Highlands Bankshares (HBSI) 10-Q 2006 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 0-16761

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

West Virginia	55-0650793
(State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)

P.O. Box 929

Petersburg, WV 26847

(Address of Principal Executive Offices, Including Zip Code)

304-257-4111

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filed, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large Accelerated Filer [   ] Accelerated Filer [   ] Non Accelerated filer [X]

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date. As of October 31, 2006: 1,436,874 shares of Common Stock, $5 Par Value

HIGHLANDS BANKSHARES, INC.
Quarterly Report on Form 10Q For The Period Ended September 30,2006
	INDEX
		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Statements of Income
	Nine Months Ended September 30, 2006 and 2005	2
	Unaudited Consolidated Statements of Income
	Three Months Ended September 30, 2006 and 2005	3
	Unaudited Consolidated Balance Sheet for September 30, 2006
	and Audited Consolidated Balance Sheet for December 31, 2005	4
	Unaudited Consolidated Statements of Changes in Stockholders’
	Equity for the Nine Months Ended September 30, 2006 and 2005	5
	Unaudited Consolidated Statements of Cash Flows for the Nine
	Months Ended September 30, 2006 and 2005	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management’ Discussion and Analysis of Financial Condition
	and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	23
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	24
Item 1A.	Risk Factors	24
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	24
Item 3.	Defaults Upon Senior Securities	24
Item 4.	Submission of Matters to a Vote of Security Holders	24
Item 5.	Other Information	24
Item 6.	Exhibits	24
SIGNATURES		25

Part I.	Page 2
Item 1. Financial Statements

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)
	Nine Months Ended September 30,
	2006		2005
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	16,149	$	13,620
Interest on federal funds sold		338		202
Interest on deposits in other banks		39		26
Interest and dividends on securities		891		558
Total Interest Income		17,417		14,406
Interest Expense
Interest on deposits		5,043		3,674
Interest on borrowed money		529		476
Total Interest Expense		5,572		4,150
Net Interest Income		11,845		10,256
Provision for Loan Losses		508		690
Net Interest Income After Provision for Loan Losses		11,337		9,566
Non-interest Income
Service Charges		892		625
Investment in insurance contracts		321		200
Other noninterest income		343		448
Total Noninterest Income		1,556		1,273
Non-interest Expense
Salaries and employee benefits		4,244		3,692
Equipment and occupancy expense		984		922
Data processing expense		580		460
Directors fees		297		256
Legal and professional fees		365		338
Other noninterest expense		1,304		1,088
Total Noninterest Expense		7,774		6,756
Income Before Provision For Income Taxes		5,119		4,083
Provision for Income Taxes		1,758		1,372
Net Income	$	3,361	$	2,711
Per Share Data
Net Income	$	2.34	$	1.89
Cash Dividends	$	.69	$	.60
Weighted Average Common Shares Outstanding		1,436,874		1,436,874
The accompanying notes are an integral part of these statements.

Page 3

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)
	Three Months Ended September 30,
	2006		2005
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	5,698	$	4,704
Interest on federal funds sold		124		101
Interest on deposits in other banks		16		15
Interest and dividends on securities		302		188
Total Interest Income		6,140		5,008
Interest Expense
Interest on deposits		1,873		1,326
Interest on borrowed money		174		167
Total Interest Expense		2,047		1,493
Net Interest Income		4,093		3,515
Provision for Loan Losses		155		255
Net Interest Income After Provision for Loan Losses		3,938		3,260
Non-interest Income
Service Charges		317		234
Investment in insurance contracts		37		79
Other noninterest income		115		138
Total Noninterest Income		469		451
Non-interest Expense
Salaries and employee benefits		1,429		1,227
Equipment and occupancy expense		336		316
Data processing expense		209		155
Directors fees		100		82
Legal and professional fees		127		170
Other noninterest expense		418		355
Total Noninterest Expense		2,619		2,305
Income Before Provision For Income Taxes		1,788		1,406
Provision for Income Taxes		632		463
Net Income	$	1,156	$	943
Per Share Data
Net Income	$	.80	$	.66
Cash Dividends	$	.23	$	.20
Weighted Average Common Shares Outstanding		1,436,874		1,436,874
The accompanying notes are an integral part of these statements.

Page 4

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands of Dollars)
	September 30, 2006			December 31, 2005
	(unaudited)			(audited)
ASSETS
Cash and due from banks—noninterest bearing	$	8,293		$	8,850
Deposits in other banks—interest bearing		2,136			963
Federal funds sold		10,905			10,808
Securities held to maturity		290			491
Securities available for sale, at market value		24,452			27,130
Restricted investments		1,448			1,250
Loans		283,317			270,020
Allowance for loan losses		(3,380	)		(3,129	)
Bank premises and equipment, net of depreciation		7,926			7,684
Interest receivable		2,044			1,818
Investment in life insurance contracts		6,007			6,396
Goodwill		1,534			1,534
Other intangible assets		1,542			1,674
Other Assets		2,666			2,084
Total Assets	$	349,180		$	337,573
LIABILITIES
Noninterest bearing deposits	$	48,670		$	47,753
Savings and interest bearing demand deposits		72,844			80,597
Time deposits		171,257			156,342
Total Deposits		292,771			284,692
Long term debt		15,638			15,063
Accrued expenses and other liabilities		4,376			3,826
Total Liabilities		312,785			303,581
STOCKHOLDERS’ EQUITY
Common Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares issued and outstanding		7,184			7,184
Surplus		1,662			1,662
Retained Earnings		28,021			25,651
Other accumulated comprehensive loss		(472	)		(505	)
Total Stockholders’ Equity		36,395			33,992
Total Liabilities and Stockholders’ Equity	$	349,180		$	337,573
The accompanying notes are an integral part of these statements.

Page 5

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In Thousands of Dollars)
	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total
Balances at December 31, 2005	$	7,184	$	1,662	$	25,651		$	(505	)	$	33,992
Net Income						3,361						3,361
Net change in unrealized appreciation on investment securities available for sale, net of taxes									33			33
Total Comprehensive Income												3,394
Dividends Paid						(991	)					(991	)
Balances September 30, 2006	$	7,184	$	1,662		28,021		$	(472	)	$	36,395

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total
Balances at December 31, 2004	$	7,184	$	1,662	$	23,028		$	(219	)	$	31,655
Net Income						2,711						2,711
Net change in unrealized appreciation on investment securities available for sale, net of taxes									(26	)		(26	)
Total Comprehensive Income												2,685
Dividends Paid						(862	)					(862	)
Balances September 30, 2005	$	7,184	$	1,662	$	24,877		$	(245	)	$	33,478
The accompanying notes are an integral part of these statements.

Page 6

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
	Nine Months Ended September 30,
	2006			2005
	(unaudited)			(unaudited)
Cash Flows From Operating Activities
Net Income	$	3,361		$	2,711
Adjustments to reconcile net income to net
cash provided by operating activities
Depreciation		496			494
Increase in cash value of life insurance contracts		(166	)		(182	)
Net amortization of securities		(112	)		47
Provision for loan losses		508			690
Amortization of intangibles		132			38
Decrease (increase) in interest receivable		(226	)		(202	)
Decrease (increase) in other assets		(582	)		359
Increase in accrued expenses		550			156
Net Cash Provided by Operating Activities		3,961			4,111
Cash Flows From Investing Activities
Increase (decrease) in federal funds sold		(97	)		(6,976	)
Proceeds from maturities of securities available for sale		9,234			7,380
Purchase of securities available for sale		(6,410	)		(6,186	)
Proceeds from maturities of securities held to maturity		201			670
Increase in restricted investments		(198	)		(118	)
Net change in interest bearing deposits in other banks		(1,173	)		(797	)
Settlement on insurance contract		555			0
Purchase of property and equipment		(739	)		(153	)
Net Change in Loans		(13,554	)		(7,658	)
Net Cash Used in Investing Activities		(12,181	)		(13,891	)
Cash Flows From Financing Activities
Net change in deposits		8,079			4,945
Additional long term debt		2,300			7,700
Repayment of long term debt		(1,725	)		(375	)
Additional short term borrowings		0			1,500
Repayment of short term borrowings		0			(3,500	)
Dividends paid in cash		(991	)		(862
Net Cash Provided by Financing Activities		7,663			11,291
Net Increase (Decrease) in Cash and Cash Equivalents		(557	)		1,511
Cash and Cash Equivalents, Beginning of Period		8,850			6,187
Cash and Cash Equivalents, End of Period	$	8,293		$	7,698
Supplemental Disclosures
Cash paid for income taxes	$	1,766		$	911
Cash paid for interest	$	5,355		$	3,972
The accompanying notes are an integral part of these statements.

Page 7

HIGHLANDS BANKSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1ACCOUNTING PRINCIPLES

The consolidated financial statements conform to U. S. generally accepted accounting principles and to general industry practices. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting solely of normal recurring adjustments, necessary to present fairly the financial position as of September 30, 2006 and the results of operations for the three and nine month periods ended September 30, 2006 and 2005.

The results of operations for the three and nine month periods ended September 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full year.

The notes included herein should be read in conjunction with the notes to financial statements included in the Company’s 2005 annual report on Form 10-K.

NOTE 2 SECURITIES AND RESTRICTED INVESTMENTS

The Company’s securities portfolio serves several purposes. Portions of the portfolio secure certain public and trust deposits while the remaining portions are held as investments or used to assist the Company in liquidity and asset/liability management.

The amortized cost and market value of securities held to maturity as of September 30, 2006 and December 31, 2005 are as follows (in thousands of dollars):

	September 30, 2006				December 31, 2005
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value
Held to Maturity Securities
Obligations of states and municipalities	$	290	$	290	$	491	$	491
Total Held to Maturity Securities	$	290	$	290	$	491	$	491
Available For Sale Securities
U.S. Treasuries and Agencies	$	16,358	$	16,318	$	17,352	$	17,234
Mortgage backed securities		5,720		5,693		7,172		7,163
Obligations of states and municipalities		2,432		2,411		2,719		2,705
Marketable equities		30		30		28		28
Total Available For Sale Securities	$	24,540	$	24,452	$	27,271	$	27,130

Restricted investments consist of investments in the Federal Home Loan Bank and the Federal Reserve Bank. Investments are carried at face value and the level of investment is dictated by the level of participation with each institution. Amounts are restricted as to transferability. Investments in the Federal Home Loan Bank act as collateral against the outstanding borrowings from that institution.

NOTE 3BRANCHES ACQUISITION

During the fourth quarter of 2005, Highlands Bankshares purchased all of the outstanding shares of common stock of the National Bank of Davis (“Davis”), located in Davis, West Virginia. Shortly after the purchase, Davis offices became branches of The Grant County Bank. The net assets of Davis were recorded at fair value. Portions of the cost of acquisition, including certain expenses related to the purchase, were allocated as intangible assets. All results of operations subsequent to the purchase of the branches acquired are included in consolidated income totals.

Page 8

HIGHLANDS BANKSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 INVESTMENTS IN INSURANCE CONTRACTS

Investments in insurance contracts consist of single premium insurance contracts which have the purpose of providing a rate of return to the Company and of providing life insurance and retirement benefits to certain executives.

During the second quarter of 2006, the Company received payment in settlement relating to two of these policies. This payment related to the death of an insured and resulted in a one-time, non-recurring income of $155,000.

NOTE 5 LOANS

A summary of loans outstanding as of September 30, 2006 and December 31, 2005 is shown in the table below (in thousands of dollars):

	September 30,		December 31,
Loan Type	2006		2005
Commercial	$	64,942	$	57,908
Real Estate construction		17,848		12,201
Real Estate mortgage		157,316		153,646
Consumer		43,211		46,265
Total Loans	$	283,317	$	270,020

In addition to loans to fund construction and traditional mortgage loans, portions of the loan portfolio identified as commercial are also secured by real estate. At September 30, 2006, the total balance of loans in the portfolio secured by real estate was $218,826,000.

NOTE 6ALLOWANCE FOR LOAN LOSSES

A summary of the transactions in the allowance for loan losses for the nine month periods ended September 30, 2006 and 2005 is shown below (in thousands of dollars):

	2006			2005
Balance, beginning of period	$	3,129		$	2,530
Provisions charged to operations		508			690
Loan recoveries		171			144
Loan charge-offs		(428	)		(445	)
Balance, end of period	$	3,380		$	2,919

NOTE 7DEBT INSTRUMENTS

The Company continues to borrow money from the Federal Home Loan Bank of Pittsburgh (FHLB) to meet specific funding needs. The interest rates of the notes payable as of September 30, 2006, range from 3.30% to 6.12%. The weighted average interest rate was 4.51% at September 30, 2006. The debt is secured by the general assets of the subsidiary banks.

During the first quarter of 2005, the Company initiated short term borrowings from the FHLB of $1,500,000 and made repayments of $3,500,000. No short term borrowings have been initiated subsequent to the first quarter of 2005.

Page 9

HIGHLANDS BANKSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8DEPOSITS

Balances of time deposits over $100,000 and of all other time deposits at September 30, 2006 and December 31, 2005 are shown below (in thousands of dollars):

	September 30,		December 31,
	2006		2005
Time deposits over $100,000	$	51,761	$	45,455
All other time deposits		119,496		110,887
Total Time Deposits	$	171,257	$	156,342

Interest expense for time deposits over $100,000 for the three and nine month periods ended September 30, 2006 and 2005 is shown below (in thousands of dollars):

	Nine Months Ended September 30,			Three Months Ended September 30,
2006		2005		2006		2005
$	1,423	$	997	$	537	$	360

NOTE 9 EMPLOYEE BENEFITS

The Company's two subsidiary banks each have separate retirement and profit sharing plans which cover substantially all full time employees at each bank.

The Capon Valley Bank has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions by the Bank. The bank matches on a limited basis the contributions of the employees. Investment of employee balances is done through the direction of each employee. Employer contributions are vested over a six year period.

The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan. Benefits under the plan are based on compensation and years of service with 100% vesting after seven years of service. Prior to 2002, the Plan's assets were in excess of the projected benefit obligations and thus the Bank was not required to make contributions to the Plan in 2003, 2002 or 2001. The bank was required to make contributions in 2004 and 2005, and made contributions in the first nine months of 2006. The Bank has recognized liabilities of $421,000 at September 30, 2006 relating to this plan. The following table provides the components of the net periodic benefit cost for the plan for the nine month periods ended September 30, 2006 and 2005 (in thousands of dollars):

	2006			2005
Service cost	$	94		$	92
Interest cost		138			134
Expected return on plan assets		(152	)		(141	)
Amortization of unrecognized prior service costs		8			8
Recognized net actuarial loss		43			20
Net periodic expense	$	131		$	113

Page 10

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

Forward Looking Statements

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other similar words. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, downturns in the trucking and timber industries, effects of mergers and/or downsizing in the poultry industry in Hardy County, and consumer spending and savings habits. Additionally, actual future results and trends may differ from historical or anticipated results to the extent: (1) any significant downturn in certain industries, particularly the trucking and timber and coal extraction industries are experienced; (2) loan demand decreases from prior periods; (3) the Company may make additional loan loss provisions due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (4) the Company may not continue to experience significant recoveries of previously charged-off loans or loans resulting in foreclosure; (5) increased liquidity needs may cause an increase in funding costs; and, (6) the Company is unable to control costs and expenses as anticipated. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

Introduction

The following discussion focuses on significant results of the Company’s operations and significant changes in our financial condition or results of operations for the periods indicated in the discussion. This discussion should be read in conjunction with the preceding financial statements and related notes, as well as the Company’s Report on Form 10-K for the period ended December 31, 2005.

Current performance does not guarantee, and may not be indicative of, similar performance in the future.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.

Page 11

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Critical Accounting Policies (continued)

Disclosure of the Company’s significant accounting policies is included in Note 2 to the Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the period ended December 31, 2005. Some of the policies are particularly sensitive, requiring significant judgments, estimates and assumptions by management.

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Additional information pertaining to the allowance for loan losses and provision for loan losses is contained on pages 15-17 of this report.

The Company has invested in and owns life insurance polices on certain officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits which will be received by the executives at the time of their retirement is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS No. 106 requires that an employer’s obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. Assumptions are used in estimating the present value of amounts due officers after their normal retirement date. These assumptions include the estimated income to be derived from the investments and an estimate of the Company’s cost of funds in these future periods. In addition, the discount rate used in the present value calculation will change in future years based on market conditions.

During 2005, the Company purchased all the outstanding shares of the National Bank of Davis. The net assets of this purchase were recorded at fair value, including goodwill. Goodwill represents the cost in excess of the fair value of net assets acquired (including identifiable intangibles) in transactions accounted for as purchases. In accordance with provisions of SFAS No. 142, "Goodwill and Other Intangible Assets", goodwill is not amortized over an estimated useful life, but rather will be tested at least annually for impairment. Core deposit and other intangible assets include premiums paid for acquisitions of core deposits (core deposit intangibles) and other identifiable intangible assets. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received.

Page 12

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Recent Accounting Pronouncements

No recent accounting pronouncements had a material impact on the Company’s consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan as an asset of liability in its statement of financial position and to recognize changes in that funded status, through comprehensive income, in the year in which the changes occur. The funded status of a benefit plan will be measured as the difference between plan assets at fair value and benefit obligation. For any other postretirement plan, the benefit obligation is the accumulated postretirement benefit obligation. SFAS 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. The Statement also requires additional disclosures in the notes to financial statements about certain effects on net periodic benefit cots for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Under SFAS 158 a company is required to initially recognize the funded status of a defined benefit postretirement plan to to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year end statement of financial position is effective for fiscal years ending after December 15, 2008. The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan, a defined benefit plan under SFAS 158. As such, certain aspects of SFAS 158 will most likely impact the financial position of Highlands Bankshares, Inc. at December 31, 2006. At present, this impact has not been determined.

Overview

Net income for the first nine months of 2006 increased 23.98% over the same period in 2005. Return on Average Assets for the period was 1.33% and Return on Average Equity was 12.76%.

Net income for the three-month period ended September 30, 2006 increased 22.59% over the same quarter in 2005. Return on Average Assets for the quarter was 1.34% and Return on Average Equity was 12.65%.

The Company experienced strong loan demand during the third quarter of 2006 and loan balances increased nearly $10,000,000 during the quarter to stand at $283,317,000 at September 30. After several periods of either decline or minimal growth, total deposits also increased during the third quarter by 4.27%, with the increase being concentrated in balances of time deposits. Owing in great part to the increases in loans and deposits, the Company’s total assets increased and stood at $349,180,000 at September 30. This expansion of the balance sheet contributed significantly to a 15.49% increase in net interest income for the first nine months of 2006 as compared to the same period in 2005.

The provision for loan losses was reduced during 2006 as compared to 2005. Although the provision taken against operational results was $182,000 less during 2006 than a year ago, the ratio of the allowance for loan losses as compared to gross loan balances increased from 1.16% at December 31, 2005 to 1.19% at September 30, 2006.

Non interest income year to date was 22.23% greater than the first nine months of 2005. The largest contributor to this increase was a rise in overdraft fees charged to demand deposit customers. This increase was a result of an increase in average balances of checking accounts and also the implementation by Capon Valley Bank, a subsidiary, of a program commonly referred to as “courtesy overdraft.” A non-recurring payment to the Company from a Company owned life insurance policy was a major contributor to an increase in earnings on investments in life insurance. Insurance related income continued to decline.

Page 13

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Overview (continued)

Non interest expense increased 15.07% during the first three quarters of 2006 as compared to last year. A large portion of this increase can be attributed to the expanded operations acquired as a result of the purchase of the National Bank of Davis, however some of the increase resulted from operational growth of legacy operations.

Highlands' results of operations are discussed in greater detail following this overview. Unless otherwise specifically noted, the underlying causes for changes in the results for the quarter ended September 30, 2006 as compared to the same quarter in 2005 are substantially the same as the causes discussed for the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005.

Impact of Acquisition on Operational Results

During the fourth quarter of 2005, the Company acquired two additional branches through the purchase of the National Bank of Davis. Further information regarding this purchase can be found in the Company’s Annual Report on Form 10-K for 2005. This acquisition has significantly impacted the results of operations for the first nine months of 2006, both in revenues and costs.

The acquisition added significant balances of both earning assets and interest bearing liabilities to the Company’s operations. The addition of these assets and liabilities has impacted the asset/liability management strategy of the Company, specifically The Grant County Bank into which the branches were integrated. Because of the full integration of these assets and liabilities, determination of the exact dollar amount of the impact on the Company’s net interest income is difficult to determine. However, the addition has increased net interest income as compared to the first nine months of 2005 both because of the increased balances of earning assets and interest bearing liabilities and because of the increased options for asset/liability management resulting from the purchase.

The addition of two branches and eleven full time equivalent employees as the result of the purchase of the National Bank of Davis has also caused an increase in non-interest expense. Specifically, occupancy and equipment expense has increased because of the added physical locations. Salary and benefits expense have increased because of the additional employees, and data processing expense has increased because of the additional loan and deposit customers. Additionally, certain other non-interest expenses have increased because of the acquisition.

Non-interest income has also been impacted by the acquisition, but to a lesser degree than the impact of the acquisition on net interest income and non-interest expense.

Net Interest Income

Year To Date September 30, 2006 Compared to Same Period in 2005

The acquisition of the branches, as discussed earlier, has had significant impact on the Company’s net interest income. The following discussion highlights recent trends in the Company’s management of its net interest margin. The comparison of net interest income in 2006 as compared to 2005 as discussed below should be considered in conjunction with the comments relating to the impact on net interest income of the acquisition of the National Bank of Davis found earlier in Management’s Discussion and Analysis under the heading of “Impact of Acquisition on Operational Results.”

A continuation of increases by the Federal Reserve Board (“The Fed”) throughout 2005 and continuing into early 2006 for the target rate on federal funds sold has caused both rates earned on assets and rates paid on liabilities to increase during 2006 as compared to 2005. Although these rate increases by the Fed have ceased during the later periods of 2006, as time deposits mature and renew, new time deposits are made, loans mature and new loans are made and adjustable rate loans re-price, average rates on both earning assets and interest bearing liabilities continue to increase as a result of the rate increases in 2005 and early 2006.

Page 14

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Interest Income (continued)

Net interest income for the first nine months of 2006, on a fully taxable equivalent basis, increased 15.46% over the same period in 2005. Average balances of earning assets increased 9.03% while average balances of interest bearing liabilities increased 8.36%.

Over the past several years, the Company has followed a strategy of funding loan growth, when possible, through reductions in comparatively lower earning assets such as federal funds sold and securities rather than attempting to attract new deposits by offering above market rates on deposit products. This strategy continued through the early months of 2006. However, during the quarter ended September 30, 2006, stronger loan demand and tightening liquidity needs necessitated a need for new deposits. In addition, rates on securities investments and federal funds sold have also increased during 2006, making it somewhat less attractive, as compared to recent years, to fund loan growth through reduction of balances of these investments. As such, the Company began offering higher rates on certain deposit products and balances of time deposits increased 8.82% from June 30, 2006 to September 30, 2006. Over this same period, loan balances increased 3.65%.

During the later months of 2005 and continuing into 2006, as The Fed increased rates, the Company experienced increases on average rates on paid on deposits greater than those experienced on earning assets. This appears to have occurred because of competitive market pressures for both loans and deposits. During the third quarter of 2006, the Company experienced a slowing of this trend as average rates earned on loans began to increase at a pace nearer to the increases in average rates on deposits. Much of the Company’s loan portfolio is comprised of adjustable rate loans, and as interest rates increase these loans have re-priced upward. This re-pricing, combined with increases in the marketplace rates for new loans and increases in loan balances have allowed the Company to increase its net interest margin. Included in the Company’s net interest margin calculations are fees on loans. These fees consist of both service fees, such as late charges, and also fees charged to customers upon loan origination. The volumes of these fees have significant impact on the average rates earned on loans and also on net interest margin percents.

Third Quarter of 2006

During the first six months of 2006, the Company experienced sluggish demand for new loans. Although loan balances grew slightly throughout the first two quarters of the year, the demand was less than experienced during recent prior years. This trend reversed in the third quarter of 2006 and the Company experienced a 3.65% increase in loans from June 30, 2006 to September 30, 2006. The balances of consumer loans continue to fall due largely to continual increases in competition for these loans from both other local financial institutions and non-traditional financing firms. In spite of the decline in consumer loans, during the third quarter the Company experienced strong growth in mortgage and commercial loans and overall loan balances increased.

Owing to the recent strategy of funding loan growth through reductions in comparatively lower earning assets, such as securities, investments and federal funds sold, balances of securities have decreased over the past periods. The acquisition of the National Bank of Davis mitigated this trend somewhat as this added balances to the securities portfolio. Because the rates earned on securities investments have increased and because Management felt that the Company had reduced securities balances enough, the Company began offering more competitive rates on deposits during the third quarter of 2006 to fund the increased loans. This caused balances of time deposits to increase during the quarter and impacted average rates paid on time deposits. However, this increase was offset by the increased rates and fees earned on loans, and net interest margin remained strong through the quarter.

While the Company expects loan demand to remain adequate, Management doesn’t anticipate the need to grow deposits significantly during the coming quarters, which would necessitate further paying of above market rates for deposits. Balances of federal funds sold at September 30, 2006 were nearly double the balances of federal funds sold at June 30, 2006. The Company views balances of federal funds sold as its indicator of short term liquidity and the first source of immediate funding for new loan growth. As such, the Company expects that net interest income will remain stable, if not increasing, in the coming quarters, although continued re-pricing trends of both loans and deposits and competitive marketplace pressures may cause net interest margin percents to decline.

Page 15

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Interest Income (continued)

The table below sets forth an analysis of net interest income for the nine-month periods ended September 30, 2006 and 2005 (Average balances and interest income/expense shown in thousands of dollars):

	2006								2005
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	274,230		$	16,149		7.85	%	$	252,118		$	13,620		7.22	%
Federal funds sold		9,695			338		4.65	%		8,675			202		3.11	%
Interest bearing deposits		1,216			39		4.28	%		1,320			26		2.63	%
Taxable investment securities		25,339			807		4.25	%		22,565			481		2.85	%
Nontaxable investment securities3		3,076			134		5.81	%		2,921			123		5.63	%
Total Earning Assets3		313,556			17,467		7.43	%		287,599			14,452		6.72	%
Cash and cash equivalents		7,957								6,949
Allowance for loan losses		(3,232	)							(2,716	)
Insurance contracts		6,256								5,898
Nonearning assets		14,615								12,323
Total Assets	$	339,152							$	310,053
Interest Expense
Interest bearing demand deposits	$	25,677		$	167		.87	%	$	25,244		$	133		.70	%
Savings and money markets		51,288			402		1.05	%		48,882			307		.84	%
Time deposits		159,320			4,474		3.74	%		143,892			3,234		3.00	%
Short term borrowings		0			0					38			1		2.40	%
Long term debt		15,779			529		4.47	%		14,561			475		4.36	%
Total Interest Bearing Liabilities		252,064			5,572		2.95	%		232,617			4,150		2.39	%
Demand deposits		47,968								39,973
Other liabilities		3,893								4,744
Stockholders’ equity		35,227								32,719
Total liabilities and stockholders’ equity	$	339,152							$	310,053
Net Interest Income				$	11,895							$	10,302
Net Yield on Earning Assets3							5.06	%							4.79	%
1Balances of loans include loans in non-accrual status
2Interest income on loans includes fees
3Yields are on a fully taxable equivalent basis

Page 16

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Net Interest Income (continued)

The table below sets forth an analysis of net interest income for the three month periods ended September 30, 2006 and 2005 (Average balances and interest/expense shown in thousands of dollars):

	2006								2005
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	278,888		$	5,698		8.17	%	$	254,577		$	4,704		7.33	%
Federal funds sold		9,636			124		5.15	%		11,987			101		3.34	%
Interest bearing deposits		1,497			16		4.28	%		1,560			15		3.81	%
Taxable investment securities		23,620			276		4.67	%		22,195			164		2.93	%
Nontaxable investment securities3		2,858			42		5.88	%		2,865			38		5.26	%
Total Earning Assets3		316,499			6,156		7.78	%		293,184			5,022		6.80	%
Cash and cash equivalents		8,015								7,296
Allowance for loan losses		(3,330	)							(2,872	)
Insurance contracts		5,976								5,960
Nonearning assets		15,010								10,120
Total Assets	$	342,170							$	313,688
Interest Expense
Interest bearing demand deposits	$	25,218		$	55		.87	%	$	25,031		$	46		.74	%
Savings and money markets		48,696			139		1.14	%		48,626			115		.94	%
Time deposits		164,822			1,679		4.04	%		145,867			1,165		3.17	%
Long term debt		15,781			174		4.41	%		15,779			167		4.20	%
Total Interest Bearing Liabilities		254,517			2,047		3.22	%		235,303			1,493		2.52	%
Demand deposits		47,930								41,073
Other liabilities		3,477								3,906
Stockholders’ equity		36,246								33,407
Total liabilities and stockholders’ equity	$	342,170							$	313,689
Net Interest Income				$	4,109							$	3,529
Net Yield on Earning Assets3							5.19	%							4.78	%
1Balances of loans include loans in non-accrual status
2Interest income on loans includes fees
3Yields are on a fully taxable equivalent basis

Page 17

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Non-interest Income

Non-interest income increased 22.23% for the first nine months of 2006 as compared to the same period in 2005.

This increase was impacted most by an increase in income received from customer overdraft charges. During the fourth quarter of 2005, Capon Valley Bank instituted a program commonly referred to as “courtesy overdraft.” This program, coupled with an increase in the volume of checking accounts at both subsidiary banks, was the primary reason for the continued increase in income from overdraft charges.

Also contributing to the increase in non-interest income was an increase in earnings on investments in life insurance contracts brought about by the settlement of two policies due to the death of an insured (see Note 4).

These increases were offset by a decline in insurance earnings. Insurance income continues to decrease due to the fact that the volume of new installment loans, the primary market for credit life and accident and health insurance, continues to fall.

Loan Portfolio

The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area. The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker, and northern Pendleton counties in West Virginia and Frederick County, Virginia. Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area.

Loan Growth During the Third Quarter of 2006

The Company, during the most recent quarter, experienced significant loan growth. The table below illustrates the change in loan balances between June 30, 2006 and September 30, 2006 (in thousands of dollars):

	Balance		Balance		(Decrease)			Percent
Loan Type	June 30, 2006		September 30, 2006		Increase			Change
Mortgage and Construction	$	171,007	$	175,164	$	4,157			2.43	%
Commercial		58,906		64,942		6,036			10.25	%
Consumer		43,437		43,211		(226	)		-.52	%
Total	$	273,350	$	283,317	$	9967			3.65	%

Management believes that the growth in its commercial loan portfolio has occurred for a number of reasons. As the Company grows it is better able to compete for large commercial loans. The local economy has continued to expand in recent years and the overall volume of commercial loans in our local area has increased. And, as the Company has expanded, the increase in the geographical footprint of operations has created opportunities for loans unavailable in the past.

Although commercial loans typically carry a larger degree of risk than the more traditional mortgage loans offered by community banks, the Company feels that the recent increase in balances in its commercial loan portfolio has not caused an abnormal increase in the amount of risk of the type which would cause significant losses. Management feels that the approval and underwriting process for new commercial loans is sufficient to mitigate abnormal risk. In most instances, new commercial loans underwritten by the Company, are secured by real estate; although the Company, as part of its underwriting process, determines that cash flows or projected cash flows for a new commercial customer are sufficient for loan repayment, there is typically an additional requirement that large commercial loans be adequately secured by real estate such that, in the event that cash flows for a commercial customer dissipate, the Company minimizes significant losses in the event of foreclosure.

Page 18

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Credit Quality and Allowance for Loan Losses

Nonperforming loans increased 11.80% from December 31, 2005 to September 30, 2006. Non performing loans represent .76% of gross loans at September 30, 2006, and .72% of gross loans at December 31, 2005.

Of the loans included below in the balances of nonperforming loans not adequately secured by real estate or other valuable assets, it is management’s opinion that amounts allowed for these loans in the allowance for loan losses is adequate to cover any potential loss and, as such, no loss material to operational results would occur.

The following table summarizes the Company’s nonperforming loans at September 30, 2006 and December 31, 2005 (in thousands of dollars):

	September 30,		December 31,
	2006		2005
Non-accrual loans	$	650	$	743
Loans past due 90 days and still accruing interest		1,510		1,189
Total nonperforming loans	$	2,160	$	1,932

Nonperforming loans include non-accrual loans, loans 90 days or more past due and restructured loans. Non-accrual loans are loans on which interest accruals have been suspended or discontinued permanently. Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower.

Loans are typically placed on non-accrual status once they have reached certain levels of delinquency, depending on loan type, and it is no longer reasonable to expect collection of principal and interest because collateral is insufficient to cover both the principal and interest due. After loans are placed on non-accrual status, they are typically returned to accrual status if the obligation is brought current by the borrower, or they are charged off if payment is not made and management believes that collection of the amounts due is doubtful. Charged-off loans are charged against the allowance for loan losses. Any subsequent collection or sale of repossessed collateral is added to the allowance as a recovery.

The carrying value of foreclosed property at September 30, 2006 was $390,000. All foreclosed property held as of September 30, 2006 was in the Company's primary service area. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance. The Company is actively marketing all foreclosed real estate and does not anticipate material write-downs in value before disposition.

Because of its large impact on the local economy, management continuously monitors the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company’s trade area.

In recent years, the Company’s loan portfolio has begun to reflect a concentration in loans collateralized by heavy equipment, particularly in the trucking, timber and coal extraction industries. In part because of rising fuel costs, and because of continued slow economic growth, the trucking sector experienced a recent downturn, and profitability growth within this sector still appears to be sluggish. While close monitoring of this sector is necessary, management expects no significant losses in the foreseeable future.

Page 19

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Credit Quality and Allowance for Loan Losses (continued)

The Company has loans to a large commercial customer who is active in coal extraction. Recently, Management has had reason to believe that timely repayment of this customer’s loans may be in doubt because of financial difficulties. Management also believes that the financial difficulties of this customer are unique to this customer and not indicative of a downturn in the local coal market. The majority of the coal extracted in the Company’s primary service area is used to supply an electrical power plant, also located in the Company’s primary service area. All indications are that this electrical power plant will continue to operate at or near capacity into the foreseeable future. Therefore, it is management’s belief that the health of the coal extraction industry in the Company’s primary service area remains stable and, other than the impact of the customer discussed above, loans to this local industry will continue to perform.

An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses provides for this risk and is reviewed periodically for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), timber and related industries. Management recognizes these concentrations and considers them when structuring its loan portfolio.

Each of the Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank, determines the adequacy of its allowance for loan losses independently. Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different charge-off rates amongst the functional areas of the banks’ portfolios. Each bank pays particular attention to individual loan performance, collateral values, borrower’s financial condition and economic conditions. The determination of an adequate allowance at each bank is done in a three step process. The first step is to identify impaired loans. Impaired loans are problem loans above a certain threshold which have estimated losses calculated based on collateral values and, to a lesser extent, projected cash flows. The second step is to identify loans above a certain threshold which are problem loans due to the borrower’s payment history or deteriorating financial condition. Losses in this category are determined based on historical loss rates adjusted for current economic conditions. The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification. The determination of specific allowances and weighting is somewhat subjective and actual losses may be greater or less than the amount of the allowance. However, Management believes that the allowance represents a fair assessment of the losses that exist in the current loan portfolio.

The required level of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula.

Management has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Nonperforming loans are closely monitored on an ongoing basis as part of the Company's loan review process.

Page 20

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Credit Quality and Allowance for Loan Losses (continued)

The following table shows the allocation for loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan type as of September 30, 2006 and December 31, 2005 (in thousands of dollars):

	September 30, 2006					December 31, 2005
			Percent of					Percent of
	Amount		Loans			Amount		Loans
Loan Type
Commercial	$	1,380		23	%	$	900		22	%
Mortgage and construction		1,012		62	%		1,139		62	%
Consumer		947		15	%		1,082		17	%
Unallocated		41					8
Totals	$	3,380				$	3,129

As certain loans identified as impaired are paid current, collateral values increase or loans are removed from watch lists for other reasons, and as other loans become identified as impaired, and because delinquency levels within each of the portfolios change, the allocation of the allowance among the loan types may change. Management feels that the allowance is a fair representation of the losses present in the portfolio given historical loss trends, economic conditions and any known credit problems as of a given date. Management believes that the allowance is to be taken as a whole, and allocation between loan types is an estimation of potential losses within each type, given information known at the time.

The following table summarizes the Company’s net charge-offs by loan type for the nine month periods ended September 30, 2006 and 2005 (in thousands of dollars):

	Quarter Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Charge-offs	$	(109	)	$	(174	)	$	(428	)	$	(445	)
Recoveries		42			59			171			144
Total net charge-offs		(67	)		(115	)		(257	)		(301	)
Components of net charge-offs
Real estate		0			(8	)		(1	)		(9	)
Commercial		(44	)		18			(23	)		(20	)
Consumer		(23	)		(125	)		(233	)		(272	)
Total	$	(67	)	$	(115	)	$	(257	)	$	(301	)

The provision for loan losses taken during the first nine months of 2006 was $182,000 less than that taken during the same period in 2005. In spite of the decrease in the provision, the percentage of the allowance for loan losses to gross loans increased from 1.16% at December 31, 2005 to 1.19% at September 30, 2006. The ratio of allowance for loan losses to nonperforming loans was 1.56 at September 30, 2006 compared to 1.62 at December 31, 2005.

Page 21

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Non-interest Expense

Non-interest expense increased 15.07% for the first nine months of 2006 as compared to 2005.

The addition of operations and the physical assets acquired with the purchase of the National Bank of Davis had a significant impact on the increase in non-interest expense. This purchase added eleven full time employees and two banking locations, increasing both the costs of salaries and benefits and occupancy and equipment expense. Also, the increase in both loan and deposit customers as a result of this acquisition caused an increase in data processing expense. Additionally, costs related to the conversion of the Davis data processing systems into the existing systems of The Grant County Bank continued into the second quarter of 2006, but these conversion costs significantly reduced in the third quarter of 2006 and Management expects that in the coming quarters there will be no further significant additional costs related to this system conversion.

Not all of the increase in non-interest expense can be attributed to the increased operational size of the Company as a result of the purchase of the additional branches. Continued growth in the operations of the Company caused marginal increases in both data processing and other types of non-interest expenses. Also, customary annual pay increases contributed to the rise in salary and benefits expense. Directors’ fees increased as the result of an increase in the per-meeting fees earned by directors.

Legal and professional fees increased both from the impact of increased operational size and usual inflationary trends and also because of an increase in the number of on-site engagements of audit firms during 2006 as compared to 2005. The company experienced a decline in legal and professional fees in the third quarter of 2006 as compared to the third quarter of last year. During the third quarter of 2005, as a result of engagements related to certain regulatory compliance efforts, the Company experienced an abnormally high amount of on-site audit and consulting engagements, hence the decline in legal and professional fees during the third quarter of 2006 as compared to last year. Management does not expect these significant year over year decreases in quarterly legal and professional fees to continue, but anticipates stabilization in these types of costs.

Borrowed Funds

The Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market rate risks, provide liquidity, and to fund capital additions. These borrowings may have fixed or variable interest rates and are amortized over a period of one to twenty years, or may be comprised of single payment borrowings with periodic interest payments and principal amounts due at maturity. In an attempt to manage interest expense and interest rate risk and as the competition for deposits have increased, the Company has, during recent years, used these available debt vehicles to fund loan growth more frequently than was utilized in the past.

During the fourth quarter of 2003, the Company obtained a $2,500,000 open line of credit with another commercial bank. This line of credit was secured by an equity interest in Capon Valley Bank, a subsidiary company. This debt instrument was obtained as a precautionary device for funding should a need arise in the future. Since this line of credit was obtained, there have been no advances of funds on this debt facility. It is not anticipated that any borrowings from this debt facility will be used to fund operating or liquidity needs.

Page 22

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Liquidity

Operating liquidity is the ability to meet present and future financial obligations. Short term liquidity is provided primarily through cash balances, deposits with other financial institutions, federal funds sold, non-pledged securities and loans maturing within one year. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds. To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions, the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.

Historically, the Company’s primary need for additional levels of operational liquidity has been to fund increases in loan balances. The Company has normally funded increases in loans by increasing deposits and by decreasing secondary liquidity sources, such as balances of Fed Funds sold and balances of securities. Although total deposit balances have decreased slightly in recent periods, the Company has substantially maintained or increased levels of these secondary liquidity resources and does not anticipate that an unexpectedly high level of loan demand in coming periods would impact liquidity to the extent that the Company would be required to pay above market rates to obtain deposits.

The parent Company’s operating funds, funds with which to pay shareholder dividends and funds for the exploration of new business ventures, have been supplied primarily through dividends paid by the Company’s subsidiary banks, Capon Valley Bank (CVB) and The Grant County Bank (GCB). The various regulatory authorities impose restrictions on dividends paid by a state bank. A state bank cannot pay dividends without the consent of the relevant banking authorities in excess of the total net profits of the current year and the combined retained profits of the previous two years. As of October 1, 2006, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $7,274,000 without permission of the regulatory authorities.

Capital

The Company seeks to maintain a strong capital base to expand facilities, promote public confidence, support current operations and grow at a manageable level. As of September 30, 2006, the Company was above the regulatory minimum levels of capital. The table below summarizes the capital ratios for the Company and its subsidiary banks as of September 30, 2006 and December 31, 2005:

	September 30, 2006						December 31, 2005
	Actual			Regulatory			Actual			Regulatory
	Ratio			Minimum			Ratio			Minimum
Total Risk Based Capital Ratio
Highlands Bankshares		13.67	%		8.00	%		13.85	%		8.00	%
Capon Valley Bank		14.39	%		8.00	%		13.45	%		8.00	%
The Grant County Bank		12.77	%		8.00	%		13.67	%		8.00	%
Tier 1 Leverage Ratio
Highlands Bankshares		9.47	%		3.00	%		9.45	%		3.00	%
Capon Valley Bank		9.49	%		3.00	%		8.87	%		3.00	%
The Grant County Bank		9.03	%		3.00	%		8.81	%		3.00	%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares		12.44	%		4.00	%		12.60	%		4.00	%
Capon Valley Bank		13.13	%		4.00	%		12.20	%		4.00	%
The Grant County Bank		11.55	%		4.00	%		12.47	%		4.00	%

Page 23

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Effects of Inflation

Inflation primarily affects industries having high levels of property, plant and equipment or inventories. Although the Company is not significantly affected in these areas, inflation does have an impact on the growth of assets. As assets grow rapidly, it becomes necessary to increase equity capital at proportionate levels to maintain the appropriate equity to asset ratios. Traditionally, the Company's earnings and high capital retention levels have enabled the Company to meet these needs. The Company's reported earnings results have been minimally affected by inflation. The different types of income and expense are affected in various ways. Interest rates are affected by inflation, but the timing and magnitude of the changes may not coincide with changes in the consumer price index. Management actively monitors interest rate sensitivity in order to minimize the effects of inflationary trends on interest rates. Other areas of non-interest expenses may be more directly affected by inflation.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in Quantitative and Qualitative Disclosures about Market Risk as reported in the Company’s Annual Report on Form 10-K for the period ended December 31, 2005.

Item 4. Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of September 30, 2006. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of September 30, 2006. The company has established procedures undertaken during the normal course of business in an effort to reasonably ensure that fraudulent activity of either an amount material to these results or in any amount is not occurring.

Changes in Internal Controls

During the period reported upon, there were no significant changes in internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that materially affected or are reasonably likely to materially affect such control.

Contained within the Company’s Report on Form 10-Q for the period ended March 31, 2006 and Report on Form 10-K for the year ended December 31, 2005 and in both instances under PART I, Item 4, the Company reported a requirement for additional controls to reasonably ensure that fraud of a material, or of any, amount were not occurring in relation to the purchase of the National Bank of Davis (Davis). In early April, 2006, all legacy Davis systems were merged fully with the systems of The Grant County Bank (Grant). Therefore, the requirement for additional controls related to this purchase are no longer necessary as the controls inherent to Grant’s operations are now sufficient to reasonably ensure that fraud of a material, or of any, amount is detected or prevented.

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PART IIOTHER INFORMATION

Item 1.Legal Proceedings

Management is not aware of any material pending or threatened litigation in which the Company or its subsidiaries may be involved as a defendant. In the normal course of business, the banks periodically must initiate suits against borrowers as a final course of action in collecting past due loans. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated legal action against the Company.

In late February of 2006, a third party alleged that an error had been made regarding the safekeeping of a deposit, specifically two certificates of deposit totaling $2,000,000 that had been assigned as collateral for a performance bond, had been released to the owners. It was alleged that the error was related to a trust account held by the now discontinued subsidiary of Highlands, Highlands Bankshares Trust Company. This third party indicated that if it experienced a loss relating to this bond, that it may pursue legal action as a potential remedy for this loss. Highlands has determined that the funds represented by the certificate of deposit had previously been delivered to the third party complainant. At this time, the potential for legal action or the amount of any potential liability to Highlands Bankshares or its subsidiaries is unknown.

Item 1A. Risk Factors

There have been no material changes to the Company’s risk factors since these factors were previously disclosed in the Company’s Annual Report on Form 10-K for the period ended December 31, 2005.

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

None

Item 3.Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

None

Item 6.	Exhibits
3(i)	Articles of Incorporation of Highlands Bankshares, Inc. are incorporated by reference to Appendix C to Highlands Bankhares, Inc.’s Form S-4 filed October 20, 1986.
3(ii)	Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhibit 3(ii) to Highlands Bankshares, Inc.’s Form 10-Q filed May 15, 2003.
31.1	Certification of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and (B).
31.2	Certification of Chief Financial Officer Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and (B).
32.1	Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.
32.2	Statement of Chief Financial Officer Pursuant to 18 U.S.C. § 1350.

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Signatures

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

	HIGHLANDS BANKSHARES, INC.
	/s/ C.E. Porter
	C.E. Porter
	President & Chief Executive Officer
	/s/ R. Alan Miller
	R. Alan Miller
	Chief Financial Officer
	Chief Accounting Officer
November 10, 2006