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

- Company: [First United Corp](/companies/func.md) (CIK 763907)
- Form: 10-Q
- Filed: 2010-11-04
- Accepted by EDGAR: Nov 4, 2010, 21:23 ET
- Period: 2010-09-30
- Accession: 0001213900-10-004490
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/763907/000121390010004490/f10q0910_firstunited.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/763907/000121390010004490/

## Management's discussion and analysis

As filed, 68,358 characters.

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 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, other-than-temporary impairment (“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 September 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 nine months ended September 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.

| Per Share Data | As of or For the nine months ended September 30, 2010 | 2009 |
| --- | ---: | ---: |
| Basic net loss per common share | $(1.12) | $(.51) |
| Diluted net loss per common share | $(1.12) | $(.51) |
| Dividends Paid on common shares | $.12 | $.60 |
| Book Value | $11.67 | $12.35 |
| Significant Ratios |  |  |
| Return on Average Assets (a) | (.43%) | (.16%) |
| Return on Average Equity (a) | (7.50%) | (2.68%) |
| Dividend Payout Ratio (b) | (12.94%) | (178.16%) |
| Average Equity to Average Assets | 5.72% | 6.15% |

Note: (a) Annualized

(b) Cash dividends paid on common stock as a percent of net loss

RESULTS OF OPERATIONS

#### Overview

Consolidated net loss attributable to common shareholders for the first nine months of 2010 was $6.87 million, compared to net loss attributable to common shareholders of $3.1 million for the same period of 2009. Basic and diluted net loss per common share for the first nine months of 2010 were $1.12, compared to basic and diluted net loss per common share of $0.51 for the same period of 2009. The net loss was a result primarily from a decline in net interest income of $7.8 million and $3.4 million of net losses related to a restructuring of the investment portfolio, and losses on the sale of foreclosed real estate. These losses were partially offset by a net income tax benefit of $6.2 million and a decrease of $2.6 million in credit-related OTTI charges when comparing the first nine months of 2010 to the first nine months of 2009. The decline in net interest income resulted in a compressed net interest margin, on a fully tax-equivalent basis, of 2.78% when compared to 3.68% in the first nine months of 2009. Interest income on our interest earning assets declined $10.0 million, on a fully tax-equivalent basis, due to the increase in non-accrual loans throughout 2009, the decline in loan balances, the decrease in the investment portfolio and the lower interest rate environment. Additionally, during 2009 and throughout the first nine months of 2010, we elected to maintain an increased liquidity position. Our cash position has increased significantly due to our election not to reinvest cash from called investments and continued growth in our deposit base. This increase in cash levels has had a negative impact on our net interest income in the first nine months of 2010 of approximately $8.3 million, or 67 basis points on our net interest margin.

The provision for loan losses was $10.7 million for the nine months ended September 30, 2010, compared to $10.8 million for the same period of 2009. 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 $2.1 million in spite of a $131 million increase in average deposits partially offset by a $20 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 $1.1 million during the first nine months of 2010 when compared to the same period of 2009. This decrease is primarily attributable to $3.4 million of net losses related to a restructuring of the investment portfolio to limit potential market and interest rate risk from a rising rate environment and credit risk, losses on sales of foreclosed real estate and sales of loans, partially offset by a decrease of $2.6 million in credit-related OTTI charges. Management also noted a decline of $.7 million in service charge income due to the decline in consumer spending and the resulting decrease in overdraft income. Operating expenses decreased $1.5 million in the first nine months of 2010 when compared to the same period of 2009. This decrease is due primarily to a $1.1 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 third quarter of 2010 totaled $.1 million or $.01 per share, compared to net loss attributable to common shareholders of $6.0 million or $.97 per share for the same period of 2009. The net interest margin, on a fully tax-equivalent basis, for the third quarter of 2010 was 2.51% compared to 3.53% for the same period of 2009. This decrease is primarily attributable to a shift in the balance sheet mix from loans and investments to cash at lower investment rates. The increased liquidity position, at lower rates, was the primary factor that negatively impacted third 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 nine months ended September 30, 2010 and 2009 (in thousands):

| Interest-Earning Assets: | For the nine months ended September 30, 2010 Average Balance | Interest | Average Rate | 2009 Average Balance | Interest | Average Rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Loans | $1,110,710 | $46,635 | 5.61% | $1,132,999 | $51,606 | 6.09% |
| Investment securities | 247,401 | 9,491 | 5.15 | 330,823 | 14,827 | 5.99 |
| Other interest earning assets | 287,453 | 407 | .19 | 65,614 | 65 | .14 |
| **Total earning assets** | $1,645,564 | 56,533 | 4.59% | $1,529,436 | 66,498 | 5.81% |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Interest-bearing deposits | $1,253,588 | 13,904 | 1.48% | $1,122,255 | 15,385 | 1.83% |
| Short-term borrowings | 45,507 | 207 | .61 | 44,231 | 237 | .72 |
| Long-term borrowings | 256,098 | 8,205 | 4.28 | 277,033 | 8,768 | 4.23 |
| **Total interest-bearing liabilities** | $1,555,193 | 22,316 | 1.92% | $1,443,519 | 24,390 | 2.26% |
| Net interest income and spread |  | $34,217 | 2.67% |  | $42,108 | 3.55% |
| Net interest margin |  |  | **2.78%** |  |  | **3.68%** |

Net interest income on an FTE basis decreased $7.9 million during the first nine months of 2010 over the same period in 2009 due to a $10.0 million (15.0%) decrease in interest income partially offset by a $2.1 million (8.5%) 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 $221.8 million in incremental average liquidity was approximately $8.3 million, or 67 basis points of the 90 basis point decrease in the net interest margin from 3.68% during the first nine months of 2009 to 2.78% for the same time period of 2010.

The overall $116.1 million increase in average interest-earning assets at lower yields also impacted the 122 basis point decline in the average yield on our average earning assets, which dropped from 5.81% for the first nine months of 2009 to 4.59% for the first nine months of 2010 (on an FTE basis).

Interest expense decreased during the first nine 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, and the shorter duration of the portfolio. This more than offset the impact of a $111.7 million increase in average interest-bearing liabilities in the first nine months of 2010 when compared to the same time period for 2009, with interest-bearing deposits increasing by approximately $131.3 million. The overall effect of these changes was a 34 basis point decrease in the average rate paid on our average interest-bearing liabilities from 2.26% for the nine months ended September 30, 2009 to 1.92% 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 September 30, 2010 and 2009 (in thousands):

| Interest-Earning Assets: | For the three months ended September 30, 2010 Average Balance | Interest | Average Rate | 2009 Average Balance | Interest | Average Rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Loans | $1,063,538 | $15,246 | 5.75% | $1,140,369 | $17,076 | 5.94% |
| Investment securities | 233,055 | 2,310 | 3.98 | 326,413 | 4,541 | 5.52 |
| Other interest earning assets | 365,817 | 183 | .20 | 89,996 | 61 | .29 |
| **Total earning assets** | $1,662,410 | 17,739 | 4.28% | $1,556,778 | 21,678 | 5.52% |
| **Interest-bearing liabilities** |  |  |  |  |  |  |
| Interest-bearing deposits | $1,283,068 | 4,682 | 1.46% | $1,103,462 | 4,835 | 1.74% |
| Short-term borrowings | 55,176 | 68 | .49 | 45,523 | 82 | .71 |
| Long-term borrowings | 243,526 | 2,602 | 4.29 | 276,770 | 2,916 | 4.18 |
| **Total interest-bearing liabilities** | $1,581,770 | 7,352 | 1.86% | $1,425,755 | 7,833 | 2.18% |
| Net interest income and spread |  | $10,387 | 2.42% |  | $13,845 | 3.34% |
| Net interest margin |  |  | **2.51%** |  |  | **3.53%** |

Net interest income on an FTE basis decreased $3.5 million for the third quarter of 2010 in comparison to the third quarter of 2009. This decrease resulted from a decrease in interest income of $3.9 million partially offset by a $0.5 million decrease in interest expense during the period. Overall, the net interest margin decreased by 102 basis points from 3.53% to 2.51% when comparing quarter to quarter, due primarily to the change in earning asset mix discussed above. Average loans decreased by $76.8 million and the average balance in investment securities declined by $93.4 million. Other interest-earning assets increased $275.8 million due to the increased liquidity position. Average interest-bearing liabilities increased by $156.0 million (10.9%) during the third quarter of 2010 when compared to the third quarter of 2009. This increase resulted primarily from increases in interest-bearing deposits partially offset by decreases in long-term borrowings. The effective rate on these liabilities decreased by 32 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 $10.7 million for the first nine months of 2010, compared to $10.8 million for the same period of 2009. The provision for loan losses is a result of increases in the rolling historical loss rates and qualitative factors utilized in the determination of the allowance for loans collectively evaluated discussed below in the section entitled “FINANCIAL CONDITION” under the heading “Allowance and Provision for Loan Losses”. Management strives to ensure that the Allowance for Loan Losses reflects a level commensurate with the risk inherent in our loan portfolio.

#### Other Operating Income

Other operating income, exclusive of losses, decreased $.5 million during the first nine months of 2010 when compared to the same period of 2009. Service charge income decreased $.7 million due primarily to a reduction in non-sufficient funds (NSF) fees and increased charge-off overdraft fees. Trust department income increased $.4 million during the first nine months of 2010 when compared to the first nine 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 $.4 million during the first nine months 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.

Net losses of $11.7 million were reported through other income in the first nine months of 2010 compared to $11.1 million during the same period of 2009. There were $8.3 million in losses in 2010 that were attributable to other-than-temporary impairment losses on the investment portfolio, down from the $10.8 million in 2009. Other losses of $3.4 million in the first nine months of 2010 consisted primarily of $2.4 million from sales of investments, $.2 million from a loan sale in the second quarter and $.8 million from sales of foreclosed real estate.

Other operating income, exclusive of losses, for the third quarter of 2010 decreased $.2 million when compared to the third quarter of 2009. Service charge income decreased $.3 million due primarily to a reduction in NSF fees and increased charge-off overdrafts. Bank Owned Life Insurance income increased $.1 million during the third quarter of 2010 when compared to the third quarter of 2009 due to the surrender of the separate account contracts and purchase of general account contracts during the fourth quarter of 2009.

Net losses of $0.9 million were reported through other income in the third quarter of 2010 compared to $8.5 million during the same period of 2009. There were $.2 million in losses in the third quarter of 2010 attributable to other-than-temporary impairment losses on the investment portfolio, down from $8.7 million in 2009. Other losses of $.7 million in the third quarter of 2010 consisted primarily of $.2 million from sales of investments and $.5 million from sales of foreclosed real estate.

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

|  | Income as % of Total Other Operating Income For the nine months ended September 30, 2010 | 2009 | For the three months ended September 30, 2010 | 2009 |
| --- | ---: | ---: | ---: | ---: |
| Service charges | 31% | 36% | 30% | 37% |
| Trust department | 26% | 22% | 25% | 24% |
| Insurance commissions | 18% | 18% | 18% | 17% |
| Debit card Income | 11% | 9% | 10% | 9% |
| Bank owned life insurance | 7% | 3% | 7% | 3% |
| Other income | 7% | 12% | 10% | 10% |
|  | 100% | 100% | 100% | 100% |

#### Other Operating Expenses

Other operating expenses decreased $1.5 million (4%) for the first nine months of 2010 when compared to the first nine months of 2009. For the third quarter 2010, other operating expenses decreased $.3 million, or 3%, when compared to the same time period of 2009. The decrease for the first nine months of 2010 is primarily due to a decline of $1.1 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 $.5 million during the first nine months of 2010 when compared to the same period of 2009 due to the increased rate structure. Other miscellaneous expenses decreased $.9 million for the first nine months of 2010 compared to the same time period of 2009. This decrease is attributable to reductions in expenses such as marketing, postage, and office supplies.

The decrease in other operating expense for the third quarter of 2010 is primarily due to a decline of $.2 million in salaries and benefits due to the aforementioned factors above. There have not been any special assessments by the FDIC as of September 30, 2010. Other miscellaneous expenses decreased $.3 million for the three months ended September 30, 2010 compared the same time period of 2009 due to the aforementioned factors above.

The composition of operating expense for the nine and three months ended September 30, 2010 and 2009 is illustrated in the following table.

|  | Expense as % of Total Other Operating Expenses For the nine months ended September 30, 2010 | 2009 | For the three months ended September 30, 2010 | 2009 |
| --- | ---: | ---: | ---: | ---: |
| Salaries and employee benefits | 49% | 50% | 48% | 48% |
| FDIC premiums | 9% | 7% | 9% | 7% |
| Occupancy, equipment and data processing | 19% | 18% | 19% | 20% |
| Other | 23% | 25% | 24% | 25% |
|  | 100% | 100% | 100% | 100% |

36

#### 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 nine months of 2010 was 52%, compared to an effective tax benefit rate of 57% for the first nine months of 2009. The decrease thus far in 2010 when compared to the same time period in 2009 is primarily attributable to the OTTI charge of $8.3 million recognized in the first nine months of the year. The year-to-date loss coupled with forecasted favorable, permanent book to tax adjustments resulted in an income tax benefit for the Corporation and the 52% effective tax benefit rate.

### FINANCIAL CONDITION

#### Balance Sheet Overview

Total assets were $1.8 billion at September 30, 2010, an increase of $51.4 million since December 31, 2009. During this time period, cash and interest-bearing deposits in banks increased $172.6 million, our investment portfolio decreased $34.5 million, gross loans decreased $77.9 million, and deferred tax assets decreased $4.3 million. During 2009 and throughout the first nine 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 our election not to reinvest cash from called investments and continued growth in our deposit base. Although the cash levels should remain high through the fourth quarter, approximately $75 million was used to payback brokered funds. The decrease in loans is due to runoff in our indirect portfolio as well as refinancings 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 September 30, 2010. Total liabilities increased by approximately $50.3 million during the first nine months of 2010, reflecting increases in total deposits of $82.3 million offset by a $3.6 million decrease in short-term borrowings as a result of a decrease in repurchase agreements, our treasury management product and a $27.2 million decrease in long-term borrowings due to repayment of two maturing FHLB advances. The increase in deposits is due in part 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:

*(In millions)*

|  | September 30, 2010 |  | December 31, 2009 |  |
| --- | ---: | ---: | ---: | ---: |
| Commercial real estate | $351.6 | 34% | $326.8 | 29% |
| Acquisition and development | 172.3 | 16 | 231.7 | 21 |
| Commercial and industrial | 71.4 | 7 | 81.3 | 7 |
| Residential mortgage | 362.5 | 35 | 373.2 | 33 |
| Consumer | 86.2 | 8 | 108.9 | 10 |
| Total Loans | $1,044.0 | 100% | $1,121.9 | 100% |

Comparing loans at September 30, 2010 to loans at December 31, 2009, our loan portfolio has decreased by $77.9 million (6.9%). Commercial real estate loans increased $24.8 million as certain acquisition and development loans, which decreased $59.4 million, were completed and transferred to permanent financing. Commercial and industrial loans declined $9.9 million and residential mortgage declined $10.7 million. 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. The consumer portfolio declined $22.7 million as repayment activity in the indirect auto portfolio exceeded new production resulting from the continued slowdown in economic activity and the special financing offered by the automotive manufacturers. At September 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.

*(In thousands)*

| Non-accrual loans: | September 30, 2010 | % of Applicable Portfolio | December 31, 2009 | % of Applicable Portfolio |
| --- | ---: | ---: | ---: | ---: |
| Commercial real estate | $4,975 | 1.4% | $4,046 | 1.2% |
| Acquisition and development | 27,376 | 15.9% | 37,244 | 16.1% |
| Commercial and industrial | 777 | 1.1% | -- | -- |
| Residential mortgage | 5,670 | 1.6% | 5,227 | 1.4% |
| Consumer | 154 | .2% | 67 | .1% |
| Total non-accrual loans | $38,952 | 3.7% | $46,584 | 4.2% |
| Accruing Loans Past Due 90 days or more: |  |  |  |  |
| Commercial real estate | $156 |  | $-- |  |
| Acquisition and development | -- |  | -- |  |
| Commercial and industrial | -- |  | -- |  |
| Residential mortgage | 822 |  | 1,483 |  |
| Consumer | 124 |  | 287 |  |
| Total loans past due 90 days or more | $1,102 |  | $1,770 |  |
| Total non-accrual and loans past due 90 days or more | $40,054 |  | $48,354 |  |
| Restructured Loans (TDRs): |  |  |  |  |
| Performing | $6,918 |  | $22,160 |  |
| Non-accrual (included above) | 11,645 |  | 13,321 |  |
| Total TDRs | $18,563 |  | $35,481 |  |
| Other Real Estate Owned | $15,612 |  | $7,591 |  |
| Other Impaired Loans – performing | $35,790 |  | $67,747 |  |
| Impaired loans without a valuation allowance | $55,857 |  | $102,553 |  |
| Impaired loans with a valuation allowance | 25,776 |  | 28,677 |  |
| Total impaired loans | $81,633 |  | $131,230 |  |
| Valuation allowance related to impaired loans | $7,260 |  | $7,624 |  |

Performing loans considered to be impaired (including performing restructured loans, or TDRs), as defined and identified by management, amounted to $42.7 million at September 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 and commercial real estate 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 to repay the loan balance if liquidated and there is no secondary source of repayment is available.

The level of performing impaired loans (other than performing TDRs) declined $31.9 million during the nine months ended September 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 nine months 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 the first nine months of 2010, $25.0 million of loans have been removed from impaired status due to satisfactory payment performance, another $2.0 million of loans were paid off and $1.6 million in principal reductions were received. Thus far in 2010, $2.9 million of previously performing impaired loans have been transferred to non-accrual or foreclosure and $2.2 million have been transferred to performing TDRs. Three loans totaling $0.8 million and $1.0 million of loans reclassified from performing TDRs were added to performing impaired loans thus far in 2010. Management will continue to monitor loans that have been removed from an impaired status and take appropriate steps in an effort to ensure that satisfactory performance is sustained.

The level of TDRs declined $16.9 million during the nine months ended September 30, 2010, with five loans totaling $3.1 million added to performing TDRs, three loans totaling $1.0 million added to non-performing TDRs and $21.0 million removed from TDR reporting. Four non-accrual TDRs totaling $3.8 million were foreclosed on and two performing TDRs totaling $2.6 million paid off during 2010. Loans that had been modified in 2009 at market rates, totaling $14.0 million, were removed from performing TDRs during 2010 because the borrowers had made at least six consecutive payments and were current at September 30, 2010. One TDR that had been performing was reclassified to non-performing in 2010 with a partial charge-off recorded on the loan.

#### 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.

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 nine months ended September 30 (in thousands):

|  | 2010 | 2009 |
| --- | ---: | ---: |
| Balance, January 1 | $20,090 | $14,347 |
| Charge-offs: |  |  |
| Commercial real estate | (513) | (584) |
| Acquisition and development | (3,601) | (3,348) |
| Commercial and industrial | (1,402) | (1,997) |
| Residential mortgage | (1,701) | (1,110) |
| Consumer | (1,489) | (1,840) |
| Total charge-offs | (8,706) | (8,879) |
| Recoveries: |  |  |
| Commercial real estate | 94 | -- |
| Acquisition and development | 1,067 | 16 |
| Commercial and industrial | 380 | 183 |
| Residential mortgage | 330 | 55 |
| Consumer | 380 | 370 |
| Total recoveries | 2,251 | 624 |
| Net credit losses | (6,455) | (8,255) |
| Provision for loan losses | 10,653 | 10,837 |
| Balance at end of period | $24,288 | $16,929 |
| Allowance for loan losses to loans outstanding (as %) | 2.33% | 1.49% |
| Net charge-offs to average loans outstanding during the period, annualized (as %) | .77% | .97% |

40

The allowance for loan losses increased to $24.3 million at September 30, 2010, compared to $20.1 million at December 31, 2009. The provision for loan losses remained stable for the first nine months at $10.7 million compared to $10.8 million for the same period of 2009. Net charge-offs also remained fairly constant. 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.

Year-to-date charge-offs include $3.0 million for two loans in the acquisition and development portfolio that were transferred to other real estate owned during the period and $0.8 million that represented a partial charge-off of one loan in the commercial and industrial portfolio during the period. These charge-offs were the primary contributors of the annualized net charge-off loss rate of 1.67% in the acquisition and development portfolio and 1.79% in the commercial and industrial portfolio. The 1.52% annualized charge-off rate in the consumer loan portfolio is the result of our policy of charging off these loans after they are 120 days contractually past due. Accruing loans past due 30 days or more declined to 2.1% of the loan portfolio at September 30, 2010 from 2.5% of the loan portfolio at December 31, 2009. Improvements in the consumer portfolio delinquency rates, which improved from 4.9% at December 31, 2009 to 2.1% at September 30, 2010, were partially offset by weakness in the commercial portfolios which have experienced an increase in the total delinquency rate from 0.8% to 2.0% in the same time periods. The rate of loans entering delinquency has slowed in the commercial portfolios, with loans 30 days past due decreasing from 0.6% of those portfolios at December 31, 2009 to 0.4% at September 30, 2010.

Management believes that the allowance for loan losses at September 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 September 30, 2010, the total amortized cost basis of the available-for-sale investment portfolio was $259.4 million, compared to a fair value of $239.3 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)*

| Securities Available-for-Sale: | September 30, 2010 Amortized Cost | Fair Value (FV) | FV as % of Total | December 31, 2009 Amortized Cost | Fair Value (FV) | FV as % of Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| U.S. government agencies | $31,827 | $32,052 | 13% | $68,487 | $68,263 | 25% |
| Residential mortgage-backed agencies | 96,852 | 98,459 | 41% | 59,640 | 62,573 | 23% |
| Collateralized mortgage obligations | 838 | 737 | 1% | 40,809 | 33,197 | 12% |
| Obligations of states and political subdivisions | 93,465 | 98,410 | 41% | 95,190 | 97,303 | 35% |
| Collateralized debt obligations | 36,382 | 9,599 | 4% | 44,478 | 12,448 | 5% |
| Total Investment Securities | $259,364 | $239,257 | 100% | $308,604 | $273,784 | 100% |

Total investment securities have decreased $34.5 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 September 30, 2010, all of the aforementioned securities had been sold, resulting in an additional $.3 million net loss on the trading transaction. As of September 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).

At September 30, 2010, the securities classified as available-for-sale included a net unrealized loss of $20.1 million, which represents the difference between the fair value and amortized cost of securities in the portfolio.

As discussed in Note H 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 $229.7 million of the available-for-sale portfolio was valued using Level 2 pricing, and had net unrealized gains of $6.7 million at September 30, 2010. The remaining $9.6 million of the securities available-for-sale represents the entire CDO portfolio, which was valued using significant unobservable inputs (Level 3 assets). The $26.8 million in unrealized losses associated with this portfolio relates to 18 pooled trust preferred securities that comprise the CDO portfolio. Unrealized losses of $17.8 million represent non-credit related OTTI charges on 13 of the securities, while $9.0 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 September 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 September 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 September 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 September 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 two securities had an additional $.2 million of credit-related OTTI during the quarter and twelve securities with previously recorded OTTI had no further impairment. The Corporation recorded $8.3 million OTTI charges on the CDO securities in earnings for the nine month period ended September 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 September 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:

*(In millions)*

|  | September 30, 2010 |  | December 31, 2009 |  |
| --- | ---: | ---: | ---: | ---: |
| Non-interest bearing demand deposits | $121.4 | 9% | $107.0 | 8% |
| Interest-bearing deposits: |  |  |  |  |
| Demand | 108.3 | 8 | 109.8 | 8 |
| Money Market: |  |  |  |  |
| Retail | 267.7 | 19 | 266.3 | 20 |
| Brokered | 65.1 | 5 | 74.8 | 6 |
| Savings deposits | 26.6 | 2 | 28.8 | 2 |
| Time deposits less than $100,000 | 286.2 | 20 | 293.5 | 23 |
| Time deposits $100,000 or more: |  |  |  |  |
| Retail | 222.3 | 16 | 190.2 | 15 |
| Brokered/CDARS | 288.8 | 21 | 233.8 | 18 |
| Total Deposits | $1,386.4 | 100% | $1,304.2 | 100% |

Total deposits increased $82.2 million during the first nine months of 2010 when compared to deposits at December 31, 2009. Non-interest bearing deposits increased $14.4 million. Retail money market accounts increased $1.4 offset by a $2.2 million decline in traditional savings accounts. Time deposits less than $100,000 declined $7.3 million and time deposits greater than $100,000 increased $87.1 million. The increase in time deposits greater than $100,000 is primarily due to a $48 million increase in the CDARs product for a local municipality. These funds are relatively short-term in nature and will mature within six months.

During October 2010, $45 million of brokered certificates of deposit were paid back and $34 million of CDARs one-way buy funds were paid back. Although brokered deposits are at very low rates in the current environment, management made the decision to deploy a portion of the excess liquidity to pay these funds back rather than renew.

#### Borrowed Funds

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

*(In millions)*

|  | September 30, 2010 | December 31, 2009 |
| --- | ---: | ---: |
| Securities sold under agreements to repurchase | $43.9 | $47.6 |
| Total short-term borrowings | $43.9 | $47.6 |
| FHLB advances | $196.7 | $227.4 |
| Junior subordinated debt | 46.7 | 43.1 |
| Total long-term borrowings | $243.4 | $270.5 |

Total short-term borrowings decreased by approximately $3.7 million during the first nine 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 nine months of 2010 by $27.1 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 Management

Liquidity is a financial institution’s capability to meet customer demands for deposit withdrawals while funding all credit-worthy loans. The factors that determine the institutions liquidity are:

- Reliabilty and stability of core deposits
- Cash flow structure and pledging status of investments
- Potential for unexpected loan demand

We actively manage our liquidity position through weekly meetings of the Treasury sub-committee of executive management, which looks forward 12 months at 30-day intervals. The measurement is based upon the projection of funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds and core growth. Monthly reviews by management and quarterly reviews by the Asset and Liability committee under prescribed policies and procedures are designed to ensure that we will maintain adequate levels of available funds.

It is our policy to manage our affairs so that liquidity needs are fully satisfied through normal Bank operations. That is, the Bank will manage its liquidity to minimize the need to make unplanned sales of assets or to borrow funds under emergency conditions. The Bank will use funding sources where the interest cost is relatively insensitive to market changes in the short run (periods of one year or less) to satisfy operating cash needs. The remaining normal funding will come from interest-sensitive liabilities, either deposits or borrowed funds. When the marginal cost of needed wholesale funding is lower than the cost of raising this funding in the retail markets, the Company may supplement retail funding with external funding sources such as:

1\. Unsecured Fed Funds lines of credit with upstream correspondent banks (FTN Financial, M&T Bank, Atlantic Central Banker’s Bank, Community Banker’s Bank)

2\. Secured advances with the Federal Home Loan Bank of Atlanta, which are collateralized by eligible one to four family residential mortgage portfolio, home equity lines of credit portfolio, commercial real estate loan portfolio, and various securities. Cash may also be pledged as collateral.

3\. Secured line of credit with the Fed Discount Window for use in borrowing funds up to 90 days, using municipal securities as collateral.

4\. Brokered deposits, including CDs and money market funds, provide a method to generate deposits quickly. These deposits are strictly rate driven but often provide the most cost effective means of funding growth.

5\. One Way Buy CDARS funding – a form of brokered deposits that has become a viable supplement to brokered deposits obtained directly.

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. While management believes that the increased liquidity position is prudent in light of the current economic environment, the increased liquidity did have 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.

#### Market Risk

Our primary market risk is interest rate fluctuation. Interest rate risk results primarily from the traditional banking activities that we engage in, such as gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates and consumer preferences affect the difference between the interest earned on our assets and the interest paid on our liabilities. Interest rate sensitivity refers to the degree that earnings will be impacted by changes in the prevailing level of interest rates. Interest rate risk arises from mismatches in the repricing or maturity characteristics between interest-bearing assets and liabilities. Management seeks to minimize fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Management uses interest sensitivity gap analysis and simulation models to measure and manage these risks. The interest rate sensitivity gap analysis assigns each interest-earning asset and interest-bearing liability to a time frame reflecting its next repricing or maturity date. The differences between total interest-sensitive assets and liabilities at each time interval represent the interest sensitivity gap for that interval. A positive gap generally indicates that rising interest rates during a given interval will increase net interest income, as more assets than liabilities will reprice. A negative gap position would benefit us during a period of declining interest rates.

Throughout 2010, we have shifted our focus on a shorter duration balance sheet to move to a more neutral to asset sensitive position as we anticipate a flat to rising rate environment in the future. As of September 30, 2010, we were slightly asset sensitive.

Our interest rate risk management goals are:

- Ensure that the Company’s Board of Directors and Senior Management will provide effective oversight and ensure that risks are adequately identified, measured, monitored and controlled;
- Enable dynamic measurement and management of interest rate risk;
- Select strategies that optimize the ability of the Company to meet its long-range financial goals while maintaining interest rate risk within policy limits established by the Board of Directors;
- Use both income and market value oriented techniques to select strategies that optimize the relationship between risk and return; and
- Establish interest rate risk exposure limits for fluctuation in net interest income (NII), net income and economic value of equity.

In order to manage interest sensitivity risk, management formulates guidelines regarding asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These guidelines are based on management’s outlook regarding future interest rate movements, the state of the regional and national economy, and other financial and business risk factors. Management uses computer simulations to measure the effect on net interest income of various interest rate scenarios. Key assumptions used in the computer simulations include cash flows and maturities of interest rate sensitive assets and liabilities, changes in asset volumes and pricing, and management’s capital plans. This modeling reflects interest rate changes and the related impact on net interest income over specified periods.

We evaluate the effect of a change in interest rates of +/-100 basis points to +/-400 basis points on both Net Interest Income (“NII”) and Net Portfolio Value (“NPV”) / Economic Value of Equity (“EVE”). We concentrate on NII rather than net income as long as net interest income remains the significant contributor to net income.

NII modeling allows management to view how changes in interest rates will affect the spread between the yield paid on assets and the cost of deposits and borrowed funds. Unlike traditional Gap modeling, NII modeling takes into account the different degree to which installments in the same repricing period will adjust to a change in interest rates. It also allows the use of different assumptions in a falling versus a rising rate environment. The period considered by the NII modeling is the next eight quarters.

NPV / EVE modeling focuses on the change in the market value of equity. NPV / EVE is defined as the market value of assets less the market value of liabilities plus/minus the market value of any off-balance sheet positions. By effectively looking at the present value of all future cash flows on or off the balance sheet, NPV / EVE modeling takes a longer-term view of interest rate risk. This complements the shorter-term view of the NII modeling.

Measures of net interest income at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.

#### Regulatory Capital Requirements

First United Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, First United Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

The following table presents First United Corporation’s capital ratios:

| Total Capital (to risk-weighted assets) | September 30, 2010 | December 31, 2009 | Required for Capital Adequacy Purposes | Required To Be Well Capitalized |
| --- | ---: | ---: | ---: | ---: |
| Consolidated | 12.29% | 11.20% | 8.00% | 10.00% |
| First United Bank | 11.62% | 11.05% | 8.00% | 10.00% |
| Tier 1 Capital (to risk-weighted assets) |  |  |  |  |
| Consolidated | 10.60% | 9.60% | 4.00% | 6.00% |
| First United Bank | 10.35% | 9.78% | 4.00% | 6.00% |
| Tier 1 Capital (to average assets) |  |  |  |  |
| Consolidated | 8.09% | 8.53% | 4.00% | 5.00% |
| First United Bank | 7.90% | 8.73% | 4.00% | 5.00% |

At September 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, in January 2009, 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 August 16, 2010, First United Corporation paid a quarterly cash dividend on the Series A Preferred Stock in the amount of $375,000. The fourth quarter dividend will be paid on November 16, 2010.

First United Corporation paid a cash dividend of $0.01 per common share on August 2, 2010. On September 22, 2010, the Board of Directors declared another dividend of $0.01, to be paid on November 1, 2010 to shareholders of record as of October 13, 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 $92.1 million and $5.2 million, respectively, at September 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 K 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.

## Market risk

As filed, 670 characters.

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.

## Controls and procedures

As filed, 2,248 characters.

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 September 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 third 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.

## Risk factors

As filed, 4,689 characters.

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 and in Item 1A of Part II of the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2010.

The following discussion updates a risk factor that was contained in the Annual Report on Form 10-K:

**The Corporation’s ability to pay dividends is limited by applicable banking and corporate law.**

In the past, the Corporation’s ability to pay dividends to shareholders has been largely dependent upon the receipt of dividends from the Bank. Since December 2009, the Corporation has used capital raised through private offerings to pay dividends, but there can be no guarantee that the Corporation's capital resources will be sufficient to continue paying dividends to shareholders without receiving dividends from the Bank. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. Federal law generally prohibits the payment of a dividend by a troubled institution. Under Maryland law, a state-chartered commercial bank may pay dividends only out of undivided profits or, with the prior approval of the Commissioner, from surplus in excess of 100% of required capital stock. If however, the surplus of a Maryland bank is less than 100% of its required capital stock, cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies also have the ability to prohibit proposed dividends by a financial institution which would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice. Moreover, the payment of dividends to shareholders and the amounts thereof are at the discretion of the Corporation’s Board of Directors. Accordingly, there can be no guarantee that we will declare dividends in any fiscal quarter or, if declared, that the amount of a dividend will remain unchanged from quarter to quarter.

The following discussion constitutes a new risk factor:

**We have entered into informal agreements with our regulators that could prevent us from paying dividends or taking other actions that reduce capital.**

The Corporation recently entered into an informal agreement with the Federal Reserve Bank of Richmond (the “FRBR”) pursuant to which the Corporation agreed not to pay dividends on outstanding shares of its common or preferred stock, or to take any other action that reduces regulatory capital, without the prior approval of the FRBR. The Bank recently entered into a similar agreement with the Federal Deposit Insurance Corporation (the “FDIC”) and the Maryland Commissioner of Financial Regulation (the “Maryland Commissioner”). These agreements give our regulators the ability to prohibit a proposed dividend payment, or any other distribution with respect to outstanding stock, including the repurchase of stock, at a time or times when applicable banking and corporate law would otherwise permit such a dividend or repurchase. There is no requirement that our regulators take consistent approaches when exercising their powers under these agreements. For example, even though the FRBR might approve the payment of a particular dividend, that dividend could be effectively prohibited by the FDIC and/or the Maryland Commissioner if the Corporation intended to fund that dividend through a dividend by the Bank and the FDIC and/or the Maryland Commissioner were to deny the Bank’s dividend request. Similarly, even though the FDIC and the Maryland Commissioner might approve a dividend by the Bank to the Corporation, the FRBR could prevent the Corporation from using that dividend to make a distribution to the holders of its outstanding common or preferred stock. It should be noted that the terms of the Corporation’s outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), entitle the holders thereof to elect two directors if the Corporation fails to pay accrued but unpaid dividends for six quarterly periods, whether or not consecutive, and this right could be triggered if the FRBR were to prohibit dividend payments with respect to the Series A Preferred Stock. These agreements increase the likelihood that the other risks related to our ability to pay dividends and make other distributions will be realized.

Other than as set forth above, management believes that no material changes have occurred in our risk factors since the date these risks were last discussed.

Filed Nov 4, 2010.
Source: SEC EDGAR, the filing index for accession 0001213900-10-004490. Last ingested by Listed: Nov 3, 2026, 22:37 ET. No prices; not investment advice.