Highlands Bankshares 10-Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended September 30,  2012

[   ] Transition Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  0-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1796693 (I.R.S. Employer Identification No.)
P.O. Box 1128 Abingdon, Virginia (Address of principal executive offices)	24212-1128 (Zip Code)

276-628-9181

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company (See definition of “large accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Act). Large Accelerated Filer  o   Accelerated Filer  o    Non-Accelerated Filer o  Smaller Reporting Company  x

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

5,011,152 shares of common stock, par value $0.625 per share,

outstanding as of November 14, 2012

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended September 30, 2012

INDEX

PART I. FINANCIAL INFORMATION	PAGE
Item 1.  Financial Statements
Consolidated Balance Sheets   at September 30, 2012 (Unaudited) and December 31, 2011
	3
Consolidated Statements of Income (Unaudited)   for the Three Months and Nine Months Ended  September 30, 2012 and 2011	4
Consolidated Statements of Comprehensive Income (Unaudited)   for the Three Months and Nine Months Ended September 30, 2012 and 2011	5
Consolidated Statements of Cash Flows (Unaudited)   for the  Nine Months Ended September 30, 2012 and 2011	6
Consolidated Statements of Changes in   Stockholders’ Equity (Unaudited) for the Three Months and Nine Months   Ended September 30, 2012 and 2011	7
Notes to Consolidated Financial Statements (Unaudited)	8-38
Item 2. Management’s Discussion and Analysis of               Financial Condition and Results of Operations	39-46
Item 3. Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.  Controls and Procedures	46
PART II.  OTHER INFORMATION
Item 1.  Legal Proceedings	47
Item 1A. Risk Factors	47
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	47
Item 3.  Defaults Upon Senior Securities	47
Item 4.  Mine Safety Disclosures	47
Item 5.  Other Information	47
Item 6.  Exhibits	48
SIGNATURES	49

2

PART I.

FINANCIAL INFORMATION

 ITEM 1.  Financial Statements

Consolidated Balance Sheets

(Amounts in thousands)

	(Unaudited)  September 30, 2012			(Note 1) December 31, 2011
ASSETS
Cash and due from banks	$	21,193		$	15,734
Federal funds sold		55,621			70,341
Total Cash and Cash Equivalents		76,814			86,075
Investment securities available for sale  (amortized cost $62,422 at  September 30, 2012, $67,372 at December 31, 2011)		59,788			64,252
Other investments, at cost		4,931			5,308
Loans, net of allowance for loan losses of $7,849 at  September 30, 2012, $9,024 at December 31, 2011		390,035			398,780
Premises and equipment, net		21,347			21,883
Deferred tax assets		7,931			8,615
Interest receivable		2,469			2,369
Bank owned life Insurance		13,573			13,230
Other real estate owned, net		18,013			16,724
Other assets		4,039			3,747
Total Assets	$	598,940		$	620,983
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	107,574		$	98,950
Interest bearing		384,060			416,411
Total Deposits		491,634			515,361
Interest, taxes and other liabilities		2,213			2,570
Other short-term borrowings		20,175			57,676
Long-term debt		51,336			13,964
Capital securities		3,150			3,150
Total Other Liabilities		76,874			77,360
Total Liabilities		568,508			592,721
STOCKHOLDERS’ EQUITY
Common stock (5,011 shares issued and outstanding)		3,132			3,132
Additional paid-in capital		7,783			7,783
Retained earnings		21,256			19,406
Accumulated other comprehensive income (loss)		(1,739	)		(2,059	)
Total Stockholders’ Equity		30,432			28,262
Total Liabilities and Stockholders’ Equity	$	598,940		$	620,983

See accompanying Notes to Consolidated Financial Statements

3

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Nine Months Ended September 30, 2012			Nine Months Ended September 30, 2011			Three Months Ended  September 30, 2012		Three Months Ended September 30, 2011
INTEREST INCOME
Loans receivable and fees on loans	$	17,712		$	18,898		$	5,728	$	6,170
Securities available for sale:
Taxable		679			1,005			210		349
Exempt from taxable income		532			611			155		201
Other investment income		73			63			29		28
Federal funds sold		109			112			33		39
Total Interest Income		19,105			20,689			6,155		6,787
INTEREST EXPENSE
Deposits		3,360			5,027			967		1,589
Other borrowed funds		2,529			2,620			824		855
Total Interest Expense		5,889			7,647			1,791		2,444
��Net Interest Income		13,216			13,042			4,364		4,343
Provision for Loan Losses		857			4,238			236		449
Net Interest Income after Provision for Loan Losses		12,359			8,804			4,128		3,894
NON-INTEREST INCOME
Securities gains, losses, net		663			251			458		108
Service charges on deposit accounts		1,516			1,565			516		534
Other service charges, commissions and fees		1,357			1,322			382		427
Other operating income		643			745			233		400
Other than temporary impairment		(167	)		(269	)		--		-
Total Non-Interest Income		4,012			3,614			1,589		1,469
NON-INTEREST EXPENSE
Salaries and employee benefits		7,025			7,516			2,358		2,454
Occupancy expense of bank premises		896			820			300		300
Furniture and equipment expense		936			1,019			292		320
Other operating expense		4,106			4,275			1,303		1,412
Foreclosed Assets – Loss on Sale / Write-down		374			1,419			166		702
Foreclosed Assets – Operating Expenses		665			919			244		224
Total Non-Interest Expense		14,002			15,968			4,663		5,412
Income (Loss) Before Income Taxes		2,369			(3,550	)		1,054		(49	)
Income Tax Expense (Benefit)		519			(1,524	)		272		(124	)
Net Income (Loss)	$	1,850		$	(2,026	)	$	782	$	75
Basic Earnings Per Common Share – Weighted Average	$	0.37		$	(0.41	)	$	0.16	$	0.01
Earnings Per Common Share – Assuming Dilution	$	0.37		$	(0.41	)	$	0.16	$	0.01

See accompanying Notes to Consolidated Financial Statements

4

Consolidated Statements of Comprehensive Income

(Amounts in thousands)

(Unaudited)

	Nine Months Ended  September 30, 2012			Nine Months Ended September 30, 2011
Net Income (Loss)	$	1,850		$	(2,026	)
Other Comprehensive Income
Unrealized gains on securities during the period		1,148			2,898
Less: reclassification adjustment for gains included in net income		(663	)		(251	)
Other Comprehensive Income, before tax		485			2,647
Income tax expense related to other            comprehensive income		165			900
Other Comprehensive Income		320			1,747
Comprehensive Income (Loss)	$	2,170		$	(279	)

	Three Months Ended  September 30, 2012			Three Months Ended September 30, 2011
Net Income (Loss)	$	782		$	75
Other Comprehensive Income
Unrealized gains on securities during the period		205			1,440
Less: reclassification adjustment for gains included in net income		(458	)		(108	)
Other Comprehensive Income (Loss), before tax		(253	)		1,332
Income tax expense (benefit)  related to other            comprehensive income		(86	)		453
Other Comprehensive Income (Loss)		(167	)		879
Comprehensive Income	$	615		$	954

See accompanying Notes to Consolidated Financial Statements

5

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

	Nine Months Ended			Nine Months Ended
	September 30, 2012			September 30, 2011
CASH FLOWS FROM OPERATING  ACTIVITIES:
Net income (loss)	$	1,850		$	(2,026	)
Adjustments to reconcile net income  (loss) to net cash provided by operating activities
Provision for loan losses		857			4,238
Depreciation and amortization		744			847
Net realized (gains) losses on available for sale securities		(663	)		(251	)
Net amortization on securities		536			353
Other than temporary impairment charge		167			269
Amortization of Capital issue costs		4			4
(Increase) decrease in interest receivable		(100	)		(12	)
Valuation adjustment of other real estate owned		243			1,321
Increase in other assets		(234	)		(155	)
Decrease in interest, taxes and other liabilities		(357	)		(472	)
Net cash provided by operating activities		3,047			4,116
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities		11,557			13,910
Proceeds from maturities of debt and equity securities		17,737			3,483
Purchase of debt and equity securities		(24,217	)		(21,358	)
Redemption of other investments		377			528
Net decrease in loans		1,387			24,275
Proceeds from sales of other real estate owned		4,970			3,117
Premises and equipment expenditures		(263	)	(35)
Net cash provided by investing activities		11,548			23,920
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in time deposits		(43,984	)		(27,305	)
Net increase in demand, savings and other deposits		20,257			15,908
Increase (decrease) in short-term borrowings		(37,501	)		(8,279	)
Increase (decrease) in long-term debt		37,372			(960	)
Net cash  used in financing activities		(23,856	)		(20,636	)
Net increase (decrease) in cash and cash equivalents		(9,261	)		7,400
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		86,075			82,152
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	76,814		$	89,552
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	5,807		$	7,761
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	6,501		$	6,041

See accompanying Notes to Consolidated Financial Statements

6

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

									Accumulated
					Additional				Other			Total
	Common Stock				Paid-in		Retained		Comprehensive			Stockholders’
	Shares		Par Value		Capital		Earnings		Income			Equity
Balance, June 30, 2011		5,011	$	3,132	$	7,783	$	23,822	$	(3,090	)	$	31,647
Net income / (loss)		-		-		-		75		-			75
Other comprehensive income		-		-		-		-		879			879
Balance, September 30, 2011		5,011	$	3,132	$	7,783	$	23,897	$	(2,211	)	$	32,601
Balance, June 30, 2012		5,011	$	3,132	$	7,783	$	20,474	$	(1,572	)	$	29,817
Net income / (loss)		-		-		-		782		-			782
Other comprehensive income		-		-		-		-		(167	)		(167	)
Balance, September  30, 2012		5,011	$	3,132	$	7,783	$	21,256	$	(1,739	)	$	30,432

										Accumulated
					Additional					Other			Total
	Common Stock				Paid-in		Retained			Comprehensive			Stockholders’
	Shares		Par Value		Capital		Earnings			Income			Equity
Balance, December 31, 2010		5,011	$	3,132	$	7,783	$	25,923		$	(3,958	)	$	32,880
Net income / (loss)		-		-		-		(2,026	)		-			(2,026	)
Other comprehensive income		-		-		-		-			1,747			1,747
Balance, September 30, 2011		5,011	$	3,132	$	7,783	$	23,897		$	(2,211	)	$	32,601
Balance, December 31, 2011		5,011	$	3,132	$	7,783	$	19,406		$	(2,059	)	$	28,262
Net income / (loss)		-		-		-		1,850			-			1,850
Other comprehensive income		-		-		-		-			320			320
Balance, September 30, 2012		5,011	$	3,132	$	7,783	$	21,256		$	(1,739	)	$	30,432

See accompanying Notes to Consolidated Financial Statements

7

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2011 has been extracted from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2011 Form 10-K. The results of operations for the three-month and nine-month periods ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Note 2  -  Loans and Allowance for Loan Losses  (amounts in thousands)

The composition of net loans is as follows:

	September 30, 2012		December 31, 2011
Real Estate Secured:
Residential 1-4 family	$	169,332	$	169,027
Multifamily		17,332		15,375
Construction and Land Loans		20,001		23,295
Commercial, Owner Occupied		65,856		71,367
Commercial, Non-owner occupied		36,886		36,489
Second mortgages		10,037		12,247
Equity lines of credit		8,452		9,126
Farmland		10,896		12,207
		338,792		349,133
Secured (other) and unsecured
Personal		23,143		23,824
Commercial		32,928		32,407
Agricultural		3,348		2,784
		59,419		59,015
Overdrafts		226		207
		398,437		408,355
Less:
Allowance for loan losses		7,849		9,024
Net deferred fees		553		551
		8,402		9,575
Loans, net	$	390,035	$	398,780

8

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following table is an analysis of past due loans as of  September 30, 2012:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Real Estate Secured
Residential 1-4 family	$	3,192	$	1,466	$	3,491	$	8,149	$	161,183	$	169,332	$	-
Equity lines of credit		-		-		26		26		8,426		8,452		26
Multifamily		-		77		-		77		17,255		17,332		-
Farmland		55		129		-		184		10,712		10,896		-
Construction, Land Development, Other Land Loans		-		298		1,883		2,181		17,820		20,001		-
Commercial Real Estate- Owner Occupied		171		1,795		2,230		4,196		61,660		65,856		-
Commercial Real Estate- Non Owner Occupied		1,686		386		290		2,362		34,524		36,886		-
Second Mortgages		263		36		354		653		9,384		10,037		-
Non Real Estate Secured
Personal		363		87		50		500		22,869		23,369		1
Commercial		337		27		495		859		32,069		32,928		-
Agricultural		35		-		4		39		3,309		3,348		-
Total	$	6,102	$	4,301	$	8,823	$	19,226	$	379,211	$	398,437	$	27

The following table is an analysis of past due loans as of  December 31, 2011:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Real Estate Secured
Residential 1-4 family	$	3,471	$	1,071	$	4,236	$	8,778	$	160,249	$	169,027	$	171
Equity lines of credit		-		205		-		205		8,921		9,126		-
Multifamily		97		-		646		743		14,632		15,375		-
Farmland		-		134		-		134		12,073		12,207		-
Construction,  Land Development, Other Land Loans		271		59		1,846		2,176		21,119		23,295		-
Commercial Real Estate- Owner Occupied		1,199		476		6,989		8,664		62,703		71,367		920
Commercial Real Estate- Non Owner Occupied		-		1,446		863		2,309		34,180		36,489		292
Second Mortgages		243		10		518		771		11,476		12,247		26
Non Real Estate Secured
Personal		244		113		134		491		23,540		24,031		41
Commercial		224		25		630		879		31,528		32,407		-
Agricultural		17		7		2		26		2,758		2,784		-
Total	$	5,766	$	3,546	$	15,864	$	25,176	$	383,179	$	408,355	$	1,450

9

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Loans are considered delinquent when payments have not been made according to the terms of the contract. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Credit card loans and other personal loans are typically charged off no later than 180 days past due.   In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

The following is a summary of non-accrual loans at September 30, 2012 and December 31, 2011:

	September 30, 2012		December 31, 2011
Real Estate Secured
Residential 1-4 Family	$	3,491	$	4,065
Multifamily		-		646
Construction and Land Loans		1,883		1,846
Commercial-Owner Occupied		4,496		6,069
Commercial- Non Owner Occupied		290		4,871
Second Mortgages		354		492
Equity Lines of Credit		-		-
Farmland		-		630
Secured (other) and Unsecured
Personal		50		94
Commercial		494		630
Agricultural		4		2
Total	$	11,062	$	19,345

The September 30, 2012 and December 31, 2011 totals include approximately $2.3 million and $4.9 million of loans, respectively, that were current and paying under the terms of their existing loan agreement but included in non-accrual per regulatory guidance.

10

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables represent a summary of credit quality indicators of the Company’s loan portfolio at September 30, 2012 and December 31, 2011. The grades are assigned and / or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of September  30, 2012

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	34,663	$	1,009	$	1,023	$	4,012	$	5,176	$	1,219
Satisfactory		79,200		12,289		3,033		6,286		25,448		14,786
Acceptable		37,296		2,729		6,326		6,179		19,511		8,431
Special Mention		3,546		-		10		1,759		4,327		1,676
Substandard		14,627		1,305		504		1,765		11,394		10,774
Doubtful		-		-		-		-		-		-
Total	$	169,332	$	17,332	$	10,896	$	20,001	$	65,856	$	36,886

Credit Risk Profile by Internally Assigned Grade as of December 31, 2011

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	37,509	$	1,220	$	1,104	$	4,108	$	6,119	$	1,604
Satisfactory		79,225		9,790		3,419		6,026		23,168		14,756
Acceptable		33,427		1,481		3,944		5,940		25,652		9,270
Special Mention		3,739		1,318		1,767		2,195		4,073		1,518
Substandard		15,127		1,566		1,973		5,026		12,355		9,341
Doubtful		-		-		-		-		-		-
Total	$	169,027	$	15,375	$	12,207	$	23,295	$	71,367	$	36,489

(1)  Quality--This grade is reserved for the Bank’s top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection.  Generally, loans assigned this rating will demonstrate the following characteristics:

· Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).

· Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.

· Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.

For existing loans, all of the requirements above apply plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are either stable or improving.

Satisfactory-This grade is given to performing loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this rating will demonstrate the following characteristics:

· General conformity to the Bank's policy requirements, product guidelines and underwriting standards.  Any exceptions that are identified during the underwriting and approval process have been adequately mitigated by other factors.

11

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

· Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  

· Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor

For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.

Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:

· Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.

· Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historical) performance.

· Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.

For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.

Special Mention -This grade is given to Watch List loans that include the following characteristics:

· Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.

· Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.

· Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.

  Substandard-Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 The weaknesses may include, but are not limited to:

· High debt to worth ratios and or declining or negative earnings trends

· Declining or inadequate liquidity

· Improper loan structure  or questionable repayment sources

· Lack of well-defined secondary repayment source, and

· Unfavorable competitive comparisons.

12

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.

Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.

However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:

· Injection of capital

· Alternative financing

· Liquidation of assets or the pledging of additional collateral.

Credit Risk Profile based on payment activity as of  September 30, 2012:

	Consumer - Non Real Estate		Equity Line of Credit / Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	23,319	$	18,109	$	32,433	$	3,344
Nonperforming (>90 days past due)		50		380		495		4
Total	$	23,369	$	18,489	$	32,928	$	3,348

Credit Risk Profile based on payment activity as of  December 31, 2011:

	Consumer - Non Real Estate		Equity Line of Credit /Jr. liens		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	23,897	$	20,855	$	31,777	$	2,782
Nonperforming (>90 days past due)		134		518		630		2
Total	$	24,031	$	21,373	$	32,407	$	2,784

13

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables reflect the Bank’s impaired loans at September 30, 2012:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	8,710	$	8,710	$	-	$	8,872	$	285
Equity lines of credit		-		-		-		-		-
Multifamily		898		898		-		909		46
Farmland		271		271		-		277		13
Construction, Land Development, Other Land Loans		1,655		1,655		-		2,071		42
Commercial Real Estate- Owner Occupied		8,282		8,282		-		8,719		162
Commercial Real Estate- Non Owner Occupied		9,193		9,193		-		7,026		221
Second Mortgages		220		220		-		406		9
Non Real Estate Secured
Personal /Consumer		51		51		-		41		1
Business Commercial		503		560		-		1,475		5
Agricultural		20		20		-		10		-
Total	$	29,803	$	29,860	$	-	$	29,806	$	784

14

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	4,717	$	4,717	$	416	$	4,262	$	107
Equity lines of credit		-		-		-		-		-
Multifamily		407		407		7		527		11
Farmland		204		204		3		256		10
Construction, Land Development, Other Land Loans		110		110		43		1,324		-
Commercial Real Estate- Owner Occupied		2,749		2,749		212		2,368		53
Commercial Real Estate- Non Owner Occupied		1,582		1,582		167		3,032		31
Second Mortgages		106		106		3		107		5
Non Real Estate Secured
Personal /Consumer		40		40		18		57		2
Business Commercial		660		660		516		758		11
Agricultural		716		1,385		131		358		57
Total	$	11,291	$	11,960	$	1,516	$	13,049	$	287

The following tables reflect the Bank’s impaired loans at December 31, 2011:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related    Allowance
Real Estate Secured
Residential 1-4 family	$	9,034	$	9,342	$	-	$	8,243	$	285
Equity lines of credit		-		-		-		-		-
Multifamily		920		920		-		480		63
Farmland		283		283		-		529		16
Construction, Land Development, Other Land Loans		2,487		2,487		-		3,170		108
Commercial Real Estate- Owner Occupied		9,155		9,155		-		7,327		187
Commercial Real Estate- Non Owner Occupied		4,859		4,859		-		4,183		143
Second Mortgages		591		591		-		646		6
Non Real Estate Secured
Personal		30		30		-		26		3
Commercial		2,446		3,115		-		1,856		64
Agricultural		-		-		-		-		-
Total	$	29,805	$	30,782	$	-	$	26,460	$	875

15

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	3,806	$	3,840	$	571	$	4,161	$	132
Equity lines of credit		-		-		-		-		-
Multifamily		646		866		201		1,139		11
Farmland		307		307		38		309		11
Construction, Land Development, Other Land Loans		2,538		2,538		606		4,787		80
Commercial Real Estate- Owner Occupied		1,986		2,086		323		3,132		11
Commercial Real Estate- Non Owner Occupied		4,482		4,482		343		4,758		54
Second Mortgages		108		108		10		138		4
Non Real Estate Secured
Personal		74		74		41		62		4
Commercial		856		856		675		1,494		22
Agricultural		-		-		-		14		-
Total	$	14,803	$	15,157	$	2,808	$	19,994	$	329

16

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment evaluation method as of September 30, 2012 and September 30, 2011.

Nine  months ended Sept. 30, 2012	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied		Second Mortgages			Equity Line of Credit		Farmland			Personal and Overdrafts		Commercial and Agricultural		Unallocated		Total
Allowance for Credit Losses:
Beginning Balance December 31,  2011	$	1,618		$	477	$	1,746		$	1,209		$	400	$	371		$	69	$	336		$	764	$	1,620	$	414		9,024
Provision for Credit Losses		(235	)		139		(889	)		(193	)		822		(65	)		7		(164	)		94		450		891		857
Charge-offs		313			246		448			183			686		68			23		4			309		566		-		2,846
Recoveries		158			-		452			-			5		2			-		2			63		132		-		814
Net Charge-offs		155			246		(4	)		183			681		66			23		2			246		434		-		2,032
Ending Balance Sept. 30, 2012		1,228			370		861			833			541		240			53		170			612		1,636		1,305		7,849
Ending Balance: Individually evaluated for impairment		416			7		43			212			167		3			-		3			18		647		-		1,516
Ending Balance:  Collectively Evaluated for Impairment		812			363		818			621			374		237			53		167			594		989		1,305		6,333
Loans:
Ending Balance: Individually Evaluated for Impairment		13,427			1,305		1,765			11,031			10,775		326			-		475			91		1,899		-		41,094
Ending Balance: Collectively Evaluated for Impairment		155,905			16,027		18,236			54,825			26,111		9,711			8,452		10,421			23,278		34,377		-		357,343
Ending Balance: Sept.  30, 2012	$	169,332		$	17,332	$	20,001		$	65,856		$	36,886	$	10,037		$	8,452	$	10,896		$	23,369	$	36,276		-	$	398,437

17

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Nine  months ended Sept. 30, 2011	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied		Commercial Non-Owner Occupied			Second Mortgages			Equity Line of Credit		Farmland			Personal and Overdrafts			Commercial and Agricultural			Unallocated			Total
Allowance for Credit Losses:
Beginning Balance December 31,  2010	$	1,521		$	229	$	2,155		$	504	$	1,353		$	323		$	83	$	229		$	516		$	2,185		$	1,222			10,320
Provision for Credit Losses		699			491		1,471			1,012		(847	)		551			22		425			665			525			(776	)		4,238
Charge-offs		445			203		1,729			276		89			351			26		272			442			942			-			4,775
Recoveries		(6	)		-		(53	)		-		-			(10	)		-		(20	)		(53	)		(13	)		-			(155	)
Net Charge-offs		439			203		1,676			276		89			341			26		252			389			929			-			4,620
Ending Balance Sept. 30, 2011		1,781			517		1,950			1,240		417			533			79		402			792			1,781			446			9,938
Ending Balance: Individually evaluated for impairment		999			269		625			490		348			78			-		40			42			715			-			3,606
Ending Balance:  Collectively Evaluated for Impairment		782			248		1,325			750		69			455			79		362			750			1,066			446			6,332
Loans:
Ending Balance: Individually Evaluated for Impairment		14,233			1,879		5,262			11,999		7,986			701			-		458			111			3,336			-			45,965
Ending Balance: Collectively Evaluated for Impairment		157,686			12,356		18,018			62,971		28,419			12,717			9,511		11,247			24,150			33,175			-			370,250
Ending Balance: Sept.  30, 2011	$	171,919		$	14,235	$	23,280		$	74,970	$	36,405		$	13,418		$	9,511	$	11,705		$	24,261		$	36,511			-		$	416,215

18

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

A loan is considered impaired when the collection of interest and principal is in doubt. An allowance for loan loss is established on loans for which it is probable that the full collection of principal is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2012, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, are analyzed to determine whether they may be impaired. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans with the following characteristics may be analyzed for impairment:

• A loan is 60 days or more delinquent on scheduled principal or interest;

• A loan is presently in an unapproved over advanced position;

• A loan is newly modified; or

• A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings. Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $19.14 million and $16.03 million of loans categorized as troubled debt restructurings as of September 30, 2012 and December 31, 2011, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed likely.

In the determination of the allowance for loan losses, management considers troubled debt restructurings and subsequent defaults in these restructurings by adjusting the loan grades of such loans. Defaults resulting in charge-offs affect the historical loss experience ratios which are a component of the allowance calculation. Additionally, specific reserves may be established on restructured loans which are evaluated individually.

19

Notes to Consolidated Financial Statements

(Unaudited)

(dollars in thousands, except share, per share and percentage data)

The following is a summary of troubled debt restructurings occurring during the nine months ended September 30, 2012.

Troubled Debt Restructurings Interest only	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family		1	$	729	$	729
Equity lines of credit
Multifamily
Farmland		1		138		138
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages		1		84		84
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total		3	$	951	$	951

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family		1	$	885	$	878
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		1		2,270		2,248
Commercial Real Estate-  Non Owner Occupied		4		8,031		7,968
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total		6	$	11,186	$	11,094

20

Notes to Consolidated Financial Statements

(Unaudited)

(dollars in thousands, except share, per share and percentage data)

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family		1	$	111	$	111
Equity lines of credit
Multifamily		1		411		407
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		2		1,017		1,003
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer		1		28		28
Business Commercial
Agricultural		1		129		129
Total		6	$	1,696	$	1,678
Troubled Debt Restructurings All	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment ��at period end
Total Restructurings		15	$	13,833	$	13,723

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts		Pre- Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family  (Loan Term Extension)		1	$	111	$	111
Commercial Real Estate-  Owner Occupied (Loan Term Extension)		1		285		278
Total		2		396		389

21

Notes to Consolidated Financial Statements

(Unaudited)

(dollars in thousands, except share, per share and percentage data)

The following is a summary of troubled debt restructurings occurring during the nine months ended September 30, 2011.

Troubled Debt Restructurings Interest only	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland		1	$	152	$	152
Construction, Land Development, Other Land Loans		1		1,364		834
Commercial Real Estate-  Owner Occupied		3		1,349		1,349
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial		1		992		992
Agricultural		1		129		129
Total		7	$	3,986	$	3,456

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured		-		-		-
Residential 1-4 family		2		850		847
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate-  Owner Occupied		-		-		-
Commercial Real Estate-  Non Owner Occupied		3	$	5,201	$	5,195
Second Mortgages		-		-		-
Non Real Estate Secured		-		-		-
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-
Total		5	$	6,051	$	6,042

22

Notes to Consolidated Financial Statements

(Unaudited)

(dollars in thousands, except share, per share and percentage data)

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Residential 1-4 family		1	$	729	$	729
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		1		69		69
Commercial Real Estate-  Non Owner Occupied
Second Mortgages		1		83		83
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural		2		1,429		780
Total		5	$	2,310	$	1,661
Troubled Debt Restructurings All	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment  at period end
Total Restructurings		17	$	12,347	$	11,159

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts		Pre-Modification  Outstanding Recorded Investment		Recorded Investment at period end
Real Estate Secured
Construction, Land Development, Other Land Loans  (Interest Only)		1	$	1,364	$	834
Commercial Real Estate-  Owner Occupied (Interest Only)		2		742		742
Commercial Real Estate-  Owner Occupied (Loan Term Extension)		1		69		69
Total		4	$	2,175	$	1,645

23

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Overview of Loan Review and ALLL Processes

The loan review function performs various tasks that are utilized to discover weaknesses within the loan portfolio.  These include annual reviews on loan relationships that are greater than $500,000.  The relationship review includes a discussion on the collateral, repayment history, guarantor(s) financial position, and debt service coverage on an individual and global level.  These reviews are based primarily upon federal tax returns for cash flow determination, internally prepared interim statements and personal financial statements.  Debt service coverage (DSC) is calculated on each individual customer, or guarantor, as well as the aggregate or global DSC.  The DSC is discounted to determine a “stressed” DSC.  Collateral evaluation includes an inspection of the collateral file to determine if the bank is indeed properly secured.  Collateral is discounted, when appropriate, to determine a “stressed” LTV.   In addition to annual loan relationship reviews, quarterly reviews are completed on all loans that are graded Substandard, Doubtful and Loss and are on the watch list, which includes all loan relationships that are greater than $100,000.  This quarterly review process is comprised of a shortened version of the full relationship review.  These quarterly reviews include a discussion on personal credit management, DSC and LTV.  In addition to these quarterly reviews of all non-pass watch list relationships, a semi-annual review is conducted on all Special Mention loan relationships that are on the watch list.  These reviews are prepared in the same manner as the quarterly non-pass relationship reviews.  The appropriateness of the risk rating of each relationship is assessed, with changes to the risk rating being made by the Senior Credit Review Officer, when deemed appropriate. Other measures taken to determine potential problem relationships include the monthly preparation of the watch list.  During that process, past due loan reports are reviewed, as well as any other information that might be presented by loan officers, regarding a particular loan relationship that is exhibiting stress.  To be considered as a watch list relationship, distinct characteristics must be exhibited.  These include, but are not limited to late payments greater than 60 days, a low DSC calculation, bankruptcy filings, casualty losses, or other issues that would cause a perceived increase in the risk of loss to the Bank. The final segment of the loan review process involves special reviews.  These reviews target specific segments of the loan portfolio, i.e. credit cards, equity lines, consumer loans, construction loans, and other specific segments of the loan portfolio that management wishes to have reviewed.  However, currently, the primary emphasis of the loan review function is loan relationship review work, and watch list management.

The following describes the Company’s basic methodology for computing its ALLL.

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to individual impairment.  All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be individually impaired.  All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans, together with any Troubled Debt Restructured (TDR) loan, may warrant further analysis before completing an assessment of impairment.  For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:

(1) Present value of expected future cash flows discounted at the loan’s effective interest rate;

(2) Loan’s observable market price; or

(3) Fair value of the collateral.

To determine the amount of loan loss exposure for the impaired ASC 310 loans, the value of collateral for secured loans is evaluated to determine the current value and potential exposure.  The collateral value is adjusted for its age and condition, and, for real estate, adjusted for condition, location, and age of the most current appraisal.  If the adjusted value of the collateral is less than the current principal balance, the difference is designated as direct exposure for loan loss calculations.

24

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Bank uses standard call report categories to segregate loans into groups with similar risk characteristics.

Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Bank’s loan portfolio are divided into three major categories:

(1) Historical Loss Factor: To calculate the anticipated loan loss in each call report category for ASC 450 loans, the bank begins with the net loss in each category for each of the last twelve quarters.  The Bank uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters.  The total of weighted factors for each call report category is applied to the current outstanding loan balance in this category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.

(2) External economic factors:  Economic conditions have a significant impact on the Bank’s loan portfolio because deteriorating conditions can adversely impact both collateral values and the customer’s ability to service debt.  Management has selected the following external factors as indicators of economic conditions:

a. National GDP Growth Rate

b. Local Unemployment Rates

c. The Prime Rate

  The values for external factors are updated on a quarterly basis based on current economic data.

(3) Internal process factors:  Internal factors that influence loss rates as a result of risk management and control practices include the following:

a. Past-Due Loans.

b. Non-Accrual Loans

c. CRE Concentrations

d. Loan Volume Level

e. Level and Trend of Classified Loans

  The values for internal factors are updated on a quarterly basis based on current portfolio metrics.

We maintain an unallocated component to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Once the quarterly ALLL is computed, the calculations are reviewed by the Company’s credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company’s controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.

25

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 3  -  Income Taxes

Income tax expense (benefit) for the nine months ended September 30 is different than the amount computed by applying the statutory corporate federal income tax rate of 34% to income before taxes.  The reasons for these differences are as follows:

	2012			2011
Tax expense (benefit) at statutory rate	$	806		$	(1,207	)
Reduction in taxes from:
Tax-exempt interest		(181	)		(237	)
Other, net		(106	)		(80	)
Income tax expense (benefit)	$	519		$	(1,524	)

Note 4  - Capital Requirements

Regulators of the Company and its subsidiary, Highlands Union Bank (the “Bank”), have implemented risk-based capital guidelines which require compliance with certain minimum capital ratios as a percent of assets and other certain off-balance sheet items that are adjusted for predefined credit risk factors.  The regulatory minimum for Tier 1 and combined Tier 1 and Tier 2 capital ratios are 4.0% and 8.0%, respectively.  Tier 1 capital includes tangible equity reduced by goodwill and certain other intangibles.  Tier 2 capital includes portions of the allowance for loan losses, not to exceed Tier 1 capital. In addition to the risk-based guidelines, a minimum leverage ratio (Tier 1 capital as a percentage of average total consolidated assets) of 4.0% is required. The following table presents the capital ratios for the Company and the Bank.

September 30, 2012
Entity	Tier 1			Total Risk Based			Leverage
Highlands Bankshares, Inc.		7.63	%		8.89	%		5.13	%
Highlands Union Bank		8.52	%		9.78	%		5.73	%

December 31, 2011
Entity	Tier 1			Total Risk Based			Leverage
Highlands Bankshares, Inc.		7.03	%		8.29	%		4.57	%
Highlands Union Bank		7.81	%		9.08	%		5.07	%

During the first quarter of 2011, the Bank’s total risk based capital ratio fell below the required minimum to be “well - capitalized.” The Bank’s Tier 1 Capital to Risk Weighted assets ratio and Tier 1 capital to Adjusted Total Assets remained above the “well-capitalized” thresholds. Because the Bank’s total risk-based capital ratio was below 10% as of December 31, 2011 and September 30 2012, the Bank is considered to be “adequately-capitalized” under the regulatory framework for prompt corrective action.  As a result of its status as “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered deposits without prior regulatory approval and may not offer interest rates on deposit accounts that are significantly higher than the average rates in its market area.

26

Notes to Consolidated Financial Statements

(Unaudited)

(dollars in thousands, except share, per share and percentage data)

The Bank has increased its total risk based capital ratio from 9.08% at December 31, 2011 to 9.78% at September 30, 2012.

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of $2.3125 Preferred Securities (the “Trust Preferred Securities”) on January 23, 1998.  These Trust Preferred Securities were issued by Highlands Capital Trust I, a wholly owned subsidiary of the Company.

Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the debt securities, which results in a deferral of distribution payments on the related Capital Securities. Effective April 15, 2010, the Company began deferring interest payments on the debt securities held by Highlands Capital Trust I.  As a result, distribution payments to holders of the Capital Securities are also being deferred.

Note 6 – Per Share Amounts

The following table contains information regarding the Company’s computation of basic earnings (loss) per share and diluted earnings (loss) per share for the nine and three months ended September 30, 2012 and 2011.

	Nine Months Ended September 30,					Three Months Ended September 30,
	2012		2011			2012		2011
Basic Earnings  (loss) per Share	$	0.37	$	(0.41	)	$	0.16	$	0.01
Basic Number of Shares		5,011,152		5,011,152			5,011,152		5,011,152
Diluted Earnings (loss) per Share	$	0.37	$	(0.41	)	$	0.16	$	0.01
Diluted Number of Shares		5,011,152		5,011,152			5,011,152		5,011,152

Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2012, these commitments included: standby letters of credit of $717 thousand; equity lines of credit of $9.74 million; credit card lines of credit of $5.74 million; commercial real estate, construction and land development commitments of $2.21 million; and other unused commitments to fund interest earning assets of $26.28 million.

27

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note  8 – Fair Value

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

Fair Value Hierarchy

Under ASC Topic 820 on Fair Value Measurements and Disclosures, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1	Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2	Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3	Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon third party models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

28

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Recurring - Investment Securities Available for Sale

Securities classified as available for sale are reported at fair value utilizing Level 2 and Level 3 inputs. For Level 2 securities, the Company obtains fair value measurements from multiple independent third party sources. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things.

As of September 30, 2012, we own approximately $3.88 million (amortized cost) in collateralized debt obligation securities (TRUP CDOs) that are backed by trust preferred securities issued by banks, thrifts, and insurance companies.  The market for these and similar securities at September 30, 2012 is not active.  The TRUP CDOs have been classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required for fair value assessment at the measurement date.

The remaining securities in the Company’s available for sale securities portfolio are classified within the Level 2 hierarchy using inputs from independent pricing models.

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy.

	September 30, 2012
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
US Treasuries	$	-	$	-	$	-	$	-
State and Political Subdivisions	$	-	$	12,808	$	-	$	12,808
Mortgage Backed Securities	$	-	$	29,643	$	-	$	29,643
TRUP CDO’s	$	-	$	-	$	283	$	283
Single Issue Trust Preferred	$	-	$	870	$	-	$	870
SBA Pools	$	-	$	15,681	$	-	$	15,681
SLMA	$	-	$	503	$	-	$	503
Total AFS Securities	$	-	$	59,505	$	283	$	59,788

	December 31, 2011
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
US Treasuries	$	-	$	6,032	$	-	$	6,032
State and Political Subdivisions	$	-	$	18,168	$	-	$	18,168
Mortgage Backed Securities	$	-	$	30,629	$	-	$	30,629
TRUP CDO’s	$	-	$	-	$	150	$	150
Single Issue Trust Preferred	$	-	$	1,815	$	-	$	1,815
SBA Pools	$	-	$	6,996	$	-	$	6,996
SLMA	$	-	$	462	$	-	$	462
Total AFS Securities	$	-	$	64,102	$	150	$	64,252

29

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Pursuant to ASC Topic 820, the following table shows a reconciliation of the beginning and ending balance at September 30, 2012 for Level 3 assets measured on a recurring basis using significant unobservable inputs. Level 3 assets represent the Company’s TRUP CDOs.

Investment Securities Available for Sale

Beginning balance, December 31, 2011	$	150
Total losses included in net income		(167	)
Included in other comprehensive income		300
Transfers in or out of Level 3		--
Ending balance, September 30, 2012	$	283

The losses included in net income represent the other than temporary impairment charges taken during the nine months ended September 30, 2012 for the securities classified as Level 3.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. At September 30, 2012 all of the total impaired loans were evaluated based on the fair value of the collateral. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. The following tables summarize the Company’s impaired loans by loan category at fair value on a non - recurring basis as of September 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy for which a specific allowance has been allocated.

	September 30, 2012
	Level 1	Level 2		Level 3	Total Fair Value
Real Estate Secured
Residential 1-4 family		$	4,717		$	4,717
Farmland			204			204
Multifamilty			407			407
Construction, Land Development,    Other  Land Loans			110			110
Commercial Real Estate – Owner Occupied			2,749			2,749
Commercial Real Estate – Non Owner Occupied			1,582			1,582
Second Mortgages			106			106
Non Real Estate Secured
Personal			40			40
Business / Commercial			660			660
Agricultural			716			716
Total		$	11,291		$	11,291

30

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

	December 31, 2011
	Level 1	Level 2		Level 3	Total Fair Value
Real Estate Secured
Residential 1-4 family		$	3,806		$	3,806
Multifamily			646			646
Farmland			307			307
Construction, Land Development,    Other  Land Loans			2,538			2,538
Commercial Real Estate – Owner Occupied			1,986			1,986
Commercial Real Estate – Non Owner Occupied			4,482			4,482
Second Mortgages			108			108
Non Real Estate Secured
Personal			74			74
Business / Commercial			856			856
Total		$	14,803		$	14,803

Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. If additional specific write-downs have occurred, then the foreclosed asset balances are reclassified as non-recurring Level 3. The following tables summarize the Company’s foreclosed and repossessed assets at fair value on a non-recurring basis as of September 30, 2012 and December 31, 2011

	September 30, 2012
	Level 1		Level 2		Level 3		Total Fair Value
Repossessions/OREO, net		--	$	18,020		--	$	18,020

	December 31, 2011
	Level 1		Level 2		Level 3		Total Fair Value
Repossessions/OREO,net		--	$	16,852		--	$	16,852

31

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

General

The Company has no liabilities carried at fair value or measured at fair value on a non-recurring basis.

Fair Value of Financial Instruments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Company’s various financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Cash and Cash Equivalents

The carrying amount reported in the balance sheets for cash, short-term investments and federal funds sold approximates fair value.

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

Other investments include Federal Home Loan Bank stock, Federal Reserve Bank stock, Community Bankers Bank stock, and Pacific Coast Bankers Bank.  The carrying value of those securities approximates fair value based on the redemption provisions of those Banks. Also included in other investments are certificates of deposit purchased from other FDIC insured banks in which the carrying amount approximates fair value.

Loans

The fair value of loans represent the amount at which the loans of the Bank could be exchanged on the open market, based upon the current lending rate for similar types of lending arrangements discounted over the remaining life of the loans. For fixed rate loans and for variable rate loans with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the cash flow analysis.

Deposits

The fair value of time deposits is based on discounted cash flows using current market rates applied to the cash flow analysis for each time deposit. Other non-maturity deposits are reported at their carrying values.

Other Short-Term Borrowings

Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. Estimated maturity dates are also included in the calculation of fair value for these borrowings.

32

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Long-term Debt and Capital Securities

Rates currently available to the Company for debt with similar terms and remaining maturities or established call prices are used to estimate fair value of existing debt.

Off-Balance Sheet Instruments

The amount of off-balance sheet commitments to extend credit, standby letters of credit, and financial guarantees, is considered equal to fair value.  Because of the uncertainty involved in attempting to assess the likelihood and timing of commitments being drawn upon, coupled with the lack of an established market and the wide diversity of fee structures, the Company does not believe it is meaningful to provide an estimate of fair value that differs from the given value of the commitment.

The carrying amounts and fair values of the Company's financial instruments at September 30, 2012 and December 31, 2011 were as follows:

	September 30, 2012						December 31, 2011
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	76,814		$	76,814		$	86,075		$	86,075
Securities available for sale		59,788			59,788			64,252			64,252
Other investments		4,931			4,931			5,308			5,308
Loans, net		390,035			390,145			398,780			398,221
Deposits		(491,634	)		(488,028	)		(515,361	)		(508,599	)
Other short-term  borrowings		(20,175	)		(23,251	)		(57,676	)		(65,844	)
Long-term debt		(51,336	)		(57,500	)		(13,964	)		(14,951	)
Capital Securities		(3,150	)		(3,014	)		(3,150	)		(3,014	)

33

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note  9. -Investment Securities Available For Sale

The amortized cost and market value of securities available for sale are as follows:

	September 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
US Treasuries	$	-		-		-	$	-
State and political subdivisions		12,465		346		3		12,808
Mortgage backed securities		28,892		757		6		29,643
TRUP CDOs		3,886		-		3,603		283
Single Issue Trust Preferred		909		-		39		870
SBA Pools		15,770		15		104		15,681
SLMA		500		3		-		503
	$	62,422	$	1,121	$	3,755	$	59,788

	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S  Treasuries	$	6,029	$	3	$	-	$	6,032
State and political subdivisions		18,030		275		137		18,168
Mortgage backed securities		30,002		632		5		30,629
TRUP CDOs		4,067		-		3,917		150
Single Issue Trust Preferred		1,923		-		108		1,815
SBA Pools		6,821		219		44		6,996
SLMA		500		-		38		462
	$	67,372	$	1,129	$	4,249	$	64,252

Investment securities available for sale with a carrying value of $44,670 and $45,258 at September 30, 2012 and December 31, 2011, respectively, and a market value of $45,611 and $46,011 at Septmeber 30, 2012 and December 31, 2011, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

34

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following table presents the age of gross unrealized losses and fair value by investment category:

	September 30, 2012
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
States and political subdivisions	$	360	$	3		-		-	$	360	$	3
Mortgage-backed securities		505		6		-		-		505		6
Pooled Trust Preferred Securities		-		-		283		3,603		283		3,603
Single Issue Trust Preferred		-		-		870		39		870		39
SBA Pools		10,848		96		1,705		8		12,553		104
SLMA		-		-		-		-		-		-
Total	$	11,713	$	105	$	2,858	$	3,650	$	14,571	$	3,755

	December 31, 2011
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and political subdivisions	$	705	$	45	$	4,367	$	92	$	5,072	$	137
Mortgage-backed securities		4,554		5		-		-		4,554		5
Pooled Trust Preferred Securities		-		-		150		3,917		150		3,917
Single Issue Trust Preferred		505		7		809		101		1,314		108
SBA Pools		-		-		2,007		44		2,007		44
SLMA		-		-		462		38		462		38
Total	$	5,764	$	57	$	7,795	$	4,192	$	13,559	$	4,249

35

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The segment of our portfolio that contains the largest unrealized loss is our pooled trust preferred securities (“TRUP CDOs”) which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. As of September 30, 2012, our TRUP CDOs book value totaled $3.88 million.

The Company reviews its investment portfolio on a quarterly basis for indications of other-than-temporary impairment (“OTTI”).

For other than temporary impairment analysis, the Company measures the change in projected cash flows for securitized assets, specifically, how the current projected cash flows differ from the most recent projection (e.g. as of the last quarter). A decrease in the present value of projected cash flows is considered an “adverse change” and may trigger a charge for other-than-temporary impairment. The Company formally analyzes the credit characteristics of the underlying collateral on each individual security as a basis for credit deferral / default assumptions.   This methodology is documented and reviewed with the audit committee quarterly for determining impairment.  Additionally, the Company utilizes certain data contained in the baseline deferral / default assumptions that were developed by the FDIC (from default data during the 1988-1992 periods). The Company’s credit evaluation of each of the entities comprising the underlying collateral considers all available information and evidence.  The initial credit evaluation focuses on asset quality (using the Texas Ratio and Modified Texas Ratio), capitalization (using Leverage, Tier 1 and Total Risk Based Capital), third party ratings of financial strength, the ratio of reserve for loan losses to loans and current earnings performance. For those underlying issuers that are determined to be potentially impaired based on the initial review, a more detailed quarterly trend analysis is completed. This analysis focuses on trends related to non-performing assets, reserve for loan losses, capitalization and earnings performance. The results of the internal assessment are factored into an analysis stressing the projections of cash flow.

At September 30, 2012, the following assumptions were used in the cash flow projections:

·       Deferral / default ranges for 2012 – 1.00% to 2.00%

·       Deferral / default rate for 2013 – 1.00%

·       Deferral / default ranges for years thereafter – 0.25% to 0.36%

·       Prepayments - 1% annually, 100% at maturity

·       The discount rate is calculated using the original discount margin as of the purchase date based on the purchase price added to the appropriate forward 3-month LIBOR rate

·       15% recovery with 2 year lag extended to 5 years if has been in deferral for 2 years

·       0% recovery on existing defaults

·       Cash flows are discounted at the effective interest rate

Underlying banks can prepay their trust preferred securities on a quarterly call date after a five year period from the original date of issue. The Company uses a constant prepayment assumption of 1% annually and 100% at maturity. The extent of future prepayments is difficult to project. The projections also include for existing deferrals a 15% recovery  after a two-year lag (if an issuer has been in deferral for two years, the Company extends the assumed recovery to the end of the 5-year deferral period, or an additional 3 years).

Deferral and default announcements that are received after the balance sheet date but before the filing date are incorporated into the OTTI calculation for the period end report. Typically deferral announcements are received on or around each payment date which is the last week of each quarter.

36

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

During the first quarter of 2012, the Company incurred credit-related OTTI charges on our TRUP CDOs of $167 thousand. No OTTI charges were incurred in the second or third quarters of 2012. For the nine months ended September 30, 2011, the Company incurred a total of $269 thousand of OTTI charges.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of September 30, 2012 and December 31, 2011, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at September 30, 2012 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Approximate Market Value
Due in one year or less	$	-	$	-
Due after one year through five years		500		503
Due after five years through ten years		4,825		4,850
Due after ten years		28,204		24,791
		33,529		30,144
Mortgage-backed securities		28,893		29,644
	$	62,422	$	59,788

Note 10–Formal Written Agreement

On October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

· strengthen board oversight of the management and operations of the Bank;

· strengthen credit risk management and administration;

· provide for the effective grading of the Bank’s loan portfolio;

· summarize the findings of its review of the adequacy of the staffing of its loan review function;

· improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;

· review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;

· maintain sufficient capital at the Company and the Bank;

· establish a revised written contingency funding plan;

· establish a revised written strategic and capital plan;

· establish a revised investment policy;

· improve the Bank’s earnings and overall condition;

· revise the Bank’s information technology program;

· establish a disaster recovery and business continuity program; and

· establish a committee to monitor compliance with all aspects of the written agreement.

37

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in Bank’s capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.

Note  11 – Summary of Significant Accounting Policy Update For Certain Required Disclosures

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03.  The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control.  The other criteria to assess effective control were not changed.  The amendments were effective for the Company on January 1, 2012 and had no effect on the financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements.  The amendments were effective for the Company beginning January 1, 2012 and had no effect on the financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011.  The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and requires consecutive presentation of the statement of net income and other comprehensive income.  The amendments were applicable to the Company on January 1, 2012 and have been applied retrospectively.  In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements.  Companies should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the amendments while FASB redeliberates future requirements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 12 – Federal Home Loan Bank Advances

During the third quarter of 2012, the Bank restructured $47.50 million of its $67.91 million of Federal Home Loan Bank (FHLB) borrowings. This restructuring resulted in a decrease in the weighted average borrowing rate by approximately 100 basis points or approximately $480,000 in reduced interest expense annually.  It also extended the average maturity dates on these borrowings by approximately 2.5 years. $37.5 million of these borrowings were previously shown as short term borrowings due to the FHLB’s option to convert these advances to a floating rate on a quarterly basis. The advances were restructured to straight fixed rate advances with maturity dates now ranging from 2017 to 2019.

38

ITEM 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is provided to address information about the Company’s financial condition and results of operations that is not otherwise apparent from the Consolidated Financial Statements and the notes thereto or included in this report.  Reference should be made to those statements and the notes thereto for an understanding of the following discussion and analysis.

The Company generates a significant amount of its income from the net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. The Company’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses. Highlands Union Insurance Services and Highlands Union Financial Services, which are subsidiaries of Highlands Union Bank, generate fee income by providing insurance and financial service products to its clients.

Critical Accounting Policy

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  For a discussion of the Company’s critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Regulatory Economic Environment

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law.  The Dodd-Frank Act contains significant modifications to the current bank regulatory structure and requires various federal agencies to adopt a broad range of new rules and regulations throughout 2012 and beyond.  While not determinable at this time, the impact of the Dodd-Frank Act and the rules and regulations that will be promulgated there-under could significantly affect our operations, increase our operating costs and divert management resources and attention from the primary business of the Bank.

On April 5, 2012, President Obama signed into law the Jumpstart our Business Startups Act, (the “JOBS Act”).  The JOBS Act significantly amends federal securities laws to relax the general solicitation and general advertising prohibitions in private placements, creates a new public offering exemption for offerings up to $50 million and increases the threshold number of shareholders of record over which companies are required to register with the SEC and begin filing periodic public reports.  The JOBS Act also increased the threshold number of shareholders of record for bank holding companies to deregister with the SEC and cease filing periodic public reports. The Company’s shareholder base currently exceeds this amended threshold, but in the event that the Company’s number of shareholders of record decreases in the future, the Company may consider deregistering to save the significant expense associated with SEC reporting.

Formal Written Agreement

As discussed in Footnote 10, on October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

39

· strengthen board oversight of the management and operations of the Bank;

· strengthen credit risk management and administration;

· provide for the effective grading of the Bank’s loan portfolio;

· summarize the findings of its review of the adequacy of the staffing of its loan review function;

· improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;

· review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;

· maintain sufficient capital at the Company and the Bank;

· establish a revised written contingency funding plan;

· establish a revised investment policy;

· establish a revised written strategic and capital plan;

· improve the Bank’s earnings and overall condition;

· revise the Bank’s information technology program;

· establish a disaster recovery and business continuity program; and

· establish a committee to monitor compliance with all aspects of the written agreement.

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in the Bank’s capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.

The following summarizes the Company’s progress to comply with the items in the Written Agreement as of September 2012.

· A new board oversight policy has been approved and implemented;

· Completed revising the Bank’s loan grading system and ALLLR methodology;

· Implemented Problem Loan Action reports and Problem Asset reports for all assets over $500,000 which are reviewed with the Board and forwarded to the Federal Reserve Bank on a quarterly basis;

· Completed revising the written contingency funding plan;

· Completed revising the investment policy;

· Completed revising the strategic and capital plan;

· Implemented a capital plan targeted to improve the Company’s and Bank’s capital levels to include strategically reducing the risk weighted assets of the Bank, improvement in earnings as well as exploring options to raise additional capital;

· Completed a Business Continuity Plan and Disaster Recovery Plan; and

· Formed a Directors Compliance Committee to monitor the progress of each item in the written agreement that meets at least quarterly and files a report with the Federal Reserve Bank

Results of Operations

Results of operations for the three-month and nine-month periods ended September 30, 2012 reflected earnings of $782 thousand and $1.85 million, respectively. For the first nine months of 2012, provisions for loan loss reserves decreased $3.38 million from the corresponding period in 2011 as the Company’s non-performing loans decreased significantly over the prior 12 months. The Company reported a net loss of $2.03 million for the nine months ended September 30, 2011 and earnings of $75 thousand for the three-month period ended September 30, 2011.

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Net interest income for the three-month period ended September 30, 2012 increased $21 thousand or 0.48% compared to the three months ended September 30, 2011. For the nine-month period ended September 30, 2012 net interest income increased $174 thousand or 1.33% as compared to the nine-month period ended September 30, 2011.  Average interest-earning assets decreased $30.16 million from the nine-month period ended September 30, 2011 to the current nine-month period, while average interest-bearing liabilities decreased $45.19 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.86% for the nine-month period ended September 30, 2012 representing a decrease of 13 basis points from the same period in 2011.  The average balance of federal funds sold during the quarter was $60.10 million during the period. The average yield on federal funds sold was .22% during the period. The rate on average interest-bearing liabilities decreased 31 basis points to 1.67% for the nine - month period ended September 30, 2012 as compared to 1.98% for the same period in 2011.

Total interest income for the three and nine months ended September 30, 2012 was $632 thousand and $1.58 million less than the comparable 2011 periods due primarily to a reduction in loan and securities balances, new loan and investment securities volume being booked at lower rates, and existing adjustable rate loans and investment securities re-pricing at lower rates. Yields on typical investment securities during the current economic cycle have decreased significantly; therefore, management has intentionally decreased its security portfolio and maintained a significant amount of cash and cash equivalents during 2012 and 2011. The majority of pay-downs during the last year have been SBAs, US treasuries, and agency mortgage backed securities. The Company has also reduced its municipal bond holdings by approximately $19.38 million over the last 24 months in an effort to reduce its exposure to municipal debt and related potential credit risk. This has negatively affected the Company’s net interest income as these proceeds were placed back into overnight federal funds sold balances.

The Company’s total interest expense decreased by $653 thousand for the three months and $1.76 million for the nine months from the same periods in 2011, due primarily to the overall reduction in time deposit balances. Additionally, new interest-bearing deposits are continuing to be recorded at lower rates and existing interest-bearing deposits and other liabilities are re-pricing lower as they renew. The Company continues to face considerable competition in all of its market areas as it pertains to rates on deposits.

During the first nine months of 2012, the Company’s non-interest income increased by $398 thousand over the corresponding period for 2011. OTTI write-downs for the first nine months of 2012 were $167 compared to $269 for the first nine months of 2011. Total non-interest income for the three months ended September 30, 2012 increased $120 thousand over the three month period ended September 30, 2011 due primarily to an increase in security gains of $350 thousand.

Total non-interest expense for the nine-month period ended September 30, 2012 decreased $1.97 million as compared to the nine-month period ended September 30, 2011. FDIC insurance premiums totaled $1 million and decreased $156 thousand for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. OREO expenses, write-downs and losses on the sale of OREO and repossessions in the amount of $1.04 million decreased $1.30 million for the nine month period ended September 30, 2012 as compared to the prior period. Salaries and employee benefits decreased $491 thousand for the nine months ended September 30, 2012 as compared to the prior year period as the Company has reduced its number of employees and additionally has seen a reduction in medical insurance costs. Total non-interest expense for the three-month period ended September 30, 2012 decreased $749 thousand compared to the three-month period ended September 30, 2011. This decrease was largely a result of decreased expenses and write-downs related to foreclosed properties and a decrease in salaries and employee benefits.

In addition to FDIC insurance premiums, for the nine months ended September 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $608 thousand, software licensing and maintenance costs totaling $558 thousand, legal expenses totaling $300 thousand and postage and freight expenses totaling $211 thousand.

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In addition to FDIC insurance premiums that totaled $1.16 million, for the nine months ended September 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $469 thousand, software licensing and maintenance costs totaling $451 thousand, postage and freight totaling $228 thousand, other loan expense totaling $212 thousand and legal expenses totaling $349 thousand.

For the three month period ended September 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $330 thousand, legal expenses totaling $79 thousand, other contracted services totaling $152 thousand and software licensing and maintenance totaling $171 thousand.

For the three-month period ended September 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $367 thousand, legal expenses totaling $109 thousand, other contracted services totaling $159 thousand, postage and freight totaling $90 thousand, other loan expense of $86 thousand and software licensing and maintenance totaling $153 thousand.

Operating results of the Company when measured as a percentage of average equity reveals an increase in return on average equity to 8.40% for the nine-month period ended September 30, 2012 from (8.47%) for the corresponding period in 2011. Return on average assets for the nine months ended September 30, 2012 was 0.41% compared to (0.42%) for the nine months ended September 30, 2011.The provision for loan losses for the three-month and nine month periods ended September 30, 2012 totaled $236 thousand and $857 thousand, respectively, a $213 thousand decrease and $3.38 million decrease as compared to the corresponding periods in 2011. This decreased provision during the first nine months of 2012 was primarily due to the Company’s improved asset quality, primarily non-accrual loans, a reduction in charge-offs, and a significant increase in recoveries. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels.  Net charge-offs (inclusive of recoveries) for the first nine months of 2012 were $2.03 million compared with $4.62 million for the first nine months of 2011. Year–to–date net charge-offs were 0.51% and 1.11% of total loans for the periods ended September 30, 2012 and September 30, 2011, respectively. Loan loss reserves decreased 21.02% to $7.85 million at September 30, 2012 from $9.94 million at September 30, 2011.  The Company’s allowance for loan loss reserves at September 30, 2012 decreased to 1.97% of total loans versus 2.39% at September 30, 2011.  At December 31, 2011, the allowance for loan loss reserve as a percentage of total loans was 2.21%.

Financial Position

Total loans decreased from $415.66 million at September 30, 2011 to $397.88 million at September 30, 2012.  Total loans at December 31, 2011 were $407.81 million. Over the last 3 years, the Company has significantly decreased its construction portfolio as a result of the economic downturn. Since September 30, 2009 the Company has reduced its construction loan and other land loan balances approximately $27.44 million. The Company has also been reducing its overall commercial real estate loan portfolio in an effort to increase its risk based capital ratios. Overall loan demand has slowed significantly over the last 3 years due to the recessionary environment. The Company’s current focus is to moderately increase its 1-4 family residential loan portfolio. The loan to deposit ratio slightly increased from 79.12% at September 30, 2011 to 80.93% at September 30, 2012. Both loans and deposits have decreased significantly over the past year. The loan to deposit ratio at December 31, 2011 was 79.13%.  Deposits at September 30, 2012 have decreased $33.74 million since September 30, 2011 and have decreased $23.73 million since December 31, 2011. During the last 36 months, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds. As a result of being “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered

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deposits without prior regulatory approval and cannot offer interest rates on deposit accounts that are significantly higher than the average rates in our market area.

The Company also owns approximately $3.88 million (book value) in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs).  The market for these securities at September 30, 2012 is not active and markets for similar securities are also not active.  These securities are currently in non-accrual status.  As of September 30, 2012, the unrealized loss in these securities totaled $3.60 million. Management feels that these losses are temporary and primarily a result of the current inactive market.The market discounts reflect the current illiquidity and the negative credit events within the banking sector. A deterioration of profits of banks nationally and the possibility of increased bank failures could result in changes in the Company’s outlook for these securities and cause the Company to consider recording additional OTTI charges on these securities. During the first quarter of 2012 the Company recorded OTTI credit related impairment charges on its TRUP CDOs in the amount of $167 thousand.  No OTTI charges were incurred during the second or third quarters of 2012.

Below is a table of the Company’s remaining pooled trust preferred balances as of September 30, 2012.

(in thousands)

Description	Type	Class	Original Amount $		Book Value 9/30/12 $		Fair Value 9/30/12 $		Unrealized Gain/(Loss) $			Lowest Credit Rating
Pretsel  4-B	Pooled	Mezz B		700		85		59		(26	)	Ca
Prestel 11-B	Pooled	Mezz B		500		394		62		( 332	)	Ca
Prestel 12-B	Pooled	Mezz B		750		383		90		( 293	)	Ca
Prestel 13-B	Pooled	Mezz B		500		326		9		( 317	)	Ca
Prestel 15-B	Pooled	Mezz B		500		263		9		( 254	)	Ca
Prestel 18-C	Pooled	Mezz C		500		209		1		(208	)	Ca
Prestel 19-C	Pooled	Mezz C		500		255		1		( 254	)	Ca
Prestel 20-C	Pooled	Mezz C		500		11		1		( 10	)	Ca
Prestel 21-C	Pooled	Mezz C		500		294		9		(285	)	Ca
Prestel 22-C	Pooled	Mezz C		500		283		4		(279	)	Ca
Prestel 22-C	Pooled	Mezz C		500		317		4		( 313	)	Ca
Prestel 22-C	Pooled	Mezz C		500		316		4		(312	)	Ca
Prestel 23-C	Pooled	Mezz C		500		442		15		(427	)	C
Tropc CDO III	Pooled	Subordinate		1,000		308		15		(293	)	C

The Company currently has approximately $67.91 million in outstanding FHLB advances. No new advances were originated during the last 24 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB. During the third quarter of 2012, the Bank restructured $47.50 million of its $67.91 million of FHLB borrowings. This restructuring resulted in a decrease in the weighted average borrowing rate by approximately 100 basis points or approximately $480,000 in reduced interest expense annually.  See Footnote 12 containing additional information concerning the restructuring.

Non-performing assets (NPAs) are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. In addition, the market value of any securities available for sale placed in non accrual status is included. Non-performing assets were $29.39 million or 4.91% of total assets at September 30, 2012, compared with $37.80 million or 6.09% of total assets at December 31, 2011 and $39.23 million or 6.19% of total assets at September 30, 2011. The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non accrual loans and selling OREO property.

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset

43

quality, as well as other internal and external factors, such as general economic conditions.  At September 30, 2012 and December 31, 2011, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of US Generally Accepted Accounting Principles.

At September 30, 2012, net OREO balances were $18.01 million and consisted of 53 relationships.    The following chart details each category type, number, and balance.

OREO Property at 9/30/12
OREO Description	Number		Balance at 9/30/12
			(in thousands)
Land Development  - Vacant Land		20	$	4,570
1-4 Family		19		5,992
Multifamily		1		2,595
Commercial Real Estate		13		4,856
Total		53	$	18,013

At December 31, 2011, net OREO balances were $16.72 million and consisted of 50 relationships.    The following chart details each category type, number, and balance.

OREO Property at 12/31/2011
OREO Description	Number		Balance at 12/31/11
			(in thousands)
Land Development  - Vacant Land		17	$	4,175
1-4 Family		23		6,198
Multifamily		1		2,635
Commercial Real Estate		9		3,716
Total		50	$	16,724

The one multifamily property totaling $2.6 million contains twenty – eight residential units outside the Sevierville, Tennessee area. There has been greater deterioration in the Tennessee commercial real estate market compared to the Bank’s other markets. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods. The Company formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank’s three market areas. The ability to sell OREO has been negatively affected by the current economic climate and the reduction of non-performing assets, will to a large degree, depend on how quickly specific market areas rebound from the recession.

Investment securities and other investments totaled $64.72 million (market value) at September 30, 2012 which reflects a decrease of $4.84 million or 6.96% from the December 31, 2011 total of $69.56 million. Investment securities available for sale and other investments at September 30, 2012 were comprised of mortgage backed securities (44.28% of the total securities portfolio), municipal issues (19.79%), corporate bonds (2.56%), CMOs (1.52%),  and SBAs pools (24.23%).  The Company’s entire securities portfolio was classified as available for sale at both September 30, 2012 and December 31, 2011.

Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, and Community Bankers Bank stock. These investments (carrying value of $4.93

44

million and 7.62% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in Other Investments is a certificate of deposit purchased from another FDIC insured institution.  The balance of this CD was $250,000 at both September 30, 2012 and December 31, 2011.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $30.43 million at September 30, 2012, representing a decrease of $2.17 million or 6.66% from September 30, 2011. Total stockholders’ equity at December 31, 2011 was $28.26 million. The increase in stockholders’ equity since December 31, 2011 is a result of both the net earnings generated and the increase in the market value of the Company’s available for sale securities portfolio during the nine months ended September 30, 2012.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined in the regulations).  See Footnote 4 for a more detailed discussion of the Company’s and Bank’s regulatory capital ratios. The Board of Directors and management are committed to a return to “well-capitalized” status at all levels, and we continue to explore options for raising additional capital in addition to improved earnings.

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($76.81 million as of September 30, 2012) and unrestricted investment securities available for sale ($13.89 million market value).  Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank.  The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. The Bank also has the ability to attract certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

On April 27, 2009, the Company announced that it entered into a $7,500,000 Loan Commitment Agreement with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company an aggregate of $7,500,000 under a Revolving Line of Credit of up to $3,000,000 (“Loan A”) and a Closed-End Term Loan of up to $4,500,000 (“Loan B”) (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. As of March 31, 2010, the Company had borrowed $4,104,000 of Loan B and $1,000,000 of Loan A.  Proceeds of the loans of $3,200,000 were down-streamed into the Bank as additional Tier 1 capital with the remaining proceeds of $2,300,000 held in cash by the Company. Subsequently, during the second quarter of 2011, the Company requested and CBB agreed to modify the closed-end loan to extend the amortization period of the loan for a new 20-year period. The Company simultaneously paid off the Revolving Line of Credit. The Closed – End Term Loan has a balloon maturity in April 2014 and the Company deposited the 35 monthly payments up to the balloon date into a reserve account held at CBB. The Closed – End Term Loan had a balance of $3,573,707 at September 30, 2012. One of the covenants included in the loan documents requires that the Bank and Company remain well-capitalized. The Company did receive a covenant waiver from CBB during the second quarter of 2011 after falling below “well-capitalized” to “adequately-capitalized ”. Also at year end 2011, the Company was granted a debt service coverage covenant waiver. The covenant requires a two to one ratio as it pertains to net operating income versus annual debt service payments. This waiver was granted in part due to having already prepaid the monthly payments up to the April 2014 balloon date.

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Caution About Forward-Looking Statements

This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including certain plans, expectations, goals and projections, which are inherently subject to numerous assumptions, risks and uncertainties. The Company's actual results could differ materially from those set forth or implied in the forward-looking statements.

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:

· The ability to attract and maintain capital levels adequate to support the Company’s asset  levels;

· Our inability to comply with the Written Agreement dated October 13, 2010;

· Our inability to comply with certain covenants of the Company’s Loans with Community Bankers Bank;

· Continued problems related to the sluggish economic recovery;

· Unemployment continuing to rise;

· Difficult market conditions in our industry;

· Unprecedented levels of market volatility;

· Effects of the soundness of other financial institutions;

· Potential impact on us of recently enacted legislation;

· Further deterioration in the housing market and collateral values;

· The ability to successfully manage the Company’s strategic plan;

· The ability to continue to attract low cost core deposits;

· Reliance on the Company’s management team, including its ability to attract and retain key personnel;

· The successful management of interest rate risk;

· Further adverse changes in general economic and business conditions in the Company’s market area;

· Changes in interest rates and interest rate policies;

· Risks inherent in making loans such as repayment risks and fluctuating collateral values;

· Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

· Demand, development and acceptance of new products and services;

· Problems with technology utilized by the Company;

· Changing trends in customer profiles and behavior; and

· Changes in banking and other laws and regulations applicable to the Company.

ITEM 3.  Quantitative and Qualitative Disclosures About Market Risk

Not Applicable

ITEM 4.  Controls and Procedures

We have carried out an evaluation, under the supervision and the participation of our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer,  Chief Financial Officer and Vice President of Accounting

46

concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, as appropriate to allow timely decisions regarding required disclosure.

There have not been any changes in the Company’s internal controls over financial reporting during the third quarter of 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

On July 9, 2010, a former borrower filed two complaints in the Circuit Court of Washington County, VA, claiming that the Bank improperly handled the repossession and disposition of collateral from a warehouse in June/July 2008.  The borrower also claims that the Bank acted as its business advisor and breached fiduciary duties owed to it in this capacity.  One complaint seeks $700,000 in damages for conversion based solely on the repossession/disposition of collateral.  The second complaint seeks $7,850,000 in damages for an alleged breach of fiduciary duty, violation of UCC Article 9, actual fraud, unjust enrichment, and business conspiracy.  In response, the Bank filed demurrers to both complaints, both of which were granted in part and denied in part with leave granted to amend. The Borrower chose not  to amend either complaint, opting instead to consolidate her remaining claims into one action.  The borrower's remaining claims against the Bank are for violation of UCC Article 9, fraud, unjust enrichment of personal property, and conversion of personal property. No trial date has been set. The Bank disputes the allegations and believes that they are without merit.  The Bank intends to defend itself vigorously.

Item 1A. Risk Factors

Not applicable

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

None

Item 3.   Defaults Upon Senior Securities

None

Item 4.   Mine Safety Disclosures

Not Applicable

Item 5.   Other Information

 None

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Item 6.   Exhibits

31.1 Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer

31.2 Rule 13a-14(a) Certification of Chief Financial Officer

31.3 Rule 13a-14(a) Certification of Vice President of Accounting

32.1 Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.

32.2 Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.

32.3 Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.

101 The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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SIGNATURES

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

	HIGHLANDS BANKSHARES, INC.
	(Registrant)
Date: November 14, 2012	/s/ Samuel L. Neese
	Samuel L. Neese
	Executive Vice President and
	Chief Executive Officer
Date:  November 14, 2012	/s/ Robert M. Little, Jr.
	Robert M. Little, Jr.
	Chief Financial Officer
Date:  November 14, 2012	/s/ James R. Edmondson
	James R. Edmondson
	Vice President -Accounting

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EXHIBIT INDEX

Exhibit Number	Description
31.1	Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
31.3	Rule 13a-14(a) Certification of Vice President of Accounting
32.1	Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
32.3	Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.
101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2012, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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