraisal requirements of these final rules. These final rules become effective January 18, 2014.

As defined by the CFPB, qualified mortgages are mortgages that meet the following standards prohibiting or limiting certain high risk product and features:

(1) No excessive upfront points and fees – generally points and fees paid by the borrower must not exceed 3% of the total amount borrowed;

(2) No toxic loan features – prohibited features are: no interest only-loans, no negative-amortization loans, no terms beyond 30 years and no balloon loans;

(3) Limited on debt-to-income ratios – borrowers’ debt-to-income ratios must be no higher than 43%.

Lenders that generate qualified mortgage loans will receive specific protections against borrower lawsuits that could result from failing to satisfy the ability to pay rule. There are two levels of liability protections for qualified mortgages – the Safe Harbor protection and the Rebuttable Presumption protection. Safe Harbor qualified mortgages are lower priced loans with interest rates closer to the prime rate, issued to borrowers with high credit scores. Borrowers suing lenders under Safe Harbor qualified mortgages are faced with overcoming the pre-determined legal conclusion that the lender has satisfied the ability-to-repay rule. Rebuttable Presumption qualified mortgages are loans at higher prices that are granted to borrowers with lower credit scores. Lenders generating Rebuttable Presumption qualified mortgages receive the protection of a presumption that they have legally satisfied the ability-to-pay rule while the borrower can rebut that presumption by proving that the lender did not consider the borrower’s living expenses after their mortgage and other debts. In addition, qualified mortgages are exempt from the new appraisal requirement rules stated above.

•

Well Capitalized and Well Managed – Effective July 21, 2011, the Dodd-Frank Act amended the BHC Act to require that a depository holding company that is a financial holding company, such as the Company, be well capitalized and well managed.

•

The Electronic Fund Transfer Act – The Dodd-Frank Act amends the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer. In February 2012, the CFPB issued a final rule to the Electronic Fund Transfer Act and Regulation E which implemented Dodd-Frank Act provisions regarding remittance

transfers. These final rules provided new protections, including new disclosures and error resolution and cancellation rights, to consumers sending remittance transfers to other consumers or businesses in a foreign country. Further additional rulemaking in August 2012 supplemented these final rules. Though originally scheduled to take effect on February 7, 2013, the CFPB proposed a temporary delay of the final remittance transfer rules to address additional changes regarding disclosure of foreign taxes and institution fees, disclosure of subnational taxes in a foreign country, and errors from incorrect account information. The effective date is now delayed until 90 days after finalizing the amendments.

The Bank

The Bank is regulated by the State of Maryland Department of Labor, Licensing and Regulation. The Bank is subject to extensive regulation, examination and supervision by the State of Maryland as its primary regulator, the Federal Reserve Bank of Richmond as its secondary regulator and the FDIC, as the deposit insurer. The Bank must file reports with the Federal Reserve and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of other institutions. The state and the Federal Reserve conduct periodic examinations to test the Bank’s safety and soundness and compliance with various regulatory requirements. Many aspects of the Bank’s operations are regulated by federal law including allowable activities, reserves against deposits, branching, mergers and investments. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the State of Maryland, the Federal Reserve, the FDIC or Congress, could have a material adverse impact on the Company or the Bank and their operations.

Insurance of Deposit Accounts. The Bank’s deposit accounts are insured up to applicable limits by the FDIC’s Deposit Insurance Fund (“DIF”) and are subject to deposit insurance assessments to maintain the DIF. Under the Dodd-Frank Act, the maximum deposit insurance amount is permanently increased from $100,000 to $250,000.

The Dodd-Frank Act also sets a new minimum DIF reserve ratio at 1.35%. The FDIC is required to attain this ratio by September 30, 2020. In addition, the Dodd-Frank Act will have a significant impact on the calculation of deposit insurance premiums going forward. On February 7, 2011 the FDIC Board approved a final rule that changes the assessment base for insurance premiums from domestic deposits to the institution’s average consolidated total assets during the assessment period minus average tangible equity. The rule defines tangible equity as Tier 1 capital. The rule requires banks under $1 billion in assets to report average weekly balances during the calendar quarter unless they elect to report daily averages. The new rate schedule and other revisions to the assessment rates became effective April 1, 2011.

On November 12, 2009, the FDIC adopted a final rule amending the assessment regulations to require insured depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution’s risk-based assessment for the third quarter of 2009. On December 30, 2009 the Bank prepaid $2.2 million in FDIC insurance for 2010, 2011 and 2012 estimated assessments. As of December 31, 2012 the Bank had $873,000 prepaid in FDIC insurance for the 2013 estimated assessments.

Emergency Economic Stabilization Act of 2008. On October 3, 2008, the President signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”), which, among other measures, authorized the Secretary of the U. S. Treasury (“Treasury”) to establish the Trouble Asset Relief Program (the “TARP”). Pursuant to TARP, the Treasury has the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. In addition, under TARP, the Treasury created the Capital Purchase Program (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. On April 18, 2012, The Company redeemed 4,076 shares of its Series A Preferred Stock for $4,076,000 and on March 6, 2013, the Company redeemed the final 4,076 shares of its Series A Preferred Stock for $4,076,000.

Comprehensive Financial Stability Plan of 2009. On February 10, 2009, the Secretary of the Treasury announced a new comprehensive financial stability plan (the “Financial Stability Plan”), which builds upon existing programs and earmarks the second $350 billion of unused funds originally authorized under the EESA. The major elements of the Financial Stability Plan include: (i) a capital assistance program that invested in convertible preferred stock of certain qualifying institutions, (ii) a

consumer and business lending initiative to fund new consumer loans, small business loans and commercial mortgage asset-backed securities issuances, (iii) a new public-private investment fund that leveraged public and private capital with public financing to purchase $500 billion to $1 trillion of legacy “toxic assets” from financial institutions, (iv) assistance for homeowners to reduce mortgage payments and interest rates and (v) establishment of loan modification guidelines for government and private programs. In addition, all banking institutions with assets over $10 billion are required to undergo a comprehensive “stress test” to determine if they have sufficient capital to continue lending and to absorb losses that could result from a more severe decline in the economy than projected. Institutions receiving assistance under the Financial Stability Plan are subject to higher transparency and accountability standards, including restrictions on dividends, acquisitions, executive compensation and additional disclosure requirements.

The U.S. Congress, state lawmaking bodies and federal and state regulatory agencies continue to consider a number of wide-ranging and comprehensive proposals for altering the structure, regulation and competitive relationships of the nation’s financial institutions. The Company cannot predict whether or in what form further legislation or regulations may be adopted or the extent to which the Company may be affected thereby.

Forward Looking Statements

This Annual Report on Form 10-K 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 credit 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, (ix) the actual results of the pending Merger with FNB could vary materially as a result of a number of factors, including the possibility that various closing conditions for the transaction may not be satisfied or waived, and the Merger Agreement could be terminated under certain circumstances; (x) delays in closing the Merger, 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 annual report on Form 10-K 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.

Important Additional Information

In connection with the Merger, FNB has filed a registration statement on Form S-4 with the SEC that includes a proxy statement/prospectus and other documents relevant to the proposed Merger. On February 25, 2013, FNB filed Amendment No. 1 to the Form S-4. The registration statement was declared effective by the SEC on February 27, 2013. On February 27, 2013, the Company filed a definitive proxy statement with the SEC. A definitive proxy statement was first mailed to the shareholders of the Company on or about March 1, 2013. SHAREHOLDERS OF THE COMPANY AND FNB ARE URGED TO READ THE REGISTRATION STATEMENT, PROXY STATEMENT/PROSPECTUS AND DEFINITIVE PROXY STATEMENT REGARDING THE MERGER AND ANY OTHER RELEVANT DOCUMENTS FILED WITH THE SEC. AS WELL AS ANY AMENDMENTS OR SUPPLEMENTS TO THOSE DOCUMENTS BECAUSE THEY CONTAIN AND WILL CONTAIN IMPORTANT INFORMATION.

A free copy of the Proxy Statement/Prospectus, Definitive Proxy Statement, as well as other filings containing important information about the Company and FNB, may be obtained at the SEC’s Internet site (http://www.sec.gov). These documents may also be obtained, free of charge, from FNB by contacting James Orie, Chief Legal Officer, F.N.B. Corporation, at One F.N.B Boulevard, Hermitage PA 16148, telephone (724) 983-3317 or by contacting Edward J. Schneider, Chief Financial Officer of the Company at 1000 Bestgate Road, Suite 400, Annapolis MD 21401.

ITEM 1A. RISK FACTORS

Not applicable.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

The executive offices of the Company and the Bank are located at 1000 Bestgate Road, Suite 400, Annapolis, Maryland 21401.

The following table sets forth the location of and certain additional information regarding the offices of the Company and the Bank at December 31, 2012:


	Leased/ Owned	Original Year Leased or Location Acquired		Year of Lease Expiration			Net Book Value of Property or Leasehold Improvements at December 31, 2012 ($000)

Administration (2)	Owned		2001		N/A		$	4,176
Bestgate	Owned		2001		N/A			1,233
Edgewater	Land Leased		1996		2016	(1)		438
Cape St. Claire	Leased		1995		2015	(1)		9
Kent Island	Land Leased		1990		2023	(1)		1,432
Severna Park	Leased		1996		2013	(1)		12
BayWoods	Leased		2003		2018	(1)		4
Annapolis Towne Centre Waugh Chapel	Leased Leased		2008 2012		2018 2032	(1) (1)		239 1,663

(1)	These leases may be extended at the option of the Company for periods ranging from one to twenty years.

(2)	The Company owns an undeveloped piece of property in Odenton, Maryland for future branch expansion.

ITEM 3. LEGAL PROCEEDINGS

Andera v. Lerner, et al

On November 8, 2012, a purported stockholder of the Company filed a derivative complaint on behalf of the Company in the Circuit Court for Anne Arundel County, Maryland, captioned Andera v. Lerner, et al., Case no. 02C12173766, and naming as defendants the Company, The Company’s board of directors and FNB. The lawsuit makes various allegations against the defendants, including that the merger consideration is inadequate and undervalues the company that the director defendants breached their fiduciary duties to the Company in approving the Merger, and that FNB aided and abetted those alleged breaches. The lawsuit generally seeks an injunction barring the defendants from consummating the Merger. In addition, the lawsuit seeks rescission of the Merger Agreement to the extent already implemented or, in the alternative, award of rescissory damages, an accounting to plaintiff for all damages caused by the defendants and for all profits and special benefits obtained as a result of the defendants’ alleged breaches of fiduciary duties, and an award of the costs and expenses incurred in the action, including a reasonable allowance for counsel fees and expert fees.

On February 7, 2013, the plaintiff filed an amended complaint with additional allegations regarding certain purported non-disclosures relating to the proxy statement/prospectus for the pending merger filed with the SEC on January 23, 2013.

On February 22, 2013, solely to avoid the costs, risks and uncertainties inherent in litigation, the Company, the Company’s board of directors and FNB, on the one hand, and the plaintiff, on the other hand, reached an agreement in principle to settle the action, and expect to memorialize that agreement in a written settlement agreement. As part of this agreement in principle, FNB and the Company have agreed to disclose additional information in the proxy statement/prospectus, including but not limited to certain information about the data that was analyzed and presented to the Company’s board of directors by the financial advisor, the engagement of the financial advisor and the negotiations process. No substantive term of the Merger Agreement will be modified as part of this settlement. The settlement set forth in the settlement agreement will be subject to court approval.

Other than as disclosed above the Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the Company’s financial condition and results of operations.

ITEM 4. MINE SAFETY DISCLOSURES

Not Applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Value and Dividend Information

The Company’s common stock is listed on The NASDAQ Capital Market® under the symbol “ANNB.” The Company’s stock began trading on October 1, 1997. At March 1, 2013 the closing price was $13.02 per share.

As of March 1, 2013 the Company had outstanding 4,059,802 shares of common stock held by approximately 201 shareholders of record. On January 30, 2009 the Company sold 8,152 shares of Series A Preferred Stock to one shareholder, the Treasury under the Treasury’s TARP CPP. The shares had a liquidation preference of $1,000 per share for an aggregate purchase price of $8.152 million. On April 18, 2012, The Company redeemed 4,076 shares of its Series A Preferred Stock for $4,076,000 and on March 6, 2013 the Company redeemed the final 4,076 shares of Series A Preferred Stock for $4,076,000. The Company also issued a warrant to purchase 299,706 shares of common stock which may be purchased upon exercise of the warrant at a price of $4.08 per share. The warrant is also issued to the Treasury under the CPP. The warrant expires on January 30, 2019. The issuances of the warrant and the Series A Preferred Stock were completed in a private placement to Treasury exempt from the registration requirements of the Securities Act of 1933.

Under the terms of the CPP the Company will be required to pay a 5% per annum dividend on the Series A Preferred Stock for the five years beginning January 30, 2009 ending February 15, 2014 and a 9% dividend for the period thereafter. The first dividend was paid to the Treasury on May 15, 2009 with future dividend payments due quarterly thereafter. During 2012 $290,415 in dividends were paid to the Treasury.

The Company discontinued the payment of cash dividends to common stockholders in 2002. The Company has no current plans to resume payments of cash dividends on its common stock as Management believes it is in the best interest of the Company to retain capital to support the growth of the Company.

As a condition to the Company’s participation in the CPP, the Company’s ability to declare or pay dividends on its common stock is restricted. Specifically, the Company may not declare dividend payments on its common stock if it is in arrears on the dividends on the Series A Preferred Stock. Until the Series A Preferred Stock issued to the Treasury under the CPP is redeemed or transferred, the Company may not pay a cash dividend without approval from the Treasury.

A summary of the Company’s quarterly stock prices is shown below:


	2012						2011
	Stock Price Range				Per Share		Stock Price Range				Per Share
Quarter	High		Low		Dividend		High		Low		Dividend

1st	$	6.34	$	3.80	$	0.0000	$	4.49	$	3.70	$	0.0000
2nd		7.59		5.00		0.0000		4.50		4.00		0.0000
3rd		7.48		6.90		0.0000		4.28		3.42		0.0000
4th		12.31		7.13		0.0000		4.10		3.61		0.0000

The closing price of the Company’s stock at December 31, 2012 was $11.84 per share.

Equity Compensation Plan Information

The table setting forth Securities Authorized for Issuance Under Equity Compensation Plans can be found under Item 12 on page 76 of this report.

Recent Sales of Unregistered Securities

None.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

None

ITEM 6. SELECTED FINANCIAL DATA

The following table summarizes the Company’s selected financial information and other financial data. The selected balance sheet and statement of income data are derived from our audited financial statements. You should read this information together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the related notes included elsewhere in this report. Results for past periods are not necessarily indicative of results that may be expected for any future period.

Selected Consolidated Financial Highlights

Selected Consolidated Financial Data at and for years ended December 31,


	2012		2011		2010		2009			2008
	(Dollars in thousands, except per share data)

Selected Financial Data
Total assets	$	446,386	$	441,570	$	432,140	$	444,332		$	394,916
Total loans, net		274,560		283,284		273,063		274,032			264,093
Total deposits		352,917		350,381		340,914		350,463			300,627
Securities sold under agreement to repurchase		14,584		11,344		14,558		14,642			12,639
Long-term debt		40,000		40,000		40,000		45,000			45,000
Stockholders’ equity		36,215		37,368		34,774		32,632			26,814

Selected Operating Data
Interest income	$	18,916	$	19,857	$	19,853	$	21,226		$	21,800
Interest expense		2,914		3,597		4,633		7,135			8,765

Net interest income		16,002		16,260		15,220		14,091			13,035
Provision for credit losses		684		2,190		2,148		6,540			2,375

Net interest income after provision for credit losses		15,318		14,070		13,072		7,551			10,660
Noninterest income		1,916		1,842		1,815		1,989			1,753
Noninterest expense		12,308		12,563		12,385		12,405			10,325

Income (loss) before income taxes		4,926		3,349		2,502		(2,865	)		2,088
Income tax expense (benefit)		1,834		1,178		886		(1,158	)		661

Net income (loss)		3,092	$	2,171	$	1,616	($	1,707	)	$	1,427
Preferred stock dividend and discount accretion		271		490		485		442			0

Net income (loss) available to common shareholders	$	2,821	$	1,681	$	1,131	($	2,149	)	$	1,427



	2012			2011			2009			2008			2007
Key Financial Ratios and Other Data
Return on average assets
Net income (loss) divided by average assets		0.70	%		0.50	%		0.37	%		(0.38	%)		0.38	%
Return on average equity
Net income (loss) divided by average equity		8.54	%		6.05	%		4.68	%		(5.24	%)		5.41	%
Equity to asset ratio
Average equity divided by average assets		8.17	%		8.23	%		7.93	%		7.33	%		7.01	%
Diluted earnings (loss) per common share	$	0.68		$	0.39		$	0.29		($	0.56	)	$	0.35
Book value per common share	$	8.02		$	7.38		$	6.81		$	6.39		$	6.98
Tangible book value per common share	$	8.02		$	7.38		$	6.81		$	6.39		$	6.98
Number of common shares outstanding		4,008,934			3,958,293			3,922,006			3,867,006			3,842,943
Efficiency ratio		68.69	%		69.40	%		72.70	%		77.15	%		69.82	%
Interest rate spread		3.65	%		3.76	%		3.47	%		3.07	%		3.28	%
Net interest margin		3.80	%		3.93	%		3.66	%		3.32	%		3.65	%
Risk based capital ratio – Tier 1		12.65	%		12.78	%		12.80	%		12.45	%		11.37	%
Risk based capital ratio – Total		13.91	%		14.04	%		14.06	%		13.72	%		12.62	%

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Pending Merger

Overview

The following is management’s discussion and analysis of the financial condition and results of operations of Annapolis Bancorp, Inc. on a consolidated basis with its wholly owned subsidiary, BankAnnapolis, for the periods presented, and should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this annual report.

The Company reported net income for 2012 of $3.1 million, an increase of $921,000 or 42.4% from net income of $2.2 million in 2011. Net income available to common shareholders after accruing for preferred stock dividends and discount accretion for 2012 was $2.8 million compared to net income available to common shareholders of $1.7 million in 2011. The increase in 2012 earnings was due to lower interest expense, lower provision for credit losses expense, lower noninterest expense, and higher noninterest income. The net income per diluted common share for 2012 was $0.68 compared to a net income of $0.39 per diluted common share in 2011.

The primary source of income of the Bank is interest on its loan and investment portfolios, while one of the principal expenses of the Bank is interest on its deposit accounts and borrowings. The difference between interest income on interest earning assets and interest expense on interest bearing liabilities is referred to as net interest income. Net interest income was $16.0 million for 2012, a decrease of $258,000 or 1.6% compared to $16.3 million in 2011. Total assets were $446.4 million as of December 31, 2012, a $4.8 million or a 1.1% increase compared to December 31, 2011 total assets of $441.6 million. The Company’s return on average assets was 0.70% and 0.50% for the years ending December 31, 2012, and 2011, respectively. The Company’s return on average common equity was 9.09% and 6.01% for the years ending December 31, 2012, and 2011, respectively.

At December 31, 2012 the Bank’s gross loan portfolio totaled $281.2 million. Of this amount, $44.4 million or 15.8% were commercial loans, $116.9 million or 41.6% were commercial real estate loans, $33.3 million or 11.8% were construction loans, $47.9 million or 17.0% were one- to four-family residential mortgage loans, $31.6 million or 11.3% were home equity loans, and $7.1 million or 2.5% were consumer and other loans.

Application of Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. 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 may 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 must 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 either based on quoted market prices or are provided by other third-party sources, when available.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements which can be found on page 37 and continuing to page 40. 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 as of the balance sheet date. 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. Note 1 to the consolidated financial statements found on page 39 describes the methodology used to determine the allowance for credit losses and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in the Credit Risk Management section of this financial analysis.

Financial Condition as of December 31, 2012 and 2011 and Results of Operations for the Years then Ended

The Company, through its Bank subsidiary, functions as a financial intermediary, and as such its financial condition and results of operations can be examined in terms of developing trends in its sources and uses of funds. These trends are the result of both external environmental factors, such as changing economic conditions, regulatory changes and competition, and also internal environmental factors such as management’s evaluation as to the best use of funds in these changing conditions.

Total assets increased by $4.8 million or 1.1% during 2012 to $446.4 million from $441.6 million at December 31, 2011 as investment securities, deposits and securities sold under agreements to repurchase increased. Total deposits and securities sold under agreements to repurchase, the Company’s primary sources of funds, increased $5.8 million or 1.6% to $367.5 million from $361.7 million at December 31, 2011. Time deposits totaled $68.8 million or 19.5% of the Bank’s total deposits at December 31, 2012, compared to $78.3 million or 22.3% in 2011. Savings and money market accounts, the largest portion of the Bank’s total deposits, totaled $189.6 million or 53.7% of the Bank’s total deposits at December 31, 2012, compared to $182.5 million or 52.1% in 2011. NOW accounts totaled $35.9 million or 10.2% and $32.9 million or 9.4% of total deposits at December 31, 2012 and 2011, respectively. Demand, noninterest bearing accounts totaled $58.5 million or 16.6% of total deposits at December 31, 2012 and $56.7 million or 16.2% at December 31, 2011. Securities sold under agreements to repurchase increased $3.3 million to $14.6 million at December 31, 2012 from $11.3 million at December 31, 2011. Long-term borrowings remained at $35.0 million at December 31, 2012 and 2011.

On March 26, 2003, Annapolis Bancorp Statutory Trust I (“Statutory Trust I”), a Connecticut business trust formed, funded and wholly owned by the Company, issued $5,000,000 of variable-rate capital securities to institutional investors. The proceeds of the securities were used to provide funding for future growth and to improve the Company’s capital ratios. The current cost of these securities is 3.46%.

The Company’s primary uses of funds are for loans and investments. Loans excluding deferred fees/costs and discounts and the allowance for credit losses, decreased $9.6 million or 3.3% to $281.2 million at December 31, 2012 from $290.8 million a year earlier. Commercial real estate balances increased $2.0 million or 1.7% due to several new customer relationships. Commercial and industrial loans decreased $3.2 million or 6.8%. Construction loans decreased $1.7 million or 4.8% and residential real estate loan balances decreased by $4.8 million or 5.7%. Installment and other consumer loans decreased by $1.9 million or 20.4%. Investment security balances increased $18.7 million during the year as proceeds from loan payoffs and increased deposit and repurchase agreement balances were placed in investment securities.

Operating Results

The following discussion outlines some of the more important factors and trends affecting the earnings of the Company as presented in its consolidated statements of income.

Net Interest Income

Net interest income is the difference between interest income and interest expense and is generally affected by increases or decreases in the amount of outstanding interest earning assets and interest bearing liabilities (volume variance). This volume

variance coupled with changes in interest rates on these same assets and liabilities (rate variance) equates to the total change in net interest income in any given period. The table on page 16 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).

Net interest income for the year ended December 31, 2012, was $16.0 million, representing a decrease of $258,000 or 1.6% from net interest income of $16.3 million for the year ended December 31, 2011. The decrease in net interest income is due primarily to a decrease in yields on the loan and securities portfolios, offset by a decrease in the yield on deposits and repurchase agreements. The net interest margin was 3.80% for the year ended December 31, 2012 and 3.93% for the year ended December 31, 2011. The yield on earning assets decreased to 4.49% for the year ended December 31, 2012 compared to 4.80% for the year ended December 31, 2011 while the cost of interest bearing liabilities decreased to 0.84% from 1.04% for the same periods, respectively. Net interest income for 2012 includes $333,000 of interest collected on a cash basis related to loans on nonaccrual status, compared to $350,000 of interest collected on nonaccrual loans in 2011.

Rate/Volume Analysis


	2012 vs. 2011												2011 vs. 2010
				Due to Change in												Due to Change in
	Increase or (Decrease)			Volume			Rate			Rate/ Volume			Increase or (Decrease)			Volume			Rate			Rate/ Volume
	(Dollars in thousands)
Interest income on:
Loans	($	404	)		176			(574	)		(6	)	$	1,144		$	724		$	401		$	19
Investment securities		(556	)		41			(588	)		(9	)		(1,137	)		(525	)		(711	)		99
Interest bearing deposits in other banks		18			4			12			2			(11	)		(5	)		(6	)		0
Federal funds sold and other overnight investments		1			(1	)		2			0			8			5			3			0

Total interest income		(941	)		220			(1,148	)		(13	)		4			199			(313	)		118

Interest expense on:
NOW accounts		(12	)		1			(13	)		0			(4	)		4			(7	)		(1	)
Money market accounts		(40	)		51			(71	)		(20	)		(83	)		6			(87	)		(2	)
Savings accounts		(453	)		(46	)		(430	)		23			(488	)		(27	)		(471	)		10
Certificates of deposit		(165	)		(87	)		(85	)		7			(402	)		(129	)		(298	)		25
Repurchase agreements		(25	)		0			(25	)		0			(33	)		(3	)		(31	)		1
Long-term borrowing		3			0			3			0			(24	)		(34	)		10			0
Junior subordinated debt		9			0			9			0			(2	)		0			(2	)		0

Total interest expense		(683	)		(81	)		(612	)		10			(1,036	)		(183	)		(886	)		33


Net interest income	($	258	)	$	301		($	536	)	($	23	)	$	1,040		$	382		$	573		$	85

Interest Income

The Company’s interest income decreased to $18.9 million for the year ended December 31, 2012 compared to $19.9 million for the year ended December 31, 2011, a decrease of $941,000 or 4.7%. The decrease in interest income can be attributed to a decrease in the yield on the loan portfolio to 5.73% compared to 5.93% for the year ended December 31, 2011. The yield on the securities portfolio dropped to 2.25% from 2.89%. Average federal funds sold balances decreased $131,000 or 0.8% and interest bearing balances with banks increased $3.0 million or 19.0%. The yield on federal funds sold increased to 0.24% from 0.23% for the year ended 2011 while the yield on interest bearing balances with banks increased to 0.21% from 0.13% for the same period.

Interest Expense

The Company’s interest expense decreased $683,000 or 19.0% to $2.9 million for 2012, compared to $3.6 million for 2011. The decrease in interest expense for the year ended December 31, 2012 can be attributed primarily to lower interest rates on all of the Bank’s deposit accounts and repurchase agreement accounts.

Provision for Credit Losses

The Company recorded a provision for credit losses of $684,000 for the year ended December 31, 2012 compared to $2.2 million for the year ended December 31, 2011, a decrease of $1.5 million or 68.8%. The decrease in provision was primarily the result of

incorporating historical loss percentages into the calculation of the allowance for credit losses rather than using peer data. The change was made as management determined that the Company had sufficient quarters of loss data to perform a meaningful analysis of the allowance for credit losses.

Nonperforming assets at year end increased to $12.1 million for the year ended December 31, 2012 from $8.3 million for the year ended December 31, 2011 primarily due to the addition of one loan with a principal balance of $4.1 million. Nonperforming assets included $769,000 of foreclosed real estate at December 31, 2012 and $337,000 of repossessed assets. Nonperforming assets of $8.3 million at December 31, 2011 included $1.2 million of foreclosed real estate and $52,000 of repossessed assets.

Net charge-offs totaled $1.5 million for the year ended December 31, 2012 compared to net charge-offs of $1.9 million for the same period in 2011. The net charge-offs in 2012 included $307,000 in commercial and industrial loans, $834,000 in loans secured by real estate and $408,000 in consumer and installment loans. See the discussion under the heading “Provision for Credit Losses and Credit Risk Management” on pages 24 through 26 for greater analysis regarding the Allowance for Credit Losses and related provision.

Noninterest Income

The Company’s primary sources of noninterest income are fees charged on deposit products, fees generated by the Bank’s VISA check card program and fees recognized on residential mortgage lending. Noninterest income of $1.9 million for the year ended December 31, 2012 was an increase of $74,000 or 4.0% from the year ended December 31, 2011. Included in noninterest income for the year ended December 31, 2011 were gains on the sale of loans in the secondary market of $166,000. There were no loans sold in the secondary market in 2012. For the year ended December 31, 2012 the Bank recorded net losses on the sale of other assets primarily real estate owned and repossessed assets of $5,000 compared to a gain on the sale of similar assets of $8,000 in 2011. In 2011 the Bank also recorded a loss of $32,000 on the disposal of fixed assets related to the closure of a branch office. Fees charged on deposit products decreased $23,000 or 1.8%, while other mortgage banking fees totaled $262,000 for the year ended December 31, 2012; an increase of $123,000 or 88.5% from fees of $139 thousand for the year ended December 31, 2011.

Noninterest Expense

Noninterest expense decreased $255,000 or 2.0% to $12.3 million from $12.6 million for the year ended December 31, 2012 compared to the year ended December 31, 2011. Personnel costs decreased $530,000 and other operating expenses decreased $288,000. These decreases were offset by Merger related expenses of $546,000 in 2012. Merger related expenses consisted primarily of professional and legal expenses totaling $413,000. Also contributing to the decrease in noninterest expenses was lower FDIC expense. FDIC expense continues to decrease as new regulation changed the method of calculation in the summer of 2011. 2012 was the first full year under the new method. FDIC expense decreased $97,000 for the year ended December 31, 2012 compared to the year ended December 31, 2011 due to changes in the insurance assessment calculations.

The decrease in personnel expense was the result of open staffing requisitions.

The decrease of $288,000 or 15.3% in other operating expenses was due to 2011 results including a partial write-down of $199,000 on a property held for future branch expansion.

Occupancy and equipment expense increased $35,000 or 2.2% primarily due to a partial year of expense on a branch office opened during 2012.

Provision for Income Taxes

The Company and the Bank file consolidated federal income tax returns and separate Maryland income tax returns. The Company recognized tax expense of $1.8 million for the year ended December 31, 2012 compared to $1.2 million for the year ended December 31, 2011, for an effective tax rate of 37.2% in 2012 and 35.2% in 2011.

Consolidated Average Balances, Yields and Rates

The following table presents a condensed average balance sheet as well as income/expense and yields/costs of funds thereon for the years ended December 31, 2012 and 2011. The yields and costs are derived by dividing income or expense by the average balance of assets or liabilities for the periods shown. Average balances are derived from average daily balances. The yields and costs include loan fees that are considered adjustments to yields. Net interest spread, the difference between the average rate on interest bearing assets and the average rate on interest bearing liabilities, decreased to 3.65% for the year ended December 31, 2012 from 3.76% at December 31, 2011.


	Years Ended
	December 31, 2012							December 31, 2011
	Average Balance		Interest (1)		Yield/ Rate			Average Balance		Interest (1)		Yield/ Rate
	(Dollars in thousands)

Assets
Interest Earning Assets
Federal funds sold and other overnight investments	$	17,102	$	41		0.24	%	$	17,233	$	40		0.23	%
Interest bearing balances in other banks		18,664		39		0.21	%		15,681		21		0.13	%
Investment securities (2)		92,632		2,083		2.25	%		91,246		2,639		2.89	%
Loans (3)		292,468		16,753		5.73	%		289,502		17,157		5.93	%

Total interest earning assets		420,866		18,916		4.49	%		413,662		19,857		4.80	%
Noninterest Earning Assets
Cash and due from banks		7,378							7,521
Other assets		14,487							14,827

Total Assets	$	442,731						$	436,010


Liabilities and Stockholders’ Equity
Interest Bearing Deposits
NOW accounts	$	32,757	$	29		0.09	%	$	32,495	$	41		0.13	%
Money market accounts		54,038		149		0.28	%		43,107		189		0.44	%
Savings accounts		130,850		407		0.31	%		137,732		860		0.62	%
Certificates of deposit		72,038		966		1.34	%		78,031		1,131		1.45	%
Repurchase agreements		16,075		49		0.30	%		16,004		74		0.46	%
Long-term borrowings		35,000		1,130		3.18	%		35,000		1,127		3.18	%
Junior subordinated debt		5,000		184		3.62	%		5,000		175		3.45	%

Total interest bearing liabilities		345,758		2,914		0.84	%		347,369		3,597		1.04	%

Noninterest Bearing Liabilities
Demand deposit accounts		58,064							50,331
Other liabilities		2,721							2,438
Stockholders’ Equity		36,188							35,872

Total Liabilities and Stockholders’ Equity	$	442,731						$	436,010


Interest rate spread						3.65	%						3.76	%
Ratio of interest earning assets to interest bearing liabilities						121.72	%						119.08	%
Net interest income and net interest margin			$	16,002		3.80	%			$	16,260		3.93	%

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

(2)	Includes Federal Reserve and Federal Home Loan Bank stock.

(3)	Includes non-accrual loans

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.

Liquidity Risk Management and Capital Resources

The objective of liquidity management is to ensure that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of the Company are met, taking into account all on- and off-balance sheet funding demands. Liquidity management also includes ensuring that cash flow needs are met at a reasonable cost. Liquidity risk arises from the possibility the

Company may not be able to satisfy current or future financial commitments, or the Company may become unduly reliant on alternative funding sources. The Company maintains a liquidity risk management policy to address and manage this risk. The policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements which comply with regulatory guidance. The policy is updated at a minimum on a yearly basis. The liquidity position is continually monitored and reported monthly to the Board of Directors.

Deposits, commercial reverse repurchase agreements, and lines of credit are the primary sources of the Bank’s funds for lending and investing activities. As of December 31, 2012 the Company’s deposit and repurchase agreement balances increased $5.8 million or 1.6% over December 31, 2011 balances. At December 31, 2012 the Company also had available both secured and unsecured lines of credit with the Federal Home Loan Bank and correspondent banks. Secondary sources of funds are derived from loan repayments and investment maturities. Loan repayments and investment maturities can be considered a relatively stable funding source, while deposit activity is greatly influenced by interest rates, general market conditions and competition.

The Bank offers a variety of retail deposit account products to both consumer and commercial deposit customers. The Bank’s deposit accounts consist of savings, NOW accounts, checking accounts, money market accounts and certificate of deposit accounts. The Bank also offers individual retirement accounts. Time deposits comprised 19.5% of the deposit portfolio at December 31, 2012. Core deposits, considered to be noninterest bearing and interest bearing demand deposit accounts, savings deposits and money market accounts, accounted for 80.5% of the deposit portfolio at December 31, 2012. Core deposits accounted for 77.7% of the deposit portfolio at December 31, 2011.

The Bank intends to continue to emphasize retail deposit accounts as its primary source of liquidity. Deposit products are promoted in periodic newspaper advertisements, along with notices provided in customer account statements. The Bank’s market strategy is based on its reputation as a community bank providing quality products and personal customer service.

The Bank pays interest rates on interest bearing deposit products competitive with rates offered by other financial institutions in its market area. Interest rates on deposits are reviewed by management which considers a number of factors including: (1) the Bank’s internal cost of funds; (2) rates offered by competing financial institutions; (3) investing and lending opportunities; and (4) the Bank’s liquidity position.

Jumbo certificates of deposit are accounts of $100,000 or more. These accounts totaled $38.0 million at December 31, 2012 and consisted principally of time certificates of deposit. The following table sets forth the amount and maturity of jumbo certificates of deposit at December 31, 2012:


Three Months or Less		Greater than Three Months to Six Months		Greater than Six Months to One Year		Greater than One Year		Total
(Dollars in thousands)

$	10,013	$	3,551	$	4,472	$	19,948	$	37,984

Securities sold under agreements to repurchase represent transactions with customers for correspondent or commercial account cash management services. Securities underlying the repurchase agreements are maintained in the Company’s control. For the years ended December 31, 2012 and 2011, the average cost of these borrowings was 0.30% and 0.46%, respectively.

The Bank maintains a secured borrowing line with the Federal Home Loan Bank (FHLB) with the potential to draw up to $111.4 million, and may borrow up to $19.2 million under secured and unsecured lines established with correspondent commercial banks. In addition, the Bank has the ability to borrow directly from the Federal Reserve Bank discount window. At December 31, 2012, the Bank had advances outstanding of $35.0 million under the Federal Home Loan Bank’s convertible advance program and had no borrowings outstanding under its secured and unsecured lines of credit.

Potential adverse impacts on liquidity can occur as a result of changes in the estimated cash flows from investment, loan, and deposit portfolios. The Bank manages this inherent risk by maintaining a portfolio of available for sale investments and through secondary sources of liquidity including FHLB advances and reverse repurchase agreements. In addition, the Bank has the ability to increase its liquidity by raising interest rates on deposit accounts, selling loans in the secondary market or curtailing the volume of loan originations.

The Bank maintains the majority of the assets held for liquidity purposes in overnight federal funds and short-term interest bearing balances with banks.

Interest Rate Risk Sensitivity

Interest rate sensitivity is an important factor in the management of the composition and maturity configurations of the Company’s interest earning assets and funding sources. Additionally, the Bank’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest bearing assets, such as loans and investments, and its interest expense on its funding sources, such as deposits and borrowings. Accordingly, the Bank’s results of operations and financial condition are largely dependent on movements in market interest rates and its ability to manage its assets in response to such movements.

The Bank attempts to manage fluctuations in interest rates by matching the maturities of its interest earning assets and interest bearing liabilities. The Bank’s current strategy to manage its sensitivity to interest rate fluctuations is to emphasize adjustable rate loans and short and intermediate-term fixed rate loans. To reduce the negative impact of engaging in excessive fixed rate lending in a volatile rate environment, the Bank originates long-term fixed rate mortgage loans as a broker for other financial institutions. The partner financial institutions underwrite and fund the loans.

The following table summarizes the anticipated maturities or repricing of the Company’s interest earning assets and interest bearing liabilities as of December 31, 2012, and the Company’s interest sensitivity gap (i.e., interest earning assets less interest bearing liabilities). A positive gap for any time period indicates that more interest earning assets will mature or reprice during that period than interest bearing liabilities. The Company’s goal is to maintain a cumulative gap position for the period of one year or less of plus or minus fifteen percent in order to mitigate the impact of changes in interest rates on liquidity, interest margins and operating results. The actual results show the Bank to be negatively gapped cumulatively in the three to twelve month category.

The analysis presented below represents a modified gap position for interest sensitive assets and liabilities at December 31, 2012.

Interest Sensitivity Gap Analysis


December 31, 2012	Within Three Months			After Three but within Twelve Months			After One but within Five Years			After Five Years			Total
				(Dollars in thousands)
Assets
Interest bearing balances with banks	$	38,175		$	0		$	0		$	0		$	38,175
Investment securities (1)		15,003			42,630			7,989			39,938			105,560
Loans (2) (3)		54,337			36,438			121,720			58,510			271,005

	$	107,515		$	79,068		$	129,709		$	98,448		$	414,740


Liabilities
Interest bearing liabilities
NOW accounts (5)	$	7,188			3,594			25,159		$	0		$	35,941
Money market accounts (5)		33,699			3,629			22,280			0			59,608
Savings accounts (5)		62,014			13,001			54,996			0			130,011
Certificates of deposit (4)		14,170			18,631			36,049			0			68,850
Commercial repurchase agreements		14,584			0			0			0			14,584
Long-term borrowings (6)		30,000			0			5,000			0			35,000
Junior subordinated debt		5,000			0			0			0			5,000

	$	166,655		$	38,855		$	143,484		$	0		$	348,994


Interest sensitivity gap	($	59,140	)	$	40,213		($	13,775	)	$	98,448		$	65,746
Cumulative interest sensitivity gap	($	59,140	)	($	18,927	)	($	32,702	)		65,746
Cumulative interest sensitivity gap as a percentage of total interest-earning assets		(14.26	%)		(4.56	%)		(7.88	%)		15.85	%

(1)	Net of Federal Reserve Bank, Federal Home Loan Bank stock and other equity investments, debt securities by call date.

(2)	Loans scheduled by contractual maturities.

(3)	Net of non-accrual loans of $9.9 million.

(4)	Certificates of deposits scheduled by contractual maturities.

(5)	NOW, savings and money market accounts are presented using decay rates and historical repricing patterns.

(6)	Long-term borrowings by call date

Investment Portfolio

At December 31, 2012, the Bank’s investment portfolio, which totaled $109.1 million, consisted primarily of U.S. Government Agency securities and mortgage-backed agency securities. Additionally, the Company owns $626,500 in stock of the Federal Reserve Bank of Richmond, $2.2 million in stock of the Federal Home Loan Bank of Atlanta (FHLB) and a $686,000 investment in a community development activity qualified mutual fund.

Investment decisions are made within policy guidelines established by the Board of Directors. It is the Bank’s policy to invest in non-speculative debt instruments, particularly debt instruments that are guaranteed by the U.S. Government or an agency thereof, to maintain a diversified investment portfolio which complements the overall asset/liability and liquidity objectives of the Bank, while limiting the related credit risk to an acceptable level. The Bank’s investment policy designates the investment portfolio to be classified as “available-for-sale,” unless otherwise designated. At December 31, 2012, 100% of the investment portfolio was classified available-for-sale. The composition of securities at December 31 for each of the past five fiscal years was:


	2012		2011		2010		2009		2008
	(Dollars in thousands)
Available for Sale
U.S. Agency	$	70,368	$	48,032	$	53,761	$	54,788	$	47,297
State and Municipal		1,026		1,136		1,089		1,089		834
Mortgage-backed		34,166		37,725		40,828		61,415		32,035
Equity Securities		686		656		617		591		564


Total Securities	$	106,246	$	87,549	$	96,295	$	117,883	$	80,730

The following table presents maturities and weighted average yields for investments in available-for-sale securities.

December 31, 2012


	Years to Maturity
	Within One Year					Within One Year to Five Years					Within Five to Ten Years
	Amount		Yield			Amount		Yield			Amount		Yield
	(Dollars in thousands)
Available for Sale
U.S. Agency	$	1,015		2.00	%	$	28,595		0.98	%	$	35,059		1.42	%
State and Municipal		0		0.00	%		791		4.41	%		235		2.75	%
Mortgage-backed		0		0.00	%		162		5.50	%		3,544		2.88	%


Total Debt Securities	$	1,015		2.00	%	$	29,548		1.09	%	$	38,838		1.55	%


	Greater than Ten Years
	Amount		Yield			Total
Available for Sale
U.S. Agency	$	5,699		3.85	%	$	70,368
State and Municipal		0		0.00	%		1,026
Mortgage-backed		30,460		3.57	%		34,166


Total Debt Securities	$	36,159		3.61	%	$	105,560

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.

Lending Activities

The types of loans that the Bank may originate are subject to federal laws and regulations. Interest rates charged by the Bank on loans are affected by the demand for such loans and the supply of money available for lending purposes and the rates offered by competitors.

These factors are, in turn, affected by, among other things, economic conditions, monetary policies of the federal government, including the Federal Reserve Board, and legislative tax policies.

Analysis of Loans

The following table presents the composition of the loan portfolio over the previous five years:

As of December 31,


	2012						2011						2010						2009						2008
	Amount			Percent			Amount			Percent			Amount			Percent			Amount			Percent			Amount			Percent
	(Dollars in thousands)

Commercial loans	$	44,422			15.8	%	$	47,683			16.4	%	$	51,359			18.3	%	$	59,900			21.2	%	$	53,366			19.9	%
Real estate loans
Commercial		116,883			41.6	%		114,883			39.5	%		94,864			33.9	%		82,168			29.2	%		78,215			29.1	%
Construction		33,319			11.8	%		35,026			12.0	%		33,534			12.0	%		36,185			12.8	%		28,381			10.6	%
One to four-family (1)		47,873			17.0	%		48,314			16.6	%		52,960			18.9	%		57,098			20.2	%		66,964			24.9	%
Home equity		31,650			11.3	%		36,005			12.4	%		36,697			13.1	%		34,262			12.2	%		27,072			10.1	%
Consumer loans		7,061			2.5	%		8,870			3.1	%		10,664			3.8	%		12,479			4.4	%		14,422			5.4	%

Total loans		281,208			100.0	%		290,781			100.0	%		280,078			100.0	%		282,092			100.0	%		268,420			100.0	%


Less:
Unearned income		(331	)					(315	)					(162	)					(134	)					(204	)
Allowance for credit losses		(6,317	)					(7,182	)					(6,853	)					(7,926	)					(4,123	)

Net loans receivable	$	274,560					$	283,284					$	273,063					$	274,032					$	264,093

(1)	Includes loans held for sale.

The Bank’s loan portfolio consists of commercial, commercial real estate, residential construction, one- to four-family residential mortgage, home equity and consumer loans. At December 31, 2012 the Bank’s loan portfolio totaled $281.2 million. All of the loans in the Bank’s portfolio are either adjustable-rate with terms to maturity of 30 days to 30 years or short- to intermediate-term fixed-rate loans.

The following table presents the maturity distribution of the loan portfolio:

As of December 31, 2012


	Due in One Year or Less		Due after One Year but before Five Years		Due after Five Years		Nonaccrual Loans		90 Days Past Due		Total
	(Dollars in thousands)
Commercial loans	$	19,250	$	14,181	$	6,511		4,480	$	0	$	44,422
Real estate loans
Commercial		10,556		76,936		27,272		2,119		0		116,883
Construction		24,677		8,642		0		0		0		33,319
One to four-family		18,957		17,740		8,189		2,773		214		47,873
Home equity		15,703		522		15,030		395		0		31,650
Consumer loans		1,748		3,429		1,779		105		0		7,061

Total loans	$	90,891	$	121,450	$	58,781	$	9,872	$	214	$	281,208


	Due After One Year (1)
	Fixed Rate		Variable Rate		Total
Commercial loans	$	16,006	$	4,685	$	20,691
Real estate loans
Commercial		70,116		34,092		104,208
Construction		8,642		0		8,642
One to four-family		14,895		11,035		25,930
Home equity		15,552		0		15,552
Consumer loans		2,105		3,103		5,208

Total loans	$	127,316	$	52,915	$	180,231

(1)	Excludes nonaccrual and 90 day past due loans.

Commercial Lending. The Bank offers commercial business loans to businesses operating in the Bank’s primary market area. These loans consist of lines of credit, which may require an annual repayment, adjustable-rate loans with terms of five to seven years, and fixed-rate loans with terms of up to five years. Such loans are generally secured by receivables, inventories, equipment and other assets of the business. The Bank generally requires personal guarantees on its commercial loans. The Bank also offers unsecured commercial loans to businesses on a selective basis. These types of loans are made to existing customers and are of a short duration, generally one year or less. The Bank also originates commercial loans which are guaranteed by the Small Business Administration. The Bank has been a participant in a variety of SBA loan programs.

Commercial Real Estate Lending. The Bank originates adjustable-rate commercial real estate loans that are generally secured by properties used for business purposes such as small office buildings and retail facilities located in the Bank’s primary market area. The Bank’s underwriting procedures provide that commercial real estate loans may generally be made in amounts up to 80-85% of the lower of the appraised value or sales price of the property, subject to the Bank’s current loans-to-one-borrower limit, which at December 31, 2012, was $6.7 million. These loans may be made with terms up to 30 years if owner occupied and are generally offered at interest rates which adjust annually or annually after an initial three-, five- or seven-year period in accordance with the prime rate, or the 3 and 5 year U.S. Constant Maturity Indices as reported in the Wall Street Journal. In reaching a decision whether to make a commercial real estate loan, the Bank considers the value of the real estate to be financed and the credit strength of the borrower and/or the lessee of the real estate project. The Bank has generally required that properties securing commercial real estate loans have debt service coverage ratios of at least 1.2:1.

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 requires personal guarantees on its commercial real estate loans.

Construction Lending. The Bank originates construction loans on both one- to four-family residences and on commercial real estate properties. The Bank originates two types of residential construction loans, consumer and builder. The Bank originates consumer construction loans to build a primary residence, a secondary residence, or an investment or rental property. The Bank will originate builder construction loans to companies engaged in the business of constructing homes for resale. These loans may be for homes currently under contract for sale, model homes from which other homes will be marketed within a subdivision or, on a very limited basis, homes built for speculative purposes to be marketed for sale during construction. The Bank offers permanent end-financing to the Bank’s construction loan customers generally on a 3/1 or 5/1 Adjustable Rate Mortgage (“ARM”) basis.

The Bank originates land acquisition and development loans with the source of repayment being either the sale of finished lots or the sale of homes to be constructed on the finished lots. The Bank will originate land acquisition, development, and construction loans on a revolving line of credit basis for subdivisions whereby the borrower may draw upon such line of credit as lots are sold for the purpose of improving additional lots. Construction loans are generally offered with terms up to twelve months for consumer and builder loans, and up to twenty-four months for land development loans.

Construction loans are generally made in amounts up to 80% of the appraised market value of the security property. During construction, loan proceeds are disbursed in draws as construction progresses based upon inspections of work in place by independent construction inspectors.

At December 31, 2012, the Bank had construction loans, including land acquisition and development loans, totaling $33.3 million, or 11.8% of the Bank’s total loan portfolio, of which $2.6 million consisted of one- to four-family owner occupied construction loans, $7.1 million consisted of non-owner occupied construction loans and $23.6 million consisted of land acquisition and development 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.

One- to Four-Family Residential Mortgage Lending. The Bank currently offers both fixed-rate and adjustable-rate mortgage loans, first and second mortgage loans secured by one- to four-family residences and lot loans for one- to four-family residences located throughout the Baltimore-Washington Metropolitan area. One- to four-family mortgage loan originations are generally obtained from the Bank’s loan representatives and their contacts in the local real estate industry, direct contacts made by the Bank’s and the Company’s directors, existing or past customers, and members of the local communities.

At December 31, 2012, one- to four-family residential mortgage loans totaled $47.9 million, or 17.0% of total loans. Of the one-to four-family mortgage loans outstanding at that date, $23.4 million were fixed-rate loans with terms of up to fifteen years with a balloon payment at the end of the term, and $24.5 million were adjustable-rate loans with terms of up to 30 years and interest rates which adjust annually from the outset of the loan or which adjust annually after a 3 or 5 year initial period in which the loan has a fixed rate. The interest rates for the majority of the Bank’s adjustable-rate mortgage loans are indexed to the one-year Treasury Constant Maturity Index. Interest rate increases on such loans are limited to a 2% annual adjustment cap with a maximum adjustment of 6% over the life of the loan.

The Company also originates fixed-rate residential mortgage loans as a broker for other financial institutions. The partner financial institutions underwrite and fund the loans. This enables the Company to expand the product offerings to its customers, earn fee income and manage its exposure to increases in interest rates.

The origination of and retention of adjustable-rate residential mortgage loans, as opposed to fixed-rate residential mortgage loans, helps 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 floors 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.

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. Mortgage loans originated by the Bank generally include due-on-sale clauses which provide the Bank with the contractual right to deem the loan immediately due and payable in the event the borrower transfers ownership of the property without the Bank’s consent. Due-on-sale clauses are an important means of adjusting the yields on the Bank’s fixed-rate mortgage loan portfolio and the Bank has generally exercised its rights under these clauses.

Home Equity Lending. As of December 31, 2012, home equity loans totaled $31.6 million, or 11.3% of the Bank’s total loan portfolio. Fixed-rate, fixed-term home equity loans and adjustable rate home equity lines of credit are generally offered in amounts up to 80% of the market value of the security property. Home equity lines of credit are offered with terms up to twenty years. Of the $31.6 million in home equity loans, $15.7 million are fixed rate with terms up to 10 years. The remaining $15.9 million of the Bank’s home equity loans are adjustable rate and reprice with changes in the Wall Street Journal prime rate.

Consumer Lending. The Bank’s portfolio of consumer loans primarily consists of adjustable rate, personal lines of credit and generally fixed rate installment loans secured by new or used automobiles, new or used boats, and loans secured by deposit accounts. At December 31, 2012, consumer loans totaled $7.1 million or 2.5% of total loans outstanding. Consumer loans are generally originated in the Bank’s primary market area.

Provision for Credit Losses and Credit Risk Management

Originating loans involves a degree of risk that credit losses will occur in varying amounts according to, among other factors, the type of loans being made, the credit-worthiness of the borrowers over the term of the loans, the quality of the collateral for the loan, if any, as well as general economic conditions.

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 Bank’s historical loss 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. Previously (in 2011) due to the Bank’s limited historical loss experience the loss experience factor was the greater of either the Bank’s historical loss experience or the peer group average historical loss experience.

•

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.

•

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 requires these 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 $684,000 for the year ended December 31, 2012 and $2.2 million in 2011. The decrease in provision was primarily the result of a decrease in loan levels and applying the Bank’s historical loss percentages when calculating the allowance for credit losses compared to the use of peer data in prior years. 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 decreased by $9.6 million for the year ended December 31, 2012. The Bank recorded charge-offs of $1.7 million on loans deemed uncollectible and recovered $170,000 on previously charged-off loans. As of December 31, 2012, the Bank’s allowance for credit losses was $6.3 million or 2.25% of total loans and 57.4% of nonperforming loans as compared to $7.2 million, or 2.47% of total loans and 102.3% of nonperforming loans as of December 31, 2011. The Bank had total nonperforming loans of $11.0 million at December 31, 2012 and $7.0 million at December 31, 2011, and nonperforming loans to total assets of 2.47% and 1.67% at December 31, 2012 and December 31, 2011, respectively.

The Bank places loans on a nonaccrual status after 90 days of not having received contractual principal or interest payments unless the loan is well secured and in the process of collection. In addition the Bank maintains a watch list of loans on a monthly basis that warrant more than the normal level of management supervision. At December 31, 2012 the Bank had approximately $25.5 million in watch list loans compared to $42.7 million at December 31, 2011.

At December 31, 2012 $9.9 million in loans were classified as nonaccrual compared to $6.2 million at December 31, 2011. Approximately 28.0% of the year-end nonaccrual total consisted of one- to four-family loans while commercial mortgages accounted for approximately 21.5% of the total. Home equity loans represented 4.0% of the total, consumer and installment loans accounted for 1.1% and commercial loans 45.4% of the total nonaccrual loans at December 31, 2012.

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.

The following table presents the allocation of the allowance for credit losses, reflecting use of the methodology presented above, along with the percentage of total loans in each category.

At December 31,


	2012					2011
	Amount		Loan Mix			Amount		Loan Mix
(Dollars in thousands)
Amount applicable to:
Commercial	$	1,381		15.8	%	$	1,387		16.4	%
Real estate
Commercial		2,177		41.6	%		2,155		39.5	%
One to four-family		1,770		28.3	%		1,422		29.0	%
Construction		714		11.8	%		1,817		12.0	%
Consumer		275		2.5	%		401		3.1	%

Total allowance	$	6,317		100.0	%	$	7,182		100.0	%

Analysis of Credit Risk

Activity in the allowance for credit losses for the two years ended December 31 is shown below:


	2012			2011

Total loans outstanding – at December 31 (1)	$	280,877		$	290,466
Average loans outstanding for the year		292,468			289,502

Allowance for credit losses at beginning of period	$	7,182		$	6,853

Provision charged to expense		684			2,190

Charge-offs:
Commercial loans		357			1,183
Real estate loans		896			810
Consumer and other loans		466			203

Total		1,719			2,196

Recoveries:
Commercial loans		50			19
Real estate loans		62			294
Consumer and other loans		58			22

Total		170			335


Net charge-offs		1,549			1,861

Allowance for credit losses at end of year	$	6,317		$	7,182


Allowance for credit losses as a percent of total loans		2.25	%		2.47	%
Net charge-offs as a percent of average loans		0.53	%		0.64	%

(1)	Net of deferred fees and costs.

Nonperforming Loans and Other Delinquent Assets

Management performs reviews of all delinquent loans. Management will generally classify loans as nonaccrual when collection of full principal and interest under the original terms of the loan is not expected or payment of principal or interest has become 90 days past due. Classifying a loan as non-accrual results in the Company no longer accruing interest on such loan and reversing any interest previously accrued but not collected. A nonaccrual loan may be restored to accrual status when delinquent principal and interest payments are brought current and future monthly principal and interest payments are expected to be collected. The Company will recognize interest on nonaccrual loans only when received. As of December 31, 2012 and 2011, the Company had $9.9 and $6.2 million of nonaccrual loans, respectively. (See the previous discussion under the heading “Provision for Credit Losses and Credit Risk Management” for additional comments regarding nonaccrual loan activity.)

The Company considers a loan to be a troubled debt restructuring when for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. The Company may consider granting a concession in an attempt to protect as much of its investment as possible.

The restructuring of a loan may include, but is not necessarily limited to: (1) the transfer from the borrower to the Bank of real estate, receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan (2) the issuance or other granting of an equity interest to the Company by the borrower to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt in to an equity interest (3) a modification of the loan terms, such as a reduction of the stated interest rate, principal, or accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk, or (4) a reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement and (5) a reduction of accrued interest. The current outstanding balance of troubled debt restructurings as of December 31, 2012 included $925,000 of loans in accrual status and $1.7 million of loans classified as nonaccrual.

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 December 31, 2012 the Company held $769,000 in real estate owned as a result of foreclosure. The Company held $1.2 million in real estate owned at December 31, 2011. Property held as the result of repossession totaled $337,000 at December 31, 2012 and $52,000 at December 31, 2011.

The following table shows the amounts of nonperforming assets at December 31 for the past five years.


	2012			2011			2010			2009			2008
	(Dollars in thousands)
Nonaccrual loans:
Commercial	$	4,480		$	390		$	2,107		$	6,718		$	292
Real estate		5,287			5,308			5,054			9,532			3,397
Consumer		105			484			630			517			604
Accrual loans – past due 90 days
Commercial		0			0			0			33			0
Real estate		214			0			598			0			2,005
Consumer		0			0			0			0			0
Restructured loans		925			856			0			0			0

Total nonperforming loans		11,011			7,038			8,389			16,800			6,298
Real estate owned		769			1,222			1,608			2,398			0
Repossessed assets		337			52			145			122			182

Total nonperforming assets	$	12,117		$	8,312		$	10,142		$	19,320		$	6,480


Allowance for credit losses to total nonperforming loans		57.37	%		102.03	%		81.69	%		47.18	%		65.47	%
Ratio of nonperforming loans to total loans		3.92	%		2.42	%		3.00	%		5.96	%		2.35	%
Ratio of nonperforming assets to total assets		2.71	%		1.88	%		2.35	%		4.35	%		1.64	%

Contractual Obligations

The Bank has various financial obligations, including contractual obligations and commitments that may require future cash payments.

The following table presents, as of December 31, 2012, significant fixed and determinable contractual obligations to third parties by payment date.


Payments due by Period	Total		Less than one year		One to three years		Three to five years		More than five years
	(Dollars in thousands)

Deposits with a stated maturity	$	68,850	$	32,801	$	18,546	$	17,503	$	0
Long-term borrowings		35,000		0		5,000		15,000		15,000
Junior subordinated debentures		5,000		0		0		0		5,000
Operating lease obligations		9,199		301		1,138		1,135		6,625
Data processing contracts		1,005		485		520		0		0

	$	119,054	$	33,587	$	25,204	$	33,638	$	26,625

Off-Balance Sheet Arrangements

As of December 31, 2012, the Company had a wholly-owned statutory trust formed for the purpose of issuing junior subordinated debentures in the form of trust preferred securities. The statutory trust has not been consolidated with the holding company.

The Company does have significant commitments to fund loans in the ordinary course of business. Such commitments and resulting off-balance sheet risk is discussed further in Note 5 to the consolidated financial statements.

With the exception of these off-balance sheet arrangements, the Company has no-off balance sheet arrangements that have or are reasonably likely to have a material current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, capital expenditures or capital resources.

Capital Management

Total stockholders’ equity was $36.2 million at December 31, 2012, representing a decrease of $1.1 million or 3.1% from December 31, 2011. The decrease in stockholders’ equity during 2012 as compared to the same period in 2011 was attributable to the redemption of $4.1 million in Fixed Rate Cumulative Preferred Stock, Series A (the “Series A Preferred Stock”), and a decrease in other comprehensive income of $137,000 offset by net income of $3.1 million.

On January 30, 2009, the Company sold 8,152 shares of the Company’s 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. On April 18, 2012, Annapolis Bancorp, Inc. (the “Company”) redeemed 4,076 shares of its Series A Preferred Stock for $4,076,000. On April 18, 2012, The Company redeemed 4,076 shares of its Series A Preferred Stock for $4,076,000 and on March 6, 2013, the Company redeemed the final 4,076 shares of its Series A Preferred Stock for $4,076,000.

Stockholder’s equity was also lowered by $264,000 in preferred stock dividends. Stock based compensation, stock purchases through the Company’s Employee Stock Purchase Plan and the exercise of options added $231,000 to the stockholder’s equity for the period ended December 31, 2012.

Regulatory Capital Requirements

The Federal Reserve’s capital regulations require state member banks to meet two minimum capital standards: a 4% Tier 1 capital to total adjusted average assets ratio (the “leverage” ratio), and an 8% risk-based capital ratio. Tier 1 capital is defined as common stockholders’ equity (including retained earnings), certain non-cumulative perpetual preferred stock and related paid in capital, and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships.

The risk-based capital standard requires the maintenance of Tier 1 and Total capital (which is defined as Tier 1 capital plus Tier 2 capital) to risk-weighted assets of at least 4% and 8%, respectively. A well-capitalized institution has Tier 1 and Total capital to risk-weighted assets of at least 6% and 10%, respectively, and a leverage ratio of at least 5%. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100%, as assigned by the Federal Reserve capital regulations, based on the risks the agency believes are inherent in the type of asset. The regulators have recently added a market risk adjustment to cover a bank’s trading account and foreign exchange and commodity positions. The components of Tier 1 capital are equivalent to those discussed above. Tier 2 capital may include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt, intermediate preferred stock and the allowance for credit losses limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of Tier 2 capital included as part of total capital cannot exceed 100% of Tier 1 capital.

Trust preferred securities are considered regulatory capital for purposes of determining the Company’s Tier 1 capital ratios. The Dodd-Frank Act requires the Federal Reserve to apply consolidated capital requirements to depository holding companies that are no less stringent than those that apply to depository institutions. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Company’s trust preferred securities were issued prior to May 19, 2010 and will not need to be excluded from Tier 1 capital.

At December 31, 2012, the Company’s Tier 1 and Total Risk-based capital ratios were 12.7% and 13.9%, respectively. At December 31, 2011, the Bank’s Tier 1 and Total Risk-based capital ratios were 12.8% and 14.0%, respectively. The Bank was considered well-capitalized for regulatory purposes as of December 31, 2012. 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.

See Note 18 of the Consolidated Financial Statements for more information on the Bank’s risk-based capital ratios.

Impact of Inflation and Changing Prices

The Consolidated Financial Statements and Notes thereto have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of operations. Nearly all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods or services.

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following consolidated financial statements are filed with this report:

Management’s Report on Internal Control over Financial Reporting

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets – December 31, 2012 and 2011

Consolidated Statements of Income – For the years ended December 31, 2012 and 2011

Consolidated Statements of Comprehensive Income – For the years ended December 31, 2012 and 2011

Consolidated Statements of Changes in Stockholders’ Equity – For the years ended December 31, 2012 and 2011

Consolidated Statements of Cash Flows – For the years ended December 31, 2012 and 2011

Notes to Consolidated Financial Statements

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management’s Report

The Management of Annapolis Bancorp, Inc. (the “Company”) is responsible for the preparation, integrity and fair presentation of the consolidated financial statements included in this Annual Report on Form 10-K. These financial statements are in conformity with accounting principles generally accepted in the United States of America and, therefore, include amounts based on informed judgments and estimates. We also accept responsibility for the preparation of other financial information that is included in this document.

Report on Internal Control Over Financial Reporting

The management of the Company, including its Chairman and Chief Executive Officer and the Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management, including its Chairman and Chief Executive Officer and the Chief Financial Officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on this assessment management believes that the Company maintained effective internal control over financial reporting as of December 31, 2012.

This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

/s/ Richard M. Lerner

Richard M. Lerner

Chairman and Chief Executive Officer

/s/ Edward J. Schneider

Edward J. Schneider

Principal Financial and Accounting Officer

March 28, 2013

ANNAPOLIS BANCORP, INC.

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Annapolis Bancorp, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheets of Annapolis Bancorp, Inc. and subsidiaries (the “Company”) as of December 31, 2012 and 2011 and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the two year period ended December 31, 2012. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of their internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Annapolis Bancorp, Inc. and subsidiaries as of December 31, 2012 and 2011 and the results of their operations and their cash flows for each of the years in the two year period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America.

/s/ Stegman & Company

Baltimore, Maryland

March 28, 2013

ANNAPOLIS BANCORP, INC.

Consolidated Balance Sheets ($000)


December 31,	2012		2011

Assets

Cash and due from banks	$	1,920	$	2,026
Interest bearing balances with banks		38,175		18,288
Federal funds sold and other overnight investments		0		26,583
Investment securities available for sale, at fair value		106,246		87,549
Federal Reserve Bank and Federal Home Loan Bank stock		2,864		2,992
Loans, less allowance for credit losses of $6,317 and $7,182		274,560		283,284
Premises and equipment, net		10,113		8,418
Accrued interest receivable		1,284		1,279
Deferred income taxes		2,264		2,617
Investment in bank owned life insurance		5,829		5,624
Prepaid FDIC insurance		873		1,198
Real estate owned		769		1,222
Other assets		1,489		490

Total assets	$	446,386	$	441,570


Liabilities and Stockholders’ Equity
Deposits
Noninterest bearing	$	58,507	$	56,664
Interest bearing		294,410		293,717
Securities sold under agreements to repurchase		14,584		11,344
Long-term borrowings		35,000		35,000
Guaranteed preferred beneficial interests in junior subordinated debentures		5,000		5,000
Accrued interest and dividends payable		184		219
Other liabilities		2,486		2,258

Total liabilities		410,171		404,202


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 4,076 shares at December 31, 2012 and 8,152 shares at December 31, 2011, net of discount of zero and $6, respectively		4,076		8,146
Common stock, par value $0.01 per share; authorized 10,000,000 shares; issued and outstanding 4,008,934 shares in 2012 and 3,958,293 shares in 2011		40		39
Warrants		234		234
Paid in capital		12,010		11,779
Retained earnings		19,001		16,179
Accumulated other comprehensive income		854		991

Total stockholders’ equity		36,215		37,368

Total liabilities and stockholders’ equity	$	446,386	$	441,570

The accompanying notes are an integral part of these financial statements.

ANNAPOLIS BANCORP, INC.

Consolidated Statements of Income ($000 except per share data)


Years Ended December 31,	2012			2011
Interest and Dividend Income
Loans, including fees	$	16,753		$	17,157
Interest bearing balances with banks		39			21
Federal funds sold and other overnight investments		41			40
Mortgage-backed securities		1,080			1,404
U.S. Treasury securities and obligations of other U.S. Government agencies		859			1,111
State and municipal securities		42			44
Equity securities		102			80

Total interest and dividend income		18,916			19,857

Interest Expense
Certificates of deposit, $100,000 or more		532			563
Other deposits		1,019			1,658
Securities sold under agreements to repurchase		49			74
Interest on long-term borrowings		1,314			1,302

Total interest expense		2,914			3,597

Net interest income		16,002			16,260
Provision for credit losses		684			2,190

Net interest income after provision for credit losses		15,318			14,070

Noninterest Income
Service charges and fees on deposits		1,227			1,250
Mortgage banking fees		262			139
Other fee income		432			311
Net gain on sale of loans		0			166
Net (loss) gain on sale of real estate owned and repossessed assets		(5	)		8
Loss on disposal of fixed assets		0			(32	)

Total noninterest income		1,916			1,842

Noninterest Expense
Personnel		6,519			7,049
Occupancy and equipment		1,595			1,560
Data processing		840			847
Merger related expenses		546			0
Legal and professional fees		540			439
Marketing and advertising		333			348
FDIC insurance		343			440
Other operating expenses		1,592			1,880

Total noninterest expense		12,308			12,563


Income Before Income Taxes		4,926			3,349
Income Tax Expense		1,834			1,178

Net Income		3,092			2,171
Preferred Stock Dividend and Discount Accretion		271			490

Net Income Available to Common Shareholders	$	2,821		$	1,681


Basic earnings per common share	$	0.71		$	0.43
Average common shares outstanding before the effect of grants, options and warrants		3,976,754			3,949,717
Diluted earnings per common share	$	0.68		$	0.39
Average common shares outstanding with the effect of grants, options and warrants		4,120,895			4,261,423

The accompanying notes are an integral part of these financial statements.

ANNAPOLIS BANCORP, INC.

Consolidated Statements of Comprehensive Income ($000)

For the years ended December 31, 2012 and 2011


	December 31,
	2012			2011

Net income	$	3,092		$	2,171
Unrealized net holding (losses) gains, on Available-for-sale portfolios, net of tax (benefit) of ($90) and tax expense of $453, respectively		(137	)		695

Comprehensive income	$	2,955		$	2,866

ANNAPOLIS BANCORP, INC.

Consolidated Statements of Changes in Stockholders’ Equity ($000)

For the years ended December 31, 2012 and 2011


	Preferred Stock			Common Stock		Warrants		Paid in Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
BALANCE JANUARY 1, 2011	$	8,063		$	39	$	234	$	11,643	$	14,499		$	296		$	34,774
Net income		0			0		0		0		2,171			0			2,171
Preferred stock dividends declared and discount accretion		83			0		0		0		(491	)		0			(408	)
Stock-based compensation		0			0		0		59		0			0			59
Issuance of restricted stock		0			0		0		55		0			0			55
Stock options exercised		0			0		0		14		0			0			14
Employee stock purchase plan		0			0		0		8		0			0			8
Unrealized gain on investment securities available for sale, net of income taxes of $453		0			0		0		0		0			695			695

BALANCE DECEMBER 31, 2011		8,146			39		234		11,779		16,179			991			37,368
Net income		0			0		0		0		3,092			0			3,092
Redemption of Series A Preferred Stock		(4,076	)		0		0		0		0			0			(4,076	)
Preferred stock dividends declared and discount accretion		6			0		0		0		(270	)		0			(264	)
Stock-based compensation		0			0		0		89		0			0			89
Stock options exercised		0			0		0		138		0			0			138
Employee stock purchase plan		0			1		0		4		0			0			5
Unrealized gain on investment securities available for sale, net of income tax benefit of ($90)		0			0		0		0		0			(137	)		(137	)

BALANCE DECEMBER 31, 2012	$	4,076		$	40	$	234	$	12,010	$	19,001		$	854		$	36,215

The accompanying notes are an integral part of these financial statements.

ANNAPOLIS BANCORP, INC.

Consolidated Statements of Cash Flows ($000)


Years Ended December 31,	2012			2011
Cash Flows from Operating Activities
Net income	$	3,092		$	2,171
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		519			591
Provision for credit losses		684			2,190
Origination of loans held for sale		0			(8,186	)
Proceeds from sale of loans held for sale		0			9,731
Stock-based compensation		89			114
Deferred income taxes		443			(141	)
Earnings on life insurance policies		(205	)		(182	)
Amortization of premiums and accretion of discounts, net		280			305
Loss (gain) on sale of real estate owned		17			(18	)
Gain on sale of loans held for sale		0			(166	)
(Gain) loss on sale of repossessed assets		(12	)		10
Loss on write-down and disposals of premise and equipment		0			231
(Increase) decrease in:
Accrued interest receivable		(5	)		288
Prepaid FDIC insurance		325			441
Real estate owned		0			(34	)
Repossessed assets		(20	)		19
Other assets		(737	)		485
(Decrease) increase in
Accrued interest payable		(35	)		32
Accrued income taxes, net of taxes refundable		(28	)		198
Deferred loan origination fees		16			153
Other liabilities		380			353

Net cash provided by operations		4,803			8,585


Cash Flows from Investing Activities
Proceeds from sales and maturities of securities available for sale		58,060			45,478
Purchase of securities available for sale		(77,137	)		(35,846	)
Net decrease (increase) in federal funds sold		26,583			(14,599	)
Net increase in interest bearing certificates of deposit.		(19,887	)		(1,432	)
Net decrease (increase) in loans receivable		7,224			(13,943	)
Proceeds from sale of repossessed assets		187			117
Proceeds from sale of real estate owned		795			385
Purchases of premises and equipment, net of disposals		(2,287	)		(440	)

Net cash used in investing activities		(6,462	)		(20,280	)


Cash Flows from Financing Activities
Net increase (decrease) in:
Time deposits		(9,406	)		636
Other deposits		11,942			8,831
Securities sold under agreements to repurchase		3,240			(3,214	)
Redemption of preferred stock		(4,076	)		0
Proceeds from stock options exercised		138			14
Proceeds from issuance of common stock		5			8
Payment of preferred stock dividend		(290	)		(408	)

Net cash provided by financing activities		1,553			5,867


Net decrease in cash and cash equivalents		(106	)		(5,828	)
Cash and cash equivalents at beginning of year		2,026			7,854

Cash and cash equivalents at end of year	$	1,920		$	2,026


Supplemental Cash Flow Information
Interest paid, including interest credited to accounts	$	3,214		$	3,620
Income taxes paid		2,322			1,298
Non-cash investing activities
Transfers from loans to other assets and real estate owned	$	800		$	97

The accompanying notes are an integral part of these financial statements.

ANNAPOLIS BANCORP, INC.

Notes to Consolidated Financial Statements ($000 except share data)

For the years ended December 31, 2012 and 2011

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accounting and reporting policies in the consolidated financial statements conform with accounting principles generally accepted in the United States of America and to general practices within the banking industry. Management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. These estimates and assumptions may affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Certain reclassifications have been made to the 2011 consolidated financial statements to conform with the 2012 presentation.

Business

Annapolis Bancorp, Inc. (the “Company”) was incorporated on May 26, 1988, under the laws of the State of Maryland to serve as a bank holding company. The Company (as a bank holding company) and BankAnnapolis (the “Bank”) are subject to governmental supervision, regulation, and control.

The principal business of the Bank is to make loans and other investments and to accept savings and time and demand deposits. The Bank’s primary market area is in Anne Arundel County, Maryland, although the Bank’s business development efforts generate business outside of the area. The Bank offers a broad range of banking products including a full line of business and personal savings and checking accounts, money market demand accounts, certificates of deposit and other banking services.

The Bank funds a variety of loan types including commercial and residential real estate loans, commercial term loans and lines of credit, consumer loans and letters of credit. The Bank’s customers are primarily individuals and small businesses.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, BankAnnapolis and Annapolis Bancorp Statutory Trust I. All significant intercompany balances and transactions have been eliminated in consolidation. The financial statements of Annapolis Bancorp, Inc. (Parent only) include its investment in the Bank under the equity method of accounting.

Cash Equivalents

For purposes of reporting cash flows, cash and demand balances due from banks are considered “cash equivalents” for financial reporting purposes.

Investment Securities

As securities are purchased, management determines if the securities should be classified as held to maturity or available for sale. Securities which management has the intent and ability to hold to maturity are recorded at amortized cost. Securities which may be sold before maturity are classified as available for sale and carried at fair value with unrealized gains and losses included in accumulated other comprehensive income, a separate component of stockholders’ equity, on an after-tax basis. Investments in Federal Home Loan Bank and Federal Reserve stock are excluded from securities classified as available for sale and are carried at cost.

Declines in the fair value of individual available for sale or held to maturity securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by the rating agency or a significant deterioration in the financial condition of the issuer.

Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value; (2) the financial condition of the issuer or issuers and (3) the structure of the security.

An impairment loss is recognized in earnings only when (1) the Bank intends to sell the debt security; (2) it is more likely than not that the Bank will be required to sell the security before recovery of its amortized cost basis or (3) the Bank does not expect to recover the entire amortized cost basis of the security. In situations where the Bank intends to sell or when it is more likely than not that the Bank will be required to sell the security, the entire impairment loss must be recognized in earnings. In all other situations, only the portion of the impairment loss representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders’ equity as a component of other comprehensive income, net of deferred taxes.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. Useful lives range from three to 10 years for furniture, fixtures, and equipment; three to five years for software, hardware, and data handling equipment; and 10 to 40 years for buildings and building improvements. Land improvements are amortized over a period of 15 years and leasehold improvements are amortized over the term of the respective lease plus the first optional renewal period, if applicable. Maintenance and repairs are charged to expense as incurred, while improvements which extend the useful life are capitalized and depreciated over the estimated remaining life of the asset.

Loans Held for Sale

Beginning in 2008 and ending in mid-2011, the Company engaged in the sale of residential mortgage loans. Loans held for sale were carried at the lower of aggregate cost or fair market value. Fair market value was determined by secondary market quotations for similar instruments. Gains and losses on the sale of these instruments were recognized after the loans sold were no longer subject to recourse from the purchasers, which was generally 90 days. The gains are shown as a component of noninterest income in the Consolidated Statement of Income.

The Company’s current practice is to originate fixed-rate mortgage loans as a broker for other financial institutions. The partner financial institutions underwrite and fund the loans directly. This allows the Company to expand the product offerings to its customers, earn fee income and manage its exposure to interest rate changes.

Loans

Loans are stated at their principal balance outstanding, plus deferred origination costs, less unearned discounts, less deferred origination fees and the allowance for credit losses.

Interest on loans is credited to income based on the principal amounts outstanding. Origination fees and costs are amortized to income over the contractual life of the related loans as an adjustment of yield. Discounts on the purchase of mortgage loans are amortized to income over the contractual lives of the loans.

Accrual of interest on a loan is discontinued when the loan is delinquent more than ninety days unless the collateral securing the loan is sufficient to liquidate the loan. Management considers all loans where the accrual of interest has been discontinued to be impaired.

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. The Bank recognizes interest income on impaired loans on a cash basis if the borrower demonstrates the ability to meet the contractual obligation and collateral is sufficient. If there is doubt regarding the borrower’s ability to make payments or the collateral is not sufficient, payments received are accounted for as a reduction in principal. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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.

Allowance for Credit Losses

The allowance for credit losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans, actual loss experience, current economic events in specific industries and geographic areas including unemployment levels and other pertinent factors including regulatory guidance and general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience and consideration of economic trends, all of which may be susceptible to significant change. Credit losses are charged off against the allowance while recoveries of amounts previously charged off are credited to the allowance. A provision for credit losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary.

The components of the allowance for credit losses represent an estimation done pursuant to FASB guidance in Accounting Standards Codification (“ASC”) Topic 310 “Receivables,” and ASC Topic 450 “Contingencies.” The specific component of the allowance for credit losses reflects expected losses resulting from analysis developed through credit allocations for individual loans and historical loss experience for each loan category. The determination of the allowance for credit losses is based on a combination of the Bank’s historical loss experience plus ten (10) qualitative factors for specific categories and types of loans. Previously (in 2011) due to the Bank’s limited historical loss experience the loss experience factor was the greater of either the Bank’s historical loss experience or the peer group average historical loss experience. In 2012, the loss experience factor was solely based on a rolling eight quarter bank historical loss experience. The combination of the loss experience factor and the total qualitative factor (“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.

Real Estate Owned

Real estate acquired in satisfaction of a debt is carried at the lower of cost or net realizable value. At the time of foreclosure, the excess if any, of the loan over the net realizable value of the assets received is charged to the allowance for credit losses. Costs incurred in maintaining foreclosed real estate and subsequent write-downs to reflect declines in the fair value of the properties after acquisition are included in noninterest expense.

Advertising Costs

Advertising costs are generally expensed when incurred.

Income Taxes

The Company and its subsidiaries file a consolidated federal income tax return. The provision for income taxes is based upon income in the financial statements adjusted for permanent differences, rather than amounts reported on the Company’s income tax return. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities (excluding components of other comprehensive income).

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, presuming that a tax examination will occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely to be realized on examination. For tax positions not meeting the “more likely than not” test, no benefit is recorded. The Company recognizes interest accrued and penalties related to unrecognized tax benefits in other expense. Management considers the likelihood of changes by taxing authorities in its filed income tax returns and recognizes a liability for or discloses potential changes that management believes are more likely than not to occur upon examination by tax authorities. Management has not identified any uncertain tax positions in filed income tax returns that require recognition or disclosure in the accompanying financial statements. The Company’s income tax returns for the past three years are subject to examination by tax authorities, and may change upon examination.

Earnings per Share

Basic earnings per common share is determined by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share is calculated by including the average dilutive common stock equivalents outstanding during the period.

Dilutive common equivalent shares consist of stock warrants, options and restricted stock grants, calculated using the treasury stock method.

Stock-Based Compensation

The fair value of stock-based awards is determined on the date of grant, and is recognized as compensation expense over the service period of the awards.

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 December, 2011 FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – “Disclosures about Offsetting Assets and Liabilities.” ASU 2012-11 amends Topic 210, “Balance Sheet,” to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU 2011-11 is effective for annual and interim periods beginning on January 1, 2013, and is not expected to have a significant impact on the Company’s financial statements.

In February 2013 FASB issued ASU 2013-02, “Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.,” The objective of the new guidance is to improve the transparency of reporting reclassifications out of accumulated other comprehensive income (“OCI”) by requiring entities to present in one place information about significant amounts reclassified and, in some cases, to provide cross references to related footnote disclosures. The amendments do not change the current requirements for reporting net income or OCI, nor do they require new information to be disclosed. The amendments should be applied prospectively and are effective for public entities in both interim and annual reporting periods beginning after December 15, 2012.

2. CASH AND DUE FROM BANKS

Banks are required to carry cash reserves of specified percentages of deposit balances. The Bank’s normal balances of cash on hand and on deposit with other banks are sufficient to satisfy these reserve requirements.

The Bank normally maintains balances with other banks that exceed the federally insured limit. The average balance maintained in excess of the limit, including federal funds sold to the same bank, was approximately $6.6 million.

3. INVESTMENT SECURITIES

Investment securities are summarized as follows:


	Amortized Cost		Unrealized Gains		Unrealized Losses		Estimated Fair Value
December 31, 2012
Available for sale
U.S. Government agency	$	70,181	$	251	$	64	$	70,368
State and municipal		961		65		0		1,026
Residential mortgage-backed securities		33,052		1,153		39		34,166
Other equity securities		643		43		0		686

	$	104,837	$	1,512	$	103	$	106,246


December 31, 2011
Available for sale
U.S. Government agency	$	47,782	$	306	$	56	$	48,032
State and municipal		1,077		59		0		1,136
Residential mortgage-backed securities		36,435		1,372		82		37,725
Other equity securities		618		38		0		656

	$	85,912	$	1,775	$	138	$	87,549

There were no sales of securities in 2012 and 2011.

Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position at December 31, 2012 and 2011 are as follows:


	Less than 12 months				12 months or more				Total
	Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses
December 31, 2012
(dollars in thousands)
U. S. Government Agency	$	19,986	$	64	$	0	$	0	$	19,986	$	64
Mortgage-backed securities issued by Government Agencies		1,798		0		0		0		1,798		0
Private mortgage-backed securities		0		0		1,339		39		1,339		39

	$	21,784	$	64	$	1,339	$	39	$	23,123	$	103


December 31, 2011
(dollars in thousands)
U. S. Government Agency	$	16,044	$	56	$	0	$	0	$	16,044	$	56
Private mortgage-backed securities		0		0		1,854		82		1,854		82

	$	16,044	$	56	$	1,854	$	82	$	17,898	$	138

The available-for-sale investment portfolio has a fair value of approximately $106.2 million at December 31, 2012 and $87.5 million at December 31, 2011. As of December 31, 2012, $70.4 million of the investment security portfolio were U.S. Government Agency securities, $1.0 million were state and municipal securities, $34.2 million were mortgage-backed securities and $686,000 were equity securities. Of the $34.2 million in mortgage-backed securities, $32.9 million were government agency issue while $1.3 million were private issue. As of December 31, 2011, $48.0 million were U.S. Government Agency securities, $1.1 million were state and municipal securities, $37.7 million were mortgage-backed securities, and $657,000 were equity securities. Of the $37.7 million in mortgage-backed securities, $35.8 million were government agency issue while $1.9 million were private issue. At December 31, 2012 $23.1 million or 21.9% showed an unrealized loss from the purchase price while $17.9 million or 20.4% showed an unrealized loss from the purchase price at December 31, 2011. As of December 31, 2012 $20.0 million or 86.6% of these securities were government agency bonds and $3.1 million or 13.4% were mortgage-backed securities. As of December 31, 2011 $16.0 million or 89.6% of these securities were government agency bonds and $1.9 million or 10.4% were mortgage-backed securities. As of December 31, 2012 and 2011 $1.3 million and $1.9 million, respectively of the mortgaged-back securities showing unrealized losses were private issue. 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 December 31, 2012. The unrealized losses shown in the table above are the result of market changes in interest rates since the original purchase.

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 December 31, 2012 and 2011 mortgage-backed securities with a fair market value of $1.3 million and $1.9 million, respectively, carried bond ratings below investment grade. These securities were evaluated by an independent third-party consulting firm and were deemed by management not to be other-than-temporarily impaired at December 31, 2012 and 2011. The valuation uses an expected cash flow model that includes assumptions related to prepayment rates, default trends, and loss severity. At December 31, 2012, both securities were current on both principal and interest payments.

The amortized cost and estimated fair-value of securities by contractual maturities at December 31, 2012 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.


	Available for Sale
	Amortized Cost		Estimated Fair Value

December 31, 2012
Due within one year	$	1,000	$	1,015
Due after one through five years		29,443		29,548
Due after five years		73,751		74,997
Equity securities		643		686

	$	104,837	$	106,246

At December 31, 2012 and 2011 investments available for sale with a carrying value of $14.6 million and $11.4 million, respectively, were pledged as collateral for certain government deposits and for other purposes as required by law.

4. LOANS, ALLOWANCE FOR CREDIT LOSSES AND CREDIT QUALITY


	2012			2011

Commercial	$	44,422		$	47,683
Real estate
Commercial		116,883			114,883
Construction		33,319			35,026
One to four-family		47,873			48,314
Home equity		31,650			36,005
Consumer		7,061			8,870

		281,208			290,781


Deferred loan fees, net		(331	)		(315	)
Allowance for credit losses		(6,317	)		(7,182	)

		(6,648	)		(7,497	)

Loans, net	$	274,560		$	283,284

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


	2012		2011

Repricing or maturing within one year	$	93,910	$	100,804
Maturing over one to five years		127,649		132,637
Maturing over five years		59,649		57,340

	$	281,208	$	290,781

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 97.4% of the portfolio as of December 31, 2012 and 96.8% as of December 31, 2011. 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 years ended December 31, 2012 and 2011:

Allowance for Credit Losses and Recorded Investment in Loans Receivable

for the Years Ended December 31, 2012 and 2011


	Commercial		Commercial Real Estate			Residential		Consumer		Unallocated		Total
2012
Beginning balance, December 31, 2011	$	1,387	$	3,972		$	1,422	$	401	$	0	$	7,182
Charge-offs		357		476			420		466		0		1,719
Recoveries		50		0			62		58		0		170
Provision		301		(605	)		706		282		0		684

Ending balance, December 31, 2012	$	1,381	$	2,891		$	1,770	$	275	$	0	$	6,317

Period ending amount allocated to: Individually evaluated for impairment	$	886	$	634		$	1,133	$	97	$	0	$	2,750

Period ending amount allocated to: Collectively evaluated for impairment	$	495	$	2,257		$	637	$	178	$	0	$	3,567

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

Loans individually evaluated for impairment	$	5,293	$	2,152		$	3,600	$	281	$	0	$	11,326

Loans collectively evaluated for impairment	$	39,129	$	148,050		$	75,923	$	6,780	$	0	$	269,882


(Dollars in thousands)	Commercial		Commercial Real Estate		Residential		Consumer		Unallocated		Total

2011
Allowance for credit losses:
Beginning balance, December 31, 2009	$	1,868	$	3,205	$	1,257	$	523	$	0	$	6,853
Charge-offs		1,183		614		196		203		0		2,196
Recoveries		19		34		260		22		0		335
Provision		683		1,347		101		59		0		2,190

Ending balance, December 31, 2011	$	1,387	$	3,972	$	1,422	$	401	$	0	$	7,182

Period ending amount allocated to: Individually evaluated for impairment	$	195	$	731	$	475	$	161	$	0	$	1,562

Period ending amount allocated to: Collectively evaluated for impairment	$	1,192	$	3,241	$	947	$	240	$	0	$	5,620

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

Loans individually evaluated for impairment	$	1,397	$	2,444	$	3,055	$	485	$	0	$	7,381

Loans collectively evaluated for impairment	$	46,286	$	147,465	$	81,264	$	8,385	$	0	$	283,400

Nonaccrual loans totaled approximately $9.9 million and $6.2 million at December 31, 2012 and 2011, respectively. As of December 31, 2012 and 2011, $2.7 million and $1.6 million, respectively, of loan loss allowances were allocated to all loans classified as impaired.

Credit Risk Monitoring

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 – 7 are assigned to “Pass” credits.

Risk Rating 7 is assigned to “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 these categories 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 December 31, 2012 and 2011

(Dollars in thousands)


			Commercial Real Estate
	Commercial		Construction		Other
	2012		2012		2012
Risk Rating:
Pass	$	36,954	$	29,570	$	99,883
Other Assets Especially Mentioned		1,592		1,908		14,111
Substandard		5,856		1,841		1,639
Doubtful		20		0		1,250
Loss		0		0		0

	$	44,422	$	33,319	$	116,

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ANNAPOLIS BANCORP INC 10-K