First United Corp: Form 10-Q for the period ended Jun 30, 2010

INTRODUCTION

The following discussion and analysis is intended as a review of material changes in and significant factors affecting the financial condition and results of operations of the Corporation and its consolidated subsidiaries for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and the notes thereto contained in Item 1 of Part I of this report. Unless the context clearly suggests otherwise, references in this report to “us”, “we”, “our”, and “the Corporation” are to First United Corporation and its consolidated subsidiaries.

FORWARD-LOOKING STATEMENTS

This report may contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Readers of this report should be aware of the speculative nature of “forward-looking statements.” Statements that are not historical in nature, including those that include the words “anticipate”, “estimate”, “should”, “expect”, “believe”, “intend”, and similar expressions, are based on current expectations, estimates and projections about, among other things, the industry and the markets in which we operate, and they are not guarantees of future performance. Whether actual results will conform to expectations and predictions is subject to known and unknown risks and uncertainties, including risks and uncertainties discussed in this report; general economic, market, or business conditions; changes in interest rates, deposit flow, the cost of funds, and demand for loan products and financial services; changes in our competitive position or competitive actions by other companies; changes in the quality or composition of our loan and investment portfolios; our ability to manage growth; changes in laws or regulations or policies of federal and state regulators and agencies; and other circumstances beyond our control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results anticipated will be realized, or if substantially realized, will have the expected consequences on our business or operations. These and other risks are discussed in detail in the periodic reports that First United Corporation files with the Securities and Exchange Commission (the “SEC”) (see Item 1A of Part II of this report for further information). Except as required by applicable laws, we do not intend to publish updates or revisions of any forward-looking statements we make to reflect new information, future events or otherwise.

THE CORPORATION

The Corporation is a Maryland corporation chartered in 1985 and a financial holding company registered under the federal Bank Holding Company Act of 1956, as amended. The Corporation’s primary business is serving as the parent company of First United Bank & Trust, a Maryland trust company (the “Bank”), First United Insurance Group, LLC, a full service insurance provider organized under Maryland law (the “Insurance Group”), First United Statutory Trust I and First United Statutory Trust II, both Connecticut statutory business trusts (“Trust I” and “Trust II”, respectively), and First United Statutory Trust III, a Delaware statutory business trust (“Trust III” and together with Trust I and Trust II, the “Trusts”). The Trusts were formed for the purpose of selling trust preferred securities. The Bank has two wholly-owned subsidiaries: OakFirst Loan Center, Inc., a West Virginia finance company; and OakFirst Loan Center, LLC, a Maryland finance company (collectively, the “OakFirst Loan Centers”); and owns 99.9% of the limited partnership interests in Liberty Mews Limited Partnership, a Maryland limited partnership formed for the purpose of acquiring, developing and operating low-income housing units in Garrett County, Maryland. First United Insurance Agency, Inc., a subsidiary of OakFirst Loan Center, Inc., was merged into the Insurance Group effective June 30, 2009. The Bank provides a complete range of retail and commercial banking services to a customer base serviced by a network of 28 offices and 33 automated teller machines.

The Corporation maintains an Internet site at www.mybank4.com (http://www.mybank4.com) on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the “SEC”.

ESTIMATES AND CRITICAL ACCOUNTING POLICIES

This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2009). On an on-going basis, management evaluates its estimates, including those related to loan losses, intangible assets, OTTI of investment securities and pension plan assumptions. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management described its critical accounting policies in First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2009. The following discussion updates critical accounting policies that were contained in the Annual Report on Form 10-K to reflect recent changes.

Other-Than-Temporary Impairment of Investment Securities

Management believes that the valuation of certain securities is a critical accounting policy that requires significant estimates in preparation of its consolidated financial statements. Management systematically evaluates securities for impairment on a quarterly basis. Beginning in the first quarter of 2010, management utilized an independent third party to prepare both the impairment valuations and fair value determinations for its collateralized debt obligation (“CDO”) portfolio consisting of pooled trust preferred securities. In previous periods, management performed internal impairment valuations and utilized a third party service for the portfolio pricing. Management will continue to review the assumptions and results and does not believe that there were any material differences in the valuations between December 31, 2009 and June 30, 2010.

Allowance for Loan Losses

Management believes that the determination of the allowance for loan losses is a critical accounting policy that requires significant estimates in preparation of its consolidated financial statements. Management reviews the components of the allowance on a quarterly basis. Historically, management has utilized an internally developed spreadsheet to track and apply the various components of the allowance. In the second quarter of 2010, management began utilizing an externally developed software application to track and apply the allowance components. Prior to implementation, management had reviewed the results of both the internal and external application to ensure that there were no material differences in the determination of the allowance.

Other than as discussed above, management does not believe that any material changes in our critical accounting policies have occurred since December 31, 2009.

SELECTED FINANCIAL DATA

The following table sets forth certain selected financial data for the six months ended June 30, 2010 and 2009 and is qualified in its entirety by the detailed information and unaudited financial statements, including the notes thereto, included elsewhere in this quarterly report.

RESULTS OF OPERATIONS

Overview

Consolidated net loss attributable to common shareholders for the first six months of 2010 was $6.81 million, compared to net income available to common shareholders of $2.88 million for the same period of 2009. Basic and diluted net loss per common share for the first six months of 2010 were $1.11, compared to basic and diluted net income per common share of $.47 for the same period of 2009. The decrease in net income resulted primarily from a decline in net interest income of $4.4 million, an additional $5.9 million of credit-related OTTI charges, $2.3 million of net losses related to a restructuring of the investment portfolio, foreclosed property and sales of loans, and $3.3 million in increased loan loss provision expense, partially offset by a net income tax benefit of $5.4 million. The decline in net interest income resulted in a compressed net interest margin of 2.99% when compared to 3.76% in the first six months of 2009. Interest income on our interest earning assets declined $6.0 million due to the increase in non-accrual loans throughout 2009, the decline in loan balances and the lower interest rate environment. Additionally, during 2009 and throughout the first six months of 2010, we elected to maintain an increased liquidity position. Our cash position has increased significantly due to electing not to reinvest cash from called investments and growth in our deposit base. This increase in cash levels has had a negative impact on our net interest income in the first six months of 2010 of approximately $5.4 million, or 63 basis points on our net interest margin. Although approximately $23 million of the deposit growth is short-term in nature (90 days), we do not anticipate reduced levels of cash for the remainder of 2010.

The provision for loan losses was $7.2 million for the six months ended June 30, 2010, compared to $3.9 million for the same period of 2009. The increased provision was necessary to provide for the inherent risk in our loan portfolio. Specific allocations were made for impaired loans where management has determined that the collateral supporting the loans is not adequate to cover the loan balance and management increased the qualitative factors affecting the allowance for loan losses as a result of the current recession and distressed economic environment.

Interest expense on our interest-bearing liabilities decreased $1.6 million in spite of a $107 million increase in average deposits partially offset by an $18 million decrease in average debt outstanding. The decline in expense was due to the low interest rate environment, our decision to only increase special pricing for full relationship customers and retail and brokered certificates of deposit renewing at lower interest rates due to the short duration of our portfolio.

Other operating income decreased $8.4 million during the first six months of 2010 when compared to the same period of 2009. This decrease is primarily attributable to the recognition of an additional $5.9 million in credit-related OTTI charges and $2.3 million of net losses related to a restructuring of the investment portfolio to limit potential market risk from a rising rate environment, foreclosed property and sales of loans. Management also noted a slight decline of $.4 million in service charge income due to the decline in consumer spending and the resulting decrease in overdraft income. Operating expenses decreased $1.0 million in the first six months of 2010 when compared to the same period of 2009. This decrease is due primarily to a $.9 million decline in salaries and benefits resulting from reduced service costs in the pension plan and elimination of all performance based pay for employees and management in 2010.

Consolidated net loss attributable to common shareholders for the second quarter of 2010 totaled $1.3 million or ($.21) per share, compared to net income available to common shareholders of $.8 million or $.12 per share for the same period of 2009. The net interest margin for the second quarter of 2010 was 2.81% compared to 3.66% for the same period of 2009. This decrease is primarily attributable to the increase in interest-earning assets of $92.2 million and a lower rate environment when compared to the second quarter 2009. The increased liquidity position, discussed above, also negatively impacted second quarter results.

Net Interest Income

Net interest income is the largest source of operating revenue and is the difference between the interest earned on interest-earning assets and the interest expense incurred on interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to a fully taxable equivalent (“FTE”) basis to facilitate performance comparisons between taxable and tax-exempt assets. Fully taxable equivalent income is determined by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. The following table sets forth the average balances, net interest income and expense, and average yields and rates of our interest-earning assets and interest-bearing liabilities for the six months ended June 30, 2010 and 2009.

For the six months ended June 30,

(Dollars in thousands)

Net interest income on a fully tax-equivalent (“FTE”) basis decreased $4.4 million during the first six months of 2010 over the same period in 2009 due to a $6.0 million (13.4%) decrease in interest income partially offset by a $1.6 million (9.6%) decrease in interest expense. The decrease in net interest income resulted primarily from a shift in the mix of earning assets from loans and investment securities into cash and cash equivalents (other interest earning assets) for the periods compared, as the Corporation made the conscious decision to increase its liquidity position during this period of risk and economic uncertainty. The cost of the liquidity position represented by the foregone interest income from the $194.8 million in incremental average liquidity was approximately $5.4 million, or 63 basis points of the 77 basis point decrease in the net interest margin from 3.76% during the first six months of 2009 to 2.99% for the same time period of 2010.

The overall $97.6 million increase in average interest-earning assets at lower yields also impacted the 111 basis point decline in the average yield on our average earning assets, which dropped from 5.96% for the first six months of 2009 to 4.85% for the first six months of 2010 (on a fully tax equivalent basis).

Interest expense decreased during the first six months of 2010 when compared to the same period of 2009 due to an overall reduction in interest rates on time deposits driven by our decision to only increase special rates for full relationship customers resulting in a shorter duration in the portfolio. This more than offset the impact of an $89.5 million increase in average interest-bearing liabilities in the first six months of 2010 compared to the same time period for 2009, with interest-bearing deposits increasing by approximately $107.2 million. The overall effect of these changes was a 33 basis point decrease in the average rate paid on our average interest-bearing liabilities from 2.30% for the six months ended June 30, 2009 to 1.97% for the same period of 2010.

The following table sets forth the average balances, net interest income and expense, and average yields and rates of our interest-earning assets and interest-bearing liabilities for the three months ended June 30, 2010 and 2009.

For the three months ended June 30,

(Dollars in thousands)

Net interest income on a FTE basis decreased $2.6 million for the second quarter of 2010 in comparison to the second quarter of 2009. This decrease resulted from a decrease in interest income of $3.2 million partially offset by a $0.6 million decrease in interest expense during the period. Overall, the net interest margin decreased by 85 basis points from 3.66% to 2.81% when comparing quarter to quarter, due primarily to the change in earning asset mix discussed above. Average loans decreased by $35.7 million and the average balance in investment securities declined by $100.7 million. Other interest-earning assets increased $228.6 million due to the increased liquidity position. Average interest-bearing liabilities increased by $116.5 million (8.1%) during the second quarter of 2010 when compared to the second quarter of 2009. This increase resulted primarily from increases in interest-bearing deposits partially offset by decreases in long and short-term borrowings. The effective rate on these liabilities decreased by 31 basis points as the Corporation continued to manage the rates on its certificates of deposit portfolio.

Provision for Loan Losses

The provision for loan losses was $7.2 million for the first six months of 2010, compared to $3.9 million for the same period of 2009. The increase in the provision was a result of specific allocations for impaired loans (primarily acquisition and development loans) where management has determined that the collateral supporting the loans is not adequate to cover the loan balance, and increases in the qualitative factors discussed below in the section entitled “FINANCIAL CONDITION” under the heading “Allowance and Provision for Loan Losses”. Management continued to increase provision expense to ensure that the Allowance for Loan Losses reflects a level commensurate with the risk inherent in our loan portfolio. Additional information regarding risk elements in the loan portfolio and management’s assessment of the adequacy of the allowance for loan losses is provided below under that same heading.

Other Operating Income

Other operating income, exclusive of losses, decreased $.2 million during the first six months of 2010 when compared to the same period of 2009. Service charge income decreased $.4 million due primarily to a reduction in NSF fees and increased charge-off overdraft fees. Trust department income increased $.4 million during the first six months of 2010 when compared to the first six months of 2009 due to an increase in assets under management and the fees received on those accounts. Income on Bank Owned Life Insurance increased $.2 million during the first half of 2010 when compared to the same period of 2009 due to the surrender of the separate account and purchase of general account contracts during the fourth quarter of 2009.

Other operating income, exclusive of losses, for the second quarter of 2010 decreased $.1 million when compared to the second quarter of 2009. Service charge income decreased $.2 million due primarily to a reduction in NSF fees and increased charge-off overdrafts. Trust department income increased $.2 million due to an increase in assets under management and the fees received on those accounts. Bank Owned Life Insurance income increased $.1 million during the second quarter of 2010 when compared to the second quarter of 2009 due to the surrender of the separate account contracts and purchase of general account contracts during the fourth quarter of 2009.

The following table shows the major components of other operating income for the six and three months ended June 30, 2010 and 2009, exclusive net losses:

Other Operating Expenses

Other operating expenses decreased $1.0 million (4%) for the first half of 2010 when compared to the first half of 2009. For the second quarter 2010, other operating expenses decreased $1.1 million, or 9%, when compared to the same time period of 2009. The decrease for the first half of 2010 is primarily due to a decline of $.9 million in salaries and benefits resulting from reduced service costs in the pension plan and elimination of all performance based pay for employees and management. FDIC premiums increased $.3 million during the first six months of 2010 when compared to the same period of 2009 due to the increased rate structure. The decrease in other operating expense for the second quarter of 2010 is primarily due to a decline of $.6 million in salaries and benefits due to the aforementioned factors above. FDIC premiums decreased $.3 million in the second quarter 2010 when compared to the second quarter 2009 due to the $.8 million special assessment paid in June 2009. There have not been any special assessments as of June 30, 2010. The composition of operating expense is illustrated in the following table for the six and three months ended June 30, 2010 and 2009.

Applicable Income Taxes

In reporting interim financial information, income tax provisions should be determined under the procedures set forth in ASC Topic, Income Taxes, in Section 740-270-30. This guidance provides that at the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate so determined should be used in providing for income taxes on a current year-to-date basis. The effective tax rate should reflect anticipated investment tax credits, capital gains rates, and other available tax planning alternatives. However, in arriving at this effective tax rate no effect should be included for the tax related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year.

Based on the guidance in ASC Topic 740, management has concluded that the OTTI charge meets the definition of a “significant, unusual or extraordinary item that will be separately reported” based on the following:

• The impairment charge related to credit loss is significant and is a highly unusual event for investments which were investment grade at the time of purchase and have become impaired as a result of the severe decline in the economy and an illiquid credit market.
• The OTTI is reported as a separate line in the Consolidated Statements of Operations.

The effective tax benefit rate for the first six months of 2010 was 40%, compared to an effective tax rate of 28% for the first six months of 2009. The effective tax benefit rate for the year ended December 31, 2009 was 43%. The decrease thus far in 2010 when compared to the same time period in 2009 is primarily attributable to the OTTI charge of $8.1 million recognized in the first half of the year. The year-to-date loss coupled with forecasted favorable, permanent book to tax adjustments results in an income tax benefit for the Corporation resulting in the 40% effective tax benefit rate.

FINANCIAL CONDITION

Balance Sheet Overview

Total assets were $1.8 billion at June 30, 2010, an increase of $32.2 million since December 31, 2009. During this time period, cash and interest-bearing deposits in banks increased $126.6 million, gross loans decreased $39.7 million, our investment portfolio decreased $42.6 million, deferred tax assets decreased $2.6 million and accrued interest receivable and other assets decreased $6.0 million. During 2009 and throughout the first six months of 2010, we elected to maintain an increased liquidity position to comply with recent guidance published by the FDIC in FIL 13-2010 and in recognition of the distressed economic environment. Our cash position has increased significantly due to electing not to reinvest cash from called investments and growth in our deposit base. Although approximately $23 million of the deposit growth is short-term in nature (90 days), we do not anticipate reduced levels of cash for the remainder of 2010. The decrease in loans is due to increased runoff in our indirect portfolio as well as increased refinancing in the mortgage portfolio. Management has made the decision to utilize the secondary mortgage markets and government agencies as opposed to booking long, fixed rate mortgages. The decrease in our investment portfolio is due in part to calls that were not reinvested and to approximately $26 million in sales from the portfolio restructuring that have not been reinvested as of June 30, 2010. Total liabilities increased by approximately $32.7 million during the first six months of 2010, reflecting increases in total deposits of $69.6 million offset by a $10.1 million decrease in short-term borrowings as a result of a decrease in repurchase agreements, our treasury management product and a $26.9 million decrease in long-term borrowings due to repayment of two maturing FHLB advances. The increase in deposits is due primarily to a $48 million increase in the accounts of a local municipality.

Loan Portfolio

The following table presents the composition of our loan portfolio at the dates indicated:

(Dollars in millions)

Comparing loans at June 30, 2010 to December 31, 2009, our loan portfolio has decreased by $39.7 million (3.5%). There was a decline in commercial loans ($16.4 million), residential mortgage and construction portfolio ($9.4 million), and our installment portfolio ($13.9 million). The decrease in installment loans is primarily attributable to a decline in the indirect loan portfolio resulting from a slowdown in economic activity as repayment activity exceeded new production. The decrease in the residential mortgage portfolio is attributable to the increased amount of loan refinancings that are occurring as consumers seek long-term fixed rate loans. The Corporation is not retaining these long-term fixed rate loans. Therefore, we are using secondary market and Fannie Mae outlets to satisfy these loan requests. At June 30, 2010 and December 31, 2009, approximately 71% of the commercial loan portfolio was collateralized by real estate.

Risk Elements of Loan Portfolio

The following table presents the risk elements of our loan portfolio at the dates indicated. Management is not aware of any potential problem loans other than those listed in this table or discussed below.

(Dollars in thousands)

Performing loans considered to be impaired (including performing total restructured loans, or TDRs), as defined and identified by management, amounted to $46.7 million at June 30, 2010 and $89.9 million at December 31, 2009. Loans are identified as impaired when based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms. These loans consist primarily of acquisition and development loans. The fair values are generally determined based upon independent third party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where management believes there is insufficient collateral and no secondary source of repayment is available.

The level of performing impaired loans (other than performing TDRs) declined $30.5 million during the six months ended June 30, 2010. In 2009, due to the deteriorating credit environment, management made a concerted effort to reduce the risk in its portfolio by enhancing its efforts to structure plans for some of its larger impaired credits to maximize their collectability by converting interest only lines of credit to amortizing term loans. During the first half of 2010, as loans have demonstrated sustained payment performance, management has determined that it should be able to collect full contractual principal and interest and, accordingly, has removed them from an impaired status. During 2010, $25.4 million of loans have been removed from impaired status due to satisfactory payment performance, another $1.6 million paid off and $0.3 million in principal reductions were received. During 2010, $2.0 million of previously performing impaired loans were transferred to non-accrual or foreclosure and $3.0 million was transferred to performing TDRs. Seven loans totaling $1.8 million have been added to performing impaired loans thus far in 2010. Management will continue to monitor loans that have been removed from an impaired status to ensure that satisfactory performance is sustained and will take appropriate action.

The level of TDRs declined $15.3 million during the six months ended June 30, 2010, with three loans totaling $2.5 million added to performing TDRs, two loans totaling $.7 million added to non-performing TDRs and $18.5 million removed from TDR reporting. Three non-accrual TDRs totaling $3.5 million were foreclosed on during 2010. Loans that had been modified in 2009 at market rates, totaling $14.6 million, were removed from performing TDRs during 2010 because they had made at least six consecutive payments and were current at June 30, 2010. Approximately $400,000 of principal has been received during 2010 on performing TDRs.

As of June 30, 2010, we had $52.5 million in funded real estate acquisition and development loans throughout our market areas, compared to $58.1 million at December 31, 2009. We rely on various monitoring policies and procedures and the extensive experience of our lending and credit personnel to help mitigate the risks related to this type of lending activity.

Allowance and Provision for Loan Losses

An allowance for loan losses is maintained to absorb losses from the loan portfolio. The allowance for loan losses is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.

We use the methodology outlined in the FDIC Statement of Policy on Allowance for Loan Losses. The starting point for this methodology is to segregate the loan portfolio into two pools, non-homogeneous (i.e., commercial) and homogeneous (i.e., consumer and residential mortgage) loans. The two pools are further segmented by loan type and by loan classification, including uncriticized (pass), other assets especially mentioned and substandard. The uncriticized (pass) pools for commercial real estate and residential real estate are further segmented based upon the geographic locations of the underlying collateral. Each loan pool is analyzed with general allowances and specific allocations being made as appropriate. For general allowances, the previous eight quarters of loss activity are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by the following qualitative factors: levels of and trends in delinquency rates and non-accrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, ability, and depth of management; national and local economic trends and conditions; value of underlying collateral and concentrations of credit in the determination of the general allowance. The qualitative factors are updated each quarter by information obtained from internal, regulatory, and governmental sources. Specific allocations of the allowance for loan losses are made for those loans on the “Watchlist” in which the collateral value is less than the outstanding loan balance with the allocation being the dollar difference between the two. The Watchlist represents loans, identified and closely monitored by management, which possess certain qualities or characteristics that may lead to collection and loss issues. Allocations are not made for loans that are cash secured, for the Small Business Administration and Farm Service Agency guaranteed portion of loans, or for loans that are sufficiently collateralized.

The allowance for loan losses is based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the allowance for loan losses. The methodology used to determine the adequacy of the allowance for loan losses is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment.

The following table presents a summary of the activity in the allowance for loan losses for the six months ended June 30 (dollars in thousands):

The allowance for loan losses increased to $23.8 million at June 30, 2010, compared to $20.1 million at December 31, 2009. The provision for loan losses was $7.2 million for the first six months of 2010, compared to $3.9 million for the same period of 2009, while net charge-offs remained fairly constant. The increase in the provision for loan losses in the first six months of 2010 when compared to the same period of 2009 was in response to an increase in non-performing and other Watchlist loans, an increase in the qualitative factors affecting the allowance as a result of our quarterly reviews of the adequacy of the factors, and an increase in specific allocations for impaired loans. As part of our loan review process, management has noted an increase in foreclosures and bankruptcies in the geographic areas in which we operate. Additionally, the current economic environment has caused a decline in real estate sales. Consequently, we have closely reviewed and applied sensitivity analyses to collateral values to more adequately measure potential future losses. Where necessary, we have obtained new appraisals on collateral. Specific allocations of the allowance have been provided in these instances where losses may occur.

Net charge-offs relating to the installment loan portfolio represented 11.4% of our total net charge-offs for the first half of 2010. Generally, installment loans are charged-off after they are 120 days contractually past due. Loans past due 30 days or more were $3.0 million or 3.1% of the installment portfolio at June 30, 2010, compared to $4.2 million or 3.7% at December 31, 2009. Mortgage and Home Equity loans net charge-offs represented 38.1% of total charge-offs for the first half of 2010. Loans past due 30 through 90 days were $4.5 million or 1.1% of the mortgage portfolio at June 30, 2010, compared to $19.2 million or 4.7% at December 31, 2009. Net charge-offs relating to the commercial loan portfolio represented 44.1% of our total net charge-offs for the first half of 2010. Loans past due 30 through 90 days were $4.9 million or .8% of the commercial portfolio at June 30, 2010, compared to $4.1 million or .68% at December 31, 2009. Net charge-offs relating to demand deposits represented 6.4% of our total net charge-offs for the first half of 2010.

Management believes that the allowance for loan losses at June 30, 2010 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors.

Investment Securities

At June 30, 2010, the total amortized cost basis of the available-for-sale investment portfolio was $254.6 million, compared to a fair value of $231.2 million. Unrealized gains and losses on securities available-for-sale are reflected in accumulated other comprehensive loss, a component of shareholders’ equity.

The following table presents the composition of our securities portfolio available-for-sale at amortized cost and fair values at the dates indicated:

(Dollars in thousands)

Total investment securities have decreased $42.6 million since December 31, 2009. During the first quarter, the Corporation embarked on a restructuring of its available-for-sale investment portfolio with goals of reducing sensitivity to future increases in interest rates and reducing future negative credit exposure. As part of this restructuring, available for sale securities with an aggregate fair value of $117.1 million were transferred to the trading portfolio, comprised of $20.0 million from the collateralized mortgage obligations (“CMO”) portfolio, $89.6 million from the U.S. government agency and residential mortgage-backed agency portfolios, and $7.5 million from the municipal securities portfolio. Previously unrealized losses of $5.1 million and previously unrealized gains of $2.9 million were recognized in earnings at the time of transfer. The bonds selected for transfer to trading and ultimate sale were chosen to maximize the following benefits: a reduction of extension and price risk in a rising interest rate environment; recognition of gains on callable agency securities and fixed rate mortgage-backed securities that will disappear with rising rates; and improvement in the credit quality of the portfolio through reduction of the private label CMO portfolio with the most exposure to potential credit risk.

As of June 30, 2010, all of the aforementioned securities had been sold, resulting in an additional $.3 million net loss on the trading transaction. As of June 30, 2010, the replacement securities had been purchased except for approximately $26 million which is reflected in the increase in cash. Management anticipates that any future acquired replacement securities will be shorter term in nature, structured to take advantage of higher interest rates through incorporation of staggered cash flows, and collateral eligible, (providing additional liquidity to the portfolio). We anticipate that the replacements for these securities will be purchased during the third quarter 2010.

At June 30, 2010, the securities classified as available-for-sale included a net unrealized loss of $23.4 million, which represents the difference between the fair value and amortized cost of securities in the portfolio.

As discussed in Note G to the consolidated financial statements presented elsewhere in this report, the Corporation measures fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level

3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.

Approximately $221.9 million of the available-for-sale portfolio was valued using Level 2 pricing, and had net unrealized gains of $3.6 million at June 30, 2010. The remaining $9.3 million of the securities available-for-sale represents the entire CDO portfolio, which was valued using significant unobservable inputs (Level 3 assets). The $27.1 million in unrealized losses associated with this portfolio relates to 18 pooled trust preferred securities that comprise the CDO portfolio. Unrealized losses of $18.4 million represent non-credit related OTTI charges on 13 of the securities, while $8.7 million of unrealized losses relates to five securities which have no credit related OTTI. The unrealized losses on these securities are primarily attributable to continued depression in the marketability and liquidity associated with CDOs.

The following table provides a summary of the trust preferred securities in the CDO portfolio and the credit status of the securities as of June 30, 2010.

The terms of the debentures underlying trust preferred securities allow the issuer of the debentures to defer interest payments for up to 20 quarters, and, in such case, the terms of the related trust preferred securities allow their issuers to defer dividend payments for up to 20 quarters. Some of the issuers of the trust preferred securities in our investment portfolio have defaulted and/or deferred payments ranging from 4.0% to 33.3% of the total collateral balances underlying the securities. The securities were designed to include structural features that provide investors with credit enhancement or support to provide default protection by subordinated tranches. These features include over-collateralization of the notes or subordination, excess interest or spread which will redirect funds in situations where collateral is insufficient, and a specified order of principal payments. There are securities in our portfolio that are under-collateralized which does represent additional stress on our tranche. However, in these cases, the terms of the securities require excess interest to be redirected from subordinate tranches as credit support, which provides additional support to our investment.

Management systematically evaluates securities for impairment on a quarterly basis. Based upon application of Topic 320 (ASC Section 320-10-35) management must assess whether (a) it has the intent to sell the security and (b) it is more likely than not that the Corporation will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair value of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses. The other losses are recognized in other comprehensive income. In estimating OTTI charges, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) adverse conditions specifically related to the security, an industry, or a geographic area, (3) the historic and implied volatility of the security, (4) changes in the rating of a security by a rating agency, (5) recoveries or additional declines in fair value subsequent to the balance sheet date, (6) failure of the issuer of the security to make scheduled interest payments, and (7) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Due to the duration and the significant market value decline in the pooled trust preferred securities held in our portfolio, we performed more extensive testing on these securities for purposes of evaluating whether or not an OTTI has occurred.

The market for these securities at June 30, 2010 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new CDOs have been issued since 2007. There are currently very few market participants who are willing to transact for these securities. The market values for these securities, or any securities other than those issued or guaranteed by the U.S. Department of the Treasury (the “Treasury”), are very depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (a) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at June 30, 2010, (b) an income valuation approach technique (i.e. present value) that maximizes the use of relevant observable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

Beginning in the first quarter of 2010, management utilized an independent third party to prepare both the evaluations of OTTI as well as the fair value determinations for its CDO portfolio. In previous periods, management performed internal impairment valuations and utilized a third party service for the portfolio pricing. Management will continue to review the assumptions and results and does not believe that there were any material differences in the impairment evaluations and pricing between December 31, 2009 and June 30, 2010.

The approach of the third party utilized beginning in the first quarter of 2010 to determine fair value involved several steps, including detailed credit and structural evaluation of each piece of collateral in each bond, default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently the only active and liquid trading market that exists is for stand-alone trust preferred securities. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.

Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that one security had an additional $.6 million of credit-related OTTI during the quarter and thirteen securities with previously recorded OTTI had no further impairment. The Corporation recorded $8.1 million OTTI charges on the CDO securities in earnings for the six month period ended June 30, 2010.

Management does not intend to sell these securities nor is it more likely than not that the Corporation will be required to sell the securities prior to recovery. The risk-based capital ratios require that banks set aside additional capital for securities that are rated below investment grade. Securities rated one level below investment grade require a 200% risk weighting. Additional methods are applicable to securities rated more than one level below investment grade. As of June 30, 2010, management believes that we maintain sufficient capital and liquidity to cover the additional capital requirements of these securities and future operating expenses. Additionally, we do not anticipate any material commitments or expected outlays of capital in the near term.

Deposits

The following table presents the composition of our deposits as of the dates indicated:

(Dollars in millions)

Deposits increased $69.6 million during the first six months of 2010 when compared to deposits at December 31, 2009. Interest-bearing demand deposits decreased $2.8 million and non-interest bearing demand deposits increased by $9.0 million. Time deposits increased $64.3 million due primarily to a $48 million increase in the accounts of a local municipality, included in time deposits $100,000 or more. These funds are short-term in nature with $23 million maturing in three months and $25 million maturing in nine months. We are shifting our focus to longer-term liabilities as we anticipate a rising interest rate environment in the future.

Borrowed Funds

The following table presents the composition of our borrowings at the dates indicated:

(Dollars in millions)

Total short-term borrowings decreased by approximately $10.1 million during the first six months of 2010 due to a decline in repurchase agreements as a result of business customers utilizing cash for operating needs. Long-term borrowings decreased during the first six months of 2010 by $26.9 million due to the repayment of two FHLB advances totaling $30 million and scheduled monthly amortization of long-term advances, offset by an increase of $3.6 million in subordinated debt due to the additional issuance of the trust preferred securities by Trust III and the underlying junior subordinated debentures by First United Corporation in January 2010.

Liquidity and Capital Resources

We derive liquidity through increased customer deposits, maturities in or sales of the investment portfolio, loan repayments and income from earning assets. When deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets through arrangements with our correspondent banks or through the purchase of brokered certificates of deposit. The Bank is also a member of the FHLB of Atlanta, Atlantic Central Bankers Bank and Community Bankers Bank which all provide other sources of liquidity. As discussed in Note I to the consolidated financial statements presented elsewhere in this report, we may from time to time access capital markets and/or borrow funds from private investors to meet some of our liquidity needs. We actively manage our liquidity position through the Asset and Liability Management Committee of the Board of Directors. Monthly reviews by management and quarterly reviews by the committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.

In response to current economic conditions, management has performed an extensive review of the Bank’s liquidity position. We have identified alternative methods to reduce the pledges on securities in our investment portfolio. Throughout 2009 and into 2010, management made the decision not to reinvest called investments. The growth in deposits and decreased loan demand has also attributed to our increased liquidity position. In addition, the FDIC’s Temporary Liquidity Guaranty Program, which has been extended to December 31, 2010, has also allowed us to release investment collateral. While management believes, the increased liquidity position is prudent in light of the current economic environment, the increased liquidity has a direct impact on the net interest margin and earnings as compared to prior periods.

Management believes that we have adequate liquidity available to respond to current and anticipated liquidity demands and is unaware of any trends or demands, commitments, events or uncertainties that will materially affect our ability to maintain liquidity at satisfactory levels.

The following table presents the Corporation’s capital ratios:

At June 30, 2010, First United Corporation and the Bank were categorized as “well capitalized” under federal banking regulatory capital requirements. Pursuant to the Treasury’s Capital Purchase Program, First United Corporation sold 30,000 shares of Series A Preferred Stock and a related warrant to purchase 326,323 shares of common stock at $13.79 per share to the Treasury for an aggregate purchase price of $30 million. The proceeds from this transaction count as Tier 1 capital and the warrant qualifies as tangible common equity.

On May 17, 2010, First United Corporation paid a quarterly cash dividend on the Series A Preferred Stock in the amount of $375,000. The third quarter dividend will be paid on August 16, 2010.

First United Corporation paid a cash dividend of $0.01 per common share on April 30, 2010. On June 23, 2010, the Board of Directors declared another dividend of $0.01, to be paid on August 2, 2010 to shareholders of record as of July 14, 2010.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

Loan commitments are made to accommodate the financial needs of our customers. Letters of credit commit us to make payments on behalf of customers when certain specified future events occur. The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies. Loan commitments and letters of credit totaled $90.2 million and $5.6 million, respectively, at June 30, 2010, compared to $87.3 million and $2.9 million, respectively, at December 31, 2009. We are not a party to any other off-balance sheet arrangements.

See Note J to the consolidated financial statements presented elsewhere in this report for further disclosure on Borrowed Funds. There have been no other significant changes to contractual obligations as presented at December 31, 2009.

Our primary market risk is interest rate fluctuation and we have procedures in place to evaluate and mitigate this risk. This market risk and our procedures are described in First United Corporation’s Annual Report on Form 10-K for the year ended December 31, 2009 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Interest Rate Sensitivity”. Management believes that no material changes in our procedures used to evaluate and mitigate these risks have occurred since December 31, 2009. We believe the investment portfolio restructuring has better positioned the Corporation for a rising interest rate environment.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the periods specified in those rules and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

An evaluation of the effectiveness of these disclosure controls as of June 30, 2010 was carried out under the supervision and with the participation of Management, including the CEO and the CFO. Based on that evaluation, Management, including the CEO and the CFO, has concluded that our disclosure controls and procedures are, in fact, effective at the reasonable assurance level.

During the second quarter of 2010, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2009. Management does not believe that any material changes in our risk factors have occurred since December 31, 2010 except as follows:

The Dodd-Frank Wall Street Reform and Consumer Protection Act may affect our business activities, financial position and profitability by increasing our regulatory compliance burden and associated costs, placing restrictions on certain products and services, and limiting our future capital raising strategies.

On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which implements significant changes in the financial regulatory landscape and will impact all financial institutions, including First United Corporation and the Bank. The Dodd-Frank Act is likely to increase our regulatory compliance burden. It is too early, however, for us to assess the full impact that the Dodd-Frank Act may have on our business, financial condition or results of operations. Many of the Dodd-Frank Act’s provisions require subsequent regulatory rulemaking.

The Dodd-Frank Act’s significant regulatory changes include the creation of a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection (the “Bureau”), that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance, which will increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers. Moreover, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and states’ attorneys general may enforce consumer protection rules issued by the Bureau. The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier 1 capital. These restrictions will limit our future capital strategies. The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate and other hedging transactions.

Although certain provisions of the Dodd-Frank Act, such as direct supervision by the Bureau, will not apply to banking organizations with less than $10 billion of assets, such as First United Corporation and the Bank, the changes resulting from the legislation will impact our business. These changes will require us to invest significant management attention and resources to evaluate and make necessary changes.

We are currently in the process of evaluating this regulatory change, but have not fully quantified the full impact.

Recent amendments to the FRB’s Regulation E may negatively impact our non-interest income.

On November 12, 2009, the Board of Governors of the Federal Reserve System announced the final rules amending Regulation E that prohibit financial institutions from charging fees to consumers for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts-in, to the overdraft service for those types of transactions. Compliance with this regulation is effective July 1, 2010 for new consumer accounts and August 15, 2010 for existing consumer accounts. The impact that these new rules will have on us is unknown at this time, but they do have the potential to reduce our non-interest income and this reduction could be material.