Highlands Bankshares (HBSI) 10-Q 2008 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, 2008.

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filed, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer [  ]	Accelerated Filer                  [   ]
Non-accelerated filer     [  ] (Do not check if a smaller reporting company)	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  [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 July 31, 2008:  1,336,873 shares of Common Stock, $5 Par Value

HIGHLANDS BANKSHARES, INC.
Quarterly Report on Form 10Q For The Period Ended September 30, 2008
	INDEX
		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Statements of Income Nine Months Ended September 30, 2008 and 2007	2
	Unaudited Consolidated Statements of Income Three Months Ended September 30, 2008 and 2007	3
	Unaudited Consolidated Balance Sheet for September 30, 2008 and Audited Consolidated Balance Sheet for December 31, 2007	4
	Unaudited Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2008 and 2007	5
	Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management’ Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.	Controls and Procedures	26
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	26
Item 1A.	Risk Factors	26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3.	Defaults Upon Senior Securities	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
Item 5.	Other Information	27
Item 6.	Exhibits	27
SIGNATURES		27

Page Two

PART I                           FINANCIAL INFORMATION

Item 1.                 Financial Statements

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)
	Nine Months Ended September 30
	2008			2007
	(unaudited)			(unaudited)
Interest Income
Interest and fees on loans	$	18,774		$	18,830
Interest on federal funds sold		231			600
Interest on deposits in other banks		38			100
Interest and dividends on securities		835			1,033
Total Interest Income		19,878			20,563
Interest Expense
Interest on deposits		6,467			7,458
Interest on federal funds purchased		10			0
Interest on borrowed money		363			447
Total Interest Expense		6,840			7,905
Net Interest Income		13,038			12,658
			��
Provision for Loan Losses		636			486
Net Interest Income After Provision for Loan Losses		12,402			12,172
Non-interest Income
Service Charges		1,286			979
Investment in insurance contracts		208			173
Gains on securities		109			0
Gains on sale of fixed assets		32			0
Other non-interest income		389			355
Total Non-interest Income		2,024			1,507
Non-interest Expense
Salaries and employee benefits		4,740			4,467
Equipment and occupancy expense		1,020			1,043
Data processing expense		616			649
Legal and professional fees		413			430
Other non-interest expense		1,782			1,728
Total Non-interest Expense		8,571			8,317
Income Before Provision For Income Taxes		5,855			5,362
Provision for Income Taxes		2,096			1,985
Net Income	$	3,759		$	3,377
Per Share Data
Net Income	$	2.69		$	2.35
Cash Dividends	$	.81		$	.75
Weighted Average Common Shares Outstanding		1,398,773			1,436,874
The accompanying notes are an integral part of these statements.

Page Three

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)
	Three Months Ended September 30
	2008		2007
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	6,162	$	6,471
Interest on federal funds sold		8		195
Interest on deposits in other banks		7		30
Interest and dividends on securities		294		383
Total Interest Income		6,471		7,079
Interest Expense
Interest on deposits		1,916		2,652
Interest on federal funds purchased		10		0
Interest on borrowed money		128		144
Total Interest Expense		2,054		2,796
Net Interest Income		4,417		4,283
Provision for Loan Losses		238		145
Net Interest Income After Provision for Loan Losses		4,179		4,138
Non-interest Income
Service Charges		467		347
Investment in insurance contracts		89		57
Gain on sale of fixed assets		7		0
Other non-interest income		124		138
Total Non-interest Income		687		542
Non-interest Expense
Salaries and employee benefits		1,599		1,504
Equipment and occupancy expense		341		352
Data processing expense		200		221
Legal and professional fees		148		153
Other non-interest expense		622		627
Total Non-interest Expense		2,910		2,857
Income Before Provision For Income Taxes		1,956		1,823
Provision for Income Taxes		656		690
Net Income	$	1,300	$	1,133
Per Share Data
Net Income	$	.97	$	.79
Cash Dividends	$	.27	$	.25
Weighted Average Common Shares Outstanding		1,337,311		1,436,874
The accompanying notes are an integral part of these statements.

Page Four

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands of Dollars)
	September 30, 2008			December 31, 2007
	(unaudited)			(audited)
ASSETS
Cash and due from banks—non-interest bearing	$	6,774		$	7,935
Deposits in other banks—interest bearing		492			1,853
Federal funds sold		828			14,246
Securities available for sale, at market value		23,398			26,090
Restricted investments		1,873			1,498
Loans		315,315			310,199
Allowance for loan losses		(3,651	)		(3,577	)
Bank premises and equipment, net of depreciation		8,085			8,104
Interest receivable		2,149			2,273
Investment in life insurance contracts		6,427			6,300
Goodwill		1,534			1,534
Other intangible assets		1,264			1,572
Other Assets		3,585			2,909
Total Assets	$	368,073		$	380,936
LIABILITIES
Non-interest bearing deposits	$	49,011		$	48,605
Savings and interest bearing demand deposits		69,364			73,736
Time deposits		192,707			201,397
Total Deposits		311,082			323,738
Long term debt		11,450			11,819
Federal funds purchased		775			0
Accrued expenses and other liabilities		5,323			4,786
Total Liabilities		328,630			340,343
STOCKHOLDERS’ EQUITY
Common stock ($5 par value, 3,000,000 shares authorized, 1,436,874 shares issued)		7,184			7,184
Surplus		1,662			1,662
Retained earnings		34,308			32,032
Other accumulated comprehensive loss		(339	)		(285	)
Treasury stock (at cost, 100,001 shares at September 30, 2008)		(3,372	)		0
Total Stockholders’ Equity		39,443			40,593
Total Liabilities and Stockholders’ Equity	$	368,073		$	380,936
The accompanying notes are an integral part of these statements.

Page Five

HIGHLANDS BANKSHARES, INC
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In Thousands of Dollars)
	Common Stock		Surplus		Treasury Stock		Retained Earnings			Accumulated Other Comprehensive Income			Total
Balances at December 31, 2006	$	7,184	$	1,662	$	0	$	28,816		$	(586	)	$	37,076
Net Income								3,377						3,377
Change in other comprehensive income											95			95
Total Comprehensive Income														3,472
Dividends Paid								(1,078	)					(1,078	)
Balances at September 30, 2007	$	7,184	$	1,662	$	0	$	31,115		$	(491	)	$	39,470

	Common Stock		Surplus		Treasury Stock			Retained Earnings			Accumulated Other Comprehensive Income			Total
Balances at December 31, 2007	$	7,184	$	1,662	$	0		$	32,032		$	(285	)	$	40,593
Net Income									3,759						3,759
Change in other comprehensive income												(54	)		(54	)
Cumulative effect adjustment to retained earnings for change in accounting principle									(348	)					(348	)
Total comprehensive Income															3,357
Treasury stock repurchased						(3,372	)								(3,372	)
Dividends paid									(1,135	)					(1,135	)
Balances at September 30, 2008	$	7,184	$	1,662	$	(3,372	)	$	34,308		$	(339	)	$	39,443

Page Six

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
	Nine Months Ended September 30,
	2008			2007
	(unaudited)			(unaudited)
Cash Flows From Operating Activities
Net Income	$	3,759		$	3,377
Adjustments to reconcile net income to net
cash provided by operating activities
(Gain) on investment securities		(109	)		0
(Gain) on sale of fixed asset		(32	)		0
Other (Gain)/Loss		22			0
Depreciation		512			519
Income from insurance contracts		(209	)		(173	)
Net amortization of securities		3			(163	)
Provision for loan losses		636			486
Deferred income tax benefit		(14	)		0
Amortization of intangibles		133			132
Net purchase of intangibles		175
Decrease (increase) in interest receivable		124			(361	)
Decrease (increase) in other assets		(685	)		(429	)
Increase (decrease) in accrued expenses and other liabilities		189			325
Net Cash Provided by Operating Activities		4,504			3,713
Cash Flows From Investing Activities
Increase (decrease) in federal funds sold		13,418			(342	)
Settlement on insurance contract		82			0
Proceeds from maturities of securities available for sale		15,282			6,479
Purchase of securities available for sale		(12,537	)		(10,827	)
Decrease (increase) in restricted investments		(375	)		71
Decrease (increase) in interest bearing deposits in other banks		1,361			(1,759	)
Purchase of property and equipment		(461	)		(428	)
Net Increase in Loans		(5,678	)		(15,476	)
Net Cash Provided by (Used in) Investing Activities		11,092			(22,282	)
Cash Flows From Financing Activities
Net change in deposits		(12,656	)		23,088
Federal funds purchased		775			0
Additional long term debt		1,500			0
Repayment of long term debt		(1,869	)		(2,727	)
Purchase of treasury stock		(3,372	)		0
Dividends paid in cash		(1,135	)		(1,078	)
Net Cash Provided (Used in) by Financing Activities		(16,757	)		19,283
Net Increase (decrease) in Cash and Cash Equivalents		(1,161	)		714
Cash and Cash Equivalents, Beginning of Period		7,935			7,111
Cash and Cash Equivalents, End of Period	$	6,774		$	7,825
Supplemental Disclosures
Cash paid for income taxes	$	1,997		$	2,315
Cash paid for interest	$	6,746		$	7,745
The accompanying notes are an integral part of these statements.

Page Seven

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 ACCOUNTING PRINCIPLES

These 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, 2008 and the results of operations for the three and nine month periods ended September 30, 2008 and 2007.

The results of operations for the three and nine month periods ended September 30, 2008 and 2007 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 2007 annual report on Form 10-K.

Certain reclassifications have been made to prior period balances to conform to the current year’s presentation format.

NOTE 2 LOANS

A summary of loans outstanding as of September 30, 2008 and December 31, 2007 is shown in the table below (in thousands of dollars):

	September 30,		December 31,
	2008		2007
Loan Type
Commercial	$	89,156	$	79,892
Real Estate construction		24,948		15,560
Real Estate mortgage		155,578		169,122
Consumer installment		45,633		45,625
Total Loans	$	315,315	$	310,199

In addition to loans to fund construction and traditional mortgage loans, portions of the portfolio identified as commercial are also secured by real estate.  At September 30, 2008, the total balance of loans in the portfolio secured by real estate was $248,980,000.

NOTE 3 INVESTMENT IN INSURANCE CONTRACTS

Investment in insurance contracts consist of single premium insurance contracts which have the dual purposes of providing a rate of return to the Company which approximately equals the Company’s average cost of funds and of providing life insurance and retirement benefits to certain executives.

A summary of the changes to the balance of investments in insurance contracts from December 31, 2007 to September 30, 2008 is shown in the table below (in thousands of dollars):

Balance December 31, 2007	$	6,300
Increases in value of policies		179
Settlement payout		(52	)
Balance September 30, 2008	$	6,427

Page Eight

NOTE 4 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 as of September 30, 2008 and December 31, 2007 is shown in the table below (in thousands of dollars). All of the securities on the Company’s balance sheet are classified as available for sale.

	September 30, 2008				December 31, 2007
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value
Available For Sale Securities
U.S. Treasuries and Agencies	$	8,704	$	8,826	$	15,040	$	15,245
Mortgage backed securities		10,785		10,839		7,718		7,784
Obligations of states and municipalities		3,696		3,711		3,034		3,039
Marketable equities		28		22		28		22
Total Available For Sale Securities	$	23,213	$	23,398	$	25,820	$	26,090

Information pertaining to securities with gross unrealized losses at December 31, 2007 and September 30, 2007, aggregated by investment category and length of time that individual securities have been in a continuous loss position is shown in the table below (in thousands of dollars):

	Total					Less than 12 Months					12 Months or Greater
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
September 30, 2008
Investment Category
Mortgage backed securities		5,794		(40	)		5,723		(39	)		71		(1	)
State and municipals		1,547		(10	)		1,547		(10	)		0		0
Other equity securities		22		(6	)		0		0			22		(6	)
Total	$	7,363	$	(56	)	$	7,270	$	(49	)	$	93	$	(7	)
December 31, 2007
Investment Category
U.S. Treasury and Agency	$	1,497	$	(2	)	$	0	$	0		$	1,497	$	(2	)
Mortgage backed securities		2,574		(8	)		1,005		(1	)		1,569		(7	)
State and municipals		575		(3	)		0		0			575		(3	)
Other equity securities		22		(6	)		22		(6	)		0		0
Total	$	4,668	$	(19	)	$	1,027	$	(7	)	$	3,641	$	(12	)

Restricted investments consist of investments in the Federal Home Loan Bank, the Federal Reserve Bank and West Virginia Bankers’ Title Insurance Company.  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 a collateral against the outstanding borrowings from that institution.

Page Nine

NOTE 5 ALLOWANCE FOR LOAN LOSSES

A summary of the transactions in the allowance for loan losses for the nine month periods ended September 30, 2008 and 2007 is shown below (in thousands of dollars):

	2008			2007
Balance, beginning of period	$	3,577		$	3,482
Provisions charged to operations		636			486
Loan recoveries		102			283
Loan charge-offs		(664	)		(540	)
Balance, end of period	$	3,651		$	3,711

NOTE 6 DEPOSITS

Balances of time deposits over $100,000 and of all other time deposits at September 30, 2008 and December 31, 2007 are shown below (in thousands of dollars):

	September 30,		December 31,
	2008		2007
Time deposits over $100,000	$	61,993	$	65,486
All other time deposits		130,714		135,911
Total Time Deposits	$	192,707	$	201,397

Interest expense for time deposits over $100,000 and for all other time deposits for the nine month and three month periods ended September 30, 2008 and 2007 is shown below (in thousands of dollars):

	Nine months ended September 30,				Three months ended September 30,
	2008		2007		2008		2007
Time deposits over $100,000	$	2,072	$	2,243	$	609	$	818
All other time deposits		3,982		4,540		1,213		1,587
Total interest paid on time deposits	$	6,054	$	6,783	$	1,822	$	2,405

NOTE 8 DEBT INSTRUMENTS

As it becomes necessary, the Company borrows money from the Federal Home Loan Bank of Pittsburgh (FHLB) to meet specificfunding needs.  The interest rates of the long term notes payable as of September 30, 2008 range from 3.94% to 5.96%.  The weighted average interest rate was 4.62% at September 30, 2008. The debt is secured by the general assets of the Banks.

On multiple instances during the third quarter of 2008, the subsidiary banks of Highlands Bankshares, due to a need for liquid funds, utilized overnight borrowing facilities available to each of the subsidiary banks. The average balance of overnight and other short term borrowings during the third quarter was $1,478,000.

Page Ten

NOTE 7 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.

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.  The bank was required to make contributions to the plan in 2007 and made a contribution to the plan during the first quarter of 2008.  The Bank has recognized liabilities of $206,000 at September 30, 2008 as a result of this shortfall.  The following table provides the components of the net periodic benefit cost for the plan for the nine month periods ended September 30, 2008 and 2007 (in thousands of dollars):

	2008			2007
Service cost	$	127		$	100
Interest cost		201			160
Expected return on plan assets		(244	)		(170	)
Amortization of unrecognized prior service costs		3			8
Recognized net actuarial loss		40			48
Net periodic expense	$	127		$	146

NOTE 9 EARNINGS PER SHARE

During the first nine months of 2007, there were no changes to the outstanding shares of common stock. During the second and third quarters of 2008, the Company purchased, at varying intervals, 100,001 shares of outstanding common stock. The weighted average shares, upon which earnings per share calculations for the three and nine month periods ended September 30, 2008, were calculated based upon the date repurchased and the number of shares repurchased on that date, as a percentage of the total period represented.

NOTE 10 INTANGIBLE ASSETS

The Company’s balance sheet contains several components of intangible assets. At September 30, 2008, the total balance of intangible assets was comprised of Goodwill and Core Deposit Intangible Assets acquired as a result of the acquisition of other banks and also an intangible asset related to the purchased naming rights for a performing arts center located within the Company’s primary business area.

During the fourth quarter of 2007, The Grant County Bank entered into an agreement to contribute $250,000 toward the erection of a performing arts center located within the Company’s primary business area. In return, the bank has been granted naming rights for this performing arts center. During the second quarter of 2008, the performing arts center reached an agreement with another party for the same rights but at better terms and cancelled the contractual agreement with The Grant County Bank. The $250,000 paid to the performing arts center was subsequently returned during the third quarter of 2008. After the cancellation of the original contract, the performing arts center and The Grant County Bank reached another agreement whereby a contribution of $75,000 was made in return for naming rights to only a portion of the same arts center.

A summary of the changes to the balance of goodwill and other intangible assets from December 31, 2007 to September 30, 2008 is shown below (in thousands of dollars):

Balance December 31, 2007	$	3,106
Amortization of intangibles other than goodwill		(133	)
Cancellation of original naming rights contract		(250	)
Purchase of new naming rights contract		75
Balance September 30, 2008	$	2,798

Page Eleven

NOTE 11 ADJUSTMENT TO RETAINED EARNINGS FOR CHANGE IN ACCOUNTING PRINCIPLE

In 2006, the FASB issued EITF 06-04 and EITF 06-10. These EITF pronouncements require that companies which own life insurance policies insuring employees and for which the employees receive a portion of the death benefits of the policies (commonly referred to as “split dollar” policies) and for which these death benefits to the employee continue post retirement record a liability for the present value of the cost of these post retirement death benefits. These EITF pronouncements became effective for Highlands Bankshares on January 1, 2008.

These EITF pronouncements provided an option for affected companies to record the resulting liability as a cumulative effect adjustment to retained earnings at the beginning of the period in which recorded or to record through retrospective application to prior periods. Highlands Bankshares opted to record the liability as a cumulative effect adjustment to prior period retained earnings and as such recorded a liability and corresponding reduction of prior period retained earnings of $348,000. There is no corresponding deferred tax consequence relating to this liability. The recording of the cumulative effect adjustment to prior period retained earnings is reflected in the June 30, 2008 balance of retained earnings and is shown as an adjustment to retained earnings in the Consolidated Statement of Changes in Stockholders’ Equity.

NOTE 12 FAIR VALUE MEASUREMENTS

SFAS No. 157, Fair Value Measurements, defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follow:

· Level One: Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

· Level Two: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

· Level Three: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Following is a description of the valuation methodologies used for instruments measured at fair value on the Company’s balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities

Where quoted prices are available in an active market, securities are classified within level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within level 3 of the valuation hierarchy.  Currently, all of the Company’s securities are considered to be Level 2 securities.

Impaired Loans

SFAS No. 157 applies to loans measured for impairment using the practical expedients permitted by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral.

Other Real Estate Owned

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of SFAS No. 157.

Page Twelve

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

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 Annual Report on Form 10-K for the period ended December 31, 2007.  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.

Disclosure of the Company’s significant accounting policies is included in Note Two to the Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the period ended December 31, 2007. Some of the policies are particularly sensitive, requiring significant judgments, estimates and assumptions by management.

Allowance for Loan Losses

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) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (SFAS 5), which requires that losses be accrued when they are probable of occurring and estimable, and (ii) Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114), 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.

The allowance for loan losses includes two basic components: estimated credit losses on individually evaluated loans that are determined to be impaired, and estimated credit losses inherent in the remainder of the loan portfolio. Under SFAS 114, an individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. An individually evaluated loan that is determined not to be impaired under SFAS 114 is evaluated under SFAS 5 when specific characteristics of the loan indicate that it is probable there would be estimated credit losses in a group of loans with those characteristics.

SFAS 114 does not specify how an institution should identify loans that are to be evaluated for collectibility, nor does it specify how an institution should determine that a loan is impaired. Each subsidiary of Highlands Bankshares uses its standard loan review procedures in making those judgments so that allowance estimates are based on a comprehensive analysis of the loan portfolio. For loans within the scope of SFAS 114 that are individually evaluated and found to be impaired, the associated allowance is based on upon the estimated fair value, less costs to sell, of any collateral securing the loan as compared to the existing balance of the loan as of the date of analysis.

All other loans, including individually evaluated loans determined not to be impaired under SFAS 114, are included in a group of loans that are measured under SFAS 5 to provide for estimated credit losses that have been incurred on groups of loans with similar risk characteristics. The methodology for measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with SFAS 5 is based on each group’s historical net charge-off rate, adjusted for the effects of the qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience.

Page Thirteen

Investment in Life Insurance Policies

The Company has invested in and owns life insurance policies 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 employers' 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.

Intangible Assets

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.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.  SFAS 157 does not require any new fair value measurements, but provides enhanced guidance to other pronouncements that require or permit assets or liabilities to be measured at fair value.  This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years.  As of December 1, 2007, the FASB has proposed a one-year deferral for the implementation of the Statement for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis.  SFAS 157 had no material impact on the Company’s September 30, 2008 financial statements. Additional disclosure information required by this pronouncement is included as a footnote to the financial statements.

In 2006, the FASB issued EITF 06-04 and 06-10. These EITF pronouncements require that companies which own life insurance policies insuring employees and for which the employees receive a portion of the death benefits of the policies (commonly referred to as “split dollar” policies) and for which these death benefits to the employee continue post retirement record a liability for the present value of the cost of these post retirement death benefits. These EITF pronouncements became effective for Highlands Bankshares on January 1, 2008. These EITF pronouncements provided an option for affected companies to record the resulting liability as a cumulative effect adjustment to retained earnings at the beginning of the period in which recorded or to record through retrospective application to prior periods. Highlands Bankshares opted to record the liability as a cumulative effect adjustment to prior period retained earnings and as such recorded a liability and corresponding reduction of prior period retained earnings of $348,000. There is no corresponding deferred tax consequence relating to this liability.

No other recent accounting pronouncements had a material impact on the Company’s consolidated financial statements, and it is believed that none will have a material impact on the Company’s operations in future years.

Page Fourteen

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 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; and (5) 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.

Overview

Income for the first nine months of 2008 increased 11.31% compared to the first nine months of 2007. For the same nine month periods, earnings per weighted average share outstanding (EPS) increased 14.47%. The Company’s increase in net income was due largely to continued increases in net interest income and increases in other non interest income, offset slightly by increases in operational expenses. Loan growth has slowed compared to recent years, however, balances of loans were 1.65% greater at September 30, 2008 than at December 31, 2007. This slowing loan growth and changes in relative rates of earning assets and liabilities prompted certain measures of balance sheet management by the Company, namely a reduction in time deposits, which allowed net interest income, before provision for loan loss, to increase 3.00% in spite of the slowing loan demand.

Income for the three months ended September 30, 2008 increased 14.74% as compared to the third quarter of 2007. For the same three month periods, EPS increased 22.78%

The increase in EPS for each of the comparative periods indicated above is larger than the increase in net income for the same periods due to a reduction in shares outstanding as the result of the Company’s repurchase of 100,001 shares during the second and third quarters of 2008.This share repurchase also had the effect of increasing the Company’s Return on Average Equity, as the effect of the share repurchase was to reduce shareholders’ equity by $3,372,000.

The Company’s assets at September 30, 2008 as compared to December 31, 2007 decreased by 3.38%. This reduction in assets came as a result of both the share repurchase program referenced above and also as a result of management efforts to maintain net interest income margins through closer management of earning assets and liabilities which is discussed further under the heading “Net Interest Income.”

Page Fifteen

Performance Measures

The table below compares selected commonly used measures of bank performance for the three and nine month periods ended September 30, 2007 and 2008:

	Three months ended September 30,						Nine months ended September 30,
	2008			2007			2008			2007
Annualized return on average assets		1.41	%		1.20	%		1.33	%		1.21	%
Annualized return on average equity		12.46	%		11.76	%		13.38	%		11.80	%
Net interest margin (1)		5.16	%		4.88	%		4.97	%		4.90	%
Efficiency Ratio (2)		57.02	%		59.21	%		56.91	%		58.72	%
Earnings per share (3)	$	.97		$	.79		$	2.69		$	2.35

(1) On a fully taxable equivalent basis and including loan origination fees

(2) Non-interest expenses for the period indicated divided by the sum of net interest income and non-interest income for the period indicated

(3) Per weighted average shares of common stock outstanding for the period indicated. Earnings per share for the three and nine month periods ended September 30, 2008 reflect share repurchase of 100,001 shares during the second and third quarters of 2008.

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, Frederick County, Virginia and Garrett County, Maryland.  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.

Securities Portfolio

The Company's securities portfolio serves several purposes.  Portions of the portfolio are used to secure certain public and trust deposits.  The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management.  Total securities, including restricted securities, represented 6.87% of total assets and 64.07% of total shareholders’ equity at September 20, 2008.

The securities portfolio typically will consist of three components:  securities held to maturity, securities available for sale and restricted securities.  Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity.  Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value.  Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors.  Restricted securities are those investments purchased as a requirement of membership in certain governmental lending institutions and cannot be transferred without the issuer’s permission.  The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities.

Page Sixteen

The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity.  Changes in market values of securities which are considered temporary changes due to changes in the market rate of interest are reflected as changes in other comprehensive income, net of the deferred tax effect.  Any changes in market values of securities deemed by management to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations  It is management’s determination that all securities held at September 30, 2008 which have fair values less than the amortized cost, have these gross unrealized losses related to increases in the current interest rates for similar issues of securities, and that no material impairment for any securities in the portfolio exists because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. A summary of the length of time of unrealized losses for all securities held at September 30, 2008 can be found in the footnotes to the financial statements. Management reviews all securities with unrealized losses, and all securities in the portfolio on a regular basis to determine whether the potential for other than temporary impairment exists. One of the criteria for making this determination is the rating given to each bond by the major ratings agencies Moodys and Standard & Poors. A summary of the Company’s securities portfolio at September 30, 2008, based on the ratings of the securities in the portfolio given by these ratings agencies is shown below (in thousands of dollars):

		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Market Value
Ratings Provided by Ratings Agencies
Moody’s	S&P
U.S. Treasuries and Agencies
Aaa	AAA	$	8,704	$	122	$	0	$	8,826
Mortgage Backed Securities
Aaa	AAA	$	10,785	$	94	$	40	$	10,839
State and Municipals
Aaa	AAA	$	1,618	$	14	$	9	$	1,623
Aa2	AA		608		5		0		613
Aa3	AA-		514		0		3		512
A2	A		205		1		0		206
A3	A-		140		2		0		142
Baa1	BBB+		155		0		0		155
No Rating			456		4		0		460
Marketable Equities
No Rating		$	28	$	0	$	6	$	22

Page Seventeen

Credit Quality and Allowance for Loan Losses

The following table illustrates certain ratios related to quality of the Company’s loan portfolio:

	September 30, 2008			December 31, 2007
Allowance for loan losses as a percentage of gross loans		1.16	%		1.15	%
Non performing loans as a percentage of gross loans		0.93	%		1.08	%
Ratio of allowance for loan losses to non-performing loans		1.25			1.07

The following table summarizes the Company’s non-performing loans at September 30, 2008 and December 31, 2007 (in thousands of dollars):

	September 30,		December 31,
	2008		2007
Non-accrual loans	$	659	$	916
Loans past due 90 days and still accruing interest		1,560		2,244
Restructured loans		705		198
Total non-performing loans	$	2,924	$	3,358

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. Non-performing loans are closely monitored on an ongoing basis as part of the Company's loan review process.   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.  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.

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, 2008 and December 31, 2007 (in thousands of dollars):

	September 30, 2008					December 31, 2007
			Percent of					Percent of
	Amount		Loans			Amount		Loans
Loan Type
Commercial	$	1,301		28	%	$	1,140		26	%
Mortgage and construction		864		57	%		1,200		59	%
Consumer		1,311		15	%		1,172		15	%
Unallocated		175					65
Totals	$	3,651				$	3,577

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. Due to concerns by management regarding deterioration of the economy and the potential effects of this deterioration on the quality of the loan portfolio, it was deemed appropriate by management that a larger unallocated portion of the allowance exist.

Page Eighteen

The following table summarizes the Company’s net charge-offs by loan type for the nine month periods ended September 30, 2008 and 2007 (in thousands of dollars):

	2008			2007
Charge-offs
Commercial	$	(170	)	$	(141	)
Mortgage and construction		(155	)		(38	)
Consumer		(339	)		(361	)
Total Charge-offs		(664	)		(540	)
Recoveries
Commercial		19			50
Mortgage		2			4
Consumer		81			229
Total Recoveries		102			283
Total Net Charge-offs	$	(562	)	$	(257	)

Year to date in 2008, the Company has experienced a significant increase in net charge-offs as compared to 2007. The recoveries experienced during 2007 on previously charged off loans was greater than the organization has typically historically experienced, with the result being that net charge-off rates for the nine month period ended September 30, 2007 were lower than often historically experienced by the Company.

Because of the 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 periods, 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 and timber sectors have experienced recent downturns, 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.

Net Interest Income

Net interest income for the first nine months of 2008, on a fully taxable equivalent basis, increased 3.05% as compared to the same period in 2007.

The Company’s loan demand, as compared to recent years, has slowed. Although demand is slowing compared to recent periods, the call for new loans in the Company’s market area has still been enough to maintain modest growth in loan balances and average loan balances during the first nine months of 2008 were 4.15% higher than during the same period in 2007 and total loan balances increased 2.20% (annualized) from December 31, 2007 to September 30, 2008.

Due do the slowing loan demand and to reductions in the relative earnings potential of other earning assets like federal funds sold as compared to costs of new deposits, management, during the second and third quarters of 2008 maintained rates on deposit products less than the rates offered by local competition for similar products. The effect of this action was a reduction in balances of deposits, mainly time deposits. Although average balances of time deposits during the first nine months of 2008 were higher than during the same period in 2007, the Company’s total balances of time deposits have decreased 4.31% from December 31, 2007 to September 30, 2008 and a corresponding effect of lowered balances of lesser earning assets such as federal funds sold, interest bearing deposits in other banks, and, to a lesser degree, securities available for sale.

Page Nineteen

Management’s efforts to increase the relative weight of loans, a higher earning asset, to total average balances of earning assets through the reduction of assets earning a lower rate of interest and reduction of interest costs through the reduction of balances of time deposits contributed to increases in the Company’s net interest margin for the first nine months and for the third quarter of 2008 as compared to the same periods in 2007.

During the latter parts of the third quarter, reduction in deposits also required the Company to begin short term borrowing of overnight federal funds purchased. Historically, management of Highlands has not frequently utilized short term borrowing facilities. However, the relative opportunity cost of these sources of funding as compared to deposits or longer term debt vehicles made this an attractive funding option given current trends in rates on both earning assets and interest bearing liabilities and trends in the Company’s loan growth. Although not considered a permanent funding option by the Company, management will continue to evaluate the relative cost of funding options as compared to growth opportunities for earning assets and will utilize overnight borrowings as feasible.

The table below illustrates the effects on net interest income, on a fully taxable equivalent basis, and for the first nine months of each year, of changes in average volumes of interest bearing liabilities and earning assets from 2007 to 2008 and changes in average rates on interest bearing liabilities and earning assets from 2007 to 2008 (in thousands of dollars):

EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
(On a fully taxable equivalent basis)
(In thousands of dollars)
Increase (Decrease) Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007
	Due to change in:
	Average Volume			Average Rate			Total Change
Interest Income
Loans	$	781		$	(837	)	$	(56	)
Federal funds sold		(136	)		(233	)		(369	)
Interest bearing deposits		(30	)		(32	)		(62	)
Taxable investment securities		(115	)		(91	)		(206	)
Nontaxable investment securities		14			0			14
Total Interest Income		514			(1,193	)		(679	)
Interest Expense
Demand deposits		(12	)		(83	)		(95	)
Savings deposits		25			(193	)		(168	)
Time deposits		76			(804	)		(728	)
Federal funds purchased		10			0			10
Borrowed money		(57	)		(27	)		(84	)
Total Interest Expense		42			(1,107	)		(1,065	)
Net Interest Income	$	472		$	(86	)	$	386

Page Twenty

The table below sets forth an analysis of net interest income for the nine month periods ended September 30, 2008 and 2007 (Average balances and interest/expense shown in thousands of dollars):

	2008								2007
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	313,392		$	18,774		7.99	%	$	300,905		$	18,830		8.34	%
Federal funds sold		12,157			231		2.53	%		15,715			600		5.09	%
Interest bearing deposits		1,747			38		2.90	%		2,490			100		5.35	%
Taxable investment securities		20,717			742		4.78	%		23,581			948		5.36	%
Nontaxable investment securities3		3,239			148		6.09	%		2,927			134		6.10	%
Total Earning Assets		351,252			19,933		7.57	%		345,618			20,612		7.95	%
Cash and cash equivalents		7,339								8,006
Allowance for loan losses		(3,605	)							(3,626	)
Insurance contracts		6,368								6,151
Non-earning assets		16,337								15,535
Total Assets	$	377,692							$	371,684
Interest Expense
Interest bearing demand deposits	$	23,700		$	73		0.41	%	$	25,528		$	168		0.88	%
Savings and money markets		50,144			339		0.90	%		47,744			507		1.42	%
Time deposits		196,328			6,055		4.11	%		194,156			6,783		4.66	%
Long term debt		11,217			363		4.31	%		12,841			447		4.64	%
Short term borrowings		496			10		2.69	%		0			0
Total Interest Bearing Liabilities		281,885			6,840		3.24	%		280,269			7,905		3.76	%
Demand deposits		50,020								48,249
Other liabilities		5,499								4,923
Stockholders’ equity		40,288								38,243
Total liabilities and stockholders’ equity	$	377,692							$	371,684
Net Interest Income				$	13,094							$	12,707
Net Yield on Earning Assets3							4.97	%							4.90	%

1Balances of loans include loans in non accrual status

2Interest income on loans includes fees

3Yields are on a fully taxable equivalent basis

Page Twenty One

The table below sets forth an analysis of net interest income for the three month periods ended September 30, 2008 and 2007 (Average balances and interest/expense shown in thousands of dollars):

	2008								2007
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	316,627		$	6,162		7.78	%	$	305,542		$	6,471		8.47	%
Federal funds sold		1,383			8		2.31	%		15,449			195		5.05	%
Interest bearing deposits		773			7		3.63	%		2,660			30		4.51	%
Taxable investment securities		21,669			257		4.74	%		25,792			354		5.49	%
Nontaxable investment securities3		3,535			57		6.45	%		2,860			46		6.43	%
Total Earning Assets		343,987			6,491		7.55	%		352,303			7,096		8.06	%
Cash and cash equivalents		7,260								7,950
Allowance for loan losses		(3,698	)							(3,693	)
Insurance contracts		6,423								6,205
Non-earning assets		16,749								16,518
Total Assets	$	370,721							$	379,283
Interest Expense
Interest bearing demand deposits	$	22,878		$	19		0.33	%	$	24,538		$	55		0.90	%
Savings and money markets		49,300			88		0.71	%		49,278			191		1.55	%
Time deposits		191,463			1,809		3.78	%		201,223			2,406		4.78	%
Long term debt		11,283			128		4.54	%		12,416			144		4.64	%
Short term borrowings		1,478			10		2.71	%		0			0
Total Interest Bearing Liabilities		276,402			2,054		2.97	%		287,275			2,796		3.89	%
Demand deposits		49,832								47,435
Other liabilities		5,410								5,550
Stockholders’ equity		39,077								39,023
Total liabilities and stockholders’ equity	$	370,721							$	379,283
Net Interest Income				$	4,437							$	4,300
Net Yield on Earning Assets3							5.16	%							4.88	%

1Balances of loans include loans in non accrual status

2Interest income on loans includes fees

3Yields are on a fully taxable equivalent basis

Page Twenty Two

Non-interest Income

Non-interest income increased 34.31% for the first nine months of 2008 as compared to the same period in 2007.

Income received from customer deposit account service charges increased $307,000 due to continued growth in balances of demand deposits, a large source of these charges, and also to the implementation by The Grant County Bank, during the last quarter of 2007, of a courtesy overdraft program, which resulted in an increase in non-sufficient funds fees collected by that bank.

Non interest income was also impacted by $177,000 in non recurring gains. The table below summarizes the components of non-recurring income recorded during the first nine months of 2008:

Description of non-recurring income	Amount
Gains recorded on called securities available for sale	$	109
Gain on life insurance settlement		30
Gain on sale of fixed assets		30
Gain on sale of other real estate owned		8

Non-interest Expense

Non-interest expense increased 3.05% for the first nine months of 2008 as compared to 2007.

Salary and benefits expense

The following table compares the components of salary and benefits expense for the nine month periods ended September 30, 2007 and 2008 (in thousands of dollars):

Salary and Benefits Expense
	Nine month periods ended September 30,
	2008		2007		Increase (Decrease)
Employee salaries	$	3,159	$	2,986	$	173
Employee benefit insurance		683		640		43
Payroll taxes		232		209		23
Post retirement plans		666		632		34
Total	$	4,740	$	4,467	$	273

The table below illustrates the change in salary expense between the first nine months of 2008 compared to salary expense for the same period in 2007 occurring because of increases in average pay per employee and increases in the average number of full time employees (in thousands of dollars):

	Amount
Changes due to increase in average salary per full time equivalent employee	$	142
Changes due to increase in the average full time equivalent employees for the periods		31
Total increase in salary expense	$	173

Data processing expense

Data processing expense decreased 5.08%. As the company has moved toward increased electronic transfer of information between branch locations and centralized data processing locations, data processing costs have been reduced.

Page Twenty Three

Occupancy and equipment expense

The following table illustrates the components of occupancy and equipment expense for the nine month periods ended September 30, 2008 and 2007 (in thousands of dollars):

	2008		2007		Increase (Decrease)
Depreciation of buildings and equipment	$	512	$	519	$	(7	)
Maintenance expense on buildings and equipment		316		327		(11	)
Utilities expense		67		73		(6	)
Real estate and personal property tax		62		62		0
Other expense related to occupancy and equipment		63		62		1
Total occupancy and equipment expense	$	1,020	$	1,043	$	(23	)

Other non interest expense

Other non interest expense remained comparatively flat for the first three quarters of 2008 as compared to the same period in 2007. The typical increases in costs associated with inflation and the increasing size of the organization were offset by decreases in state franchise tax expense as a result of a reduction in the effective rate of this tax and also decreases in advertising and marketing expense and a slight decline in legal and professional fees.

The table below illustrates components of other non interest expense for the nine month periods ended September 30, 2008 and 2007 (in thousands of dollars). All components of other non interest expense comprising over 5% of the total are itemized.

	2008		2007		Increase (Decrease)
Legal and professional fees	$	413	$	430	$	(17	)
Directors fees		274		283		(9	)
Amortization of intangible assets		134		132		2
Office supplies and postage		382		370		12
ATM expense		146		141		5
Advertising and marketing expense		134		154		(20	)
State franchise tax expense		79		108		(29	)
Miscellaneous components of other non interest expense		633		540		93
Total	$	2,195	$	2,158	$	37

.

Borrowed Funds

The Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market rate risks or to provide operating liquidity.  Management typically will initiate these borrowings in response to a specific need for managing market risks or for a specific liquidity need and will attempt to match features of these borrowings to best suit the specific need. Therefore, the borrowings on the Company’s balance sheet as of September 30, 2008 and throughout the three and nine month periods ended September 30, 2008 have varying features of amortization or single payment with periodic, regular interest payment and also have interest rates which vary based on the terms and on the features of the specific borrowing.

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.

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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 with decreases in liquid assets such as balances of federal funds sold and balances of securities. The Company also utilizes existing borrowing facilities for additional levels of operating liquidity. In choosing which sources of operating liquidity to utilize, management evaluates the implications of each liquidity source and its impact on profitability, balance sheet stability and potential future liquidity needs.

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, 2008, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $5,723,000 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, 2008, 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, 2008 and December 31, 2007:

	September 30, 2008						December 31, 2007
	Actual			Regulatory			Actual			Regulatory
	Ratio			Minimum			Ratio			Minimum
Total Risk Based Capital Ratio
Highlands Bankshares		14.24	%		8.00	%		14.53	%		8.00	%
Capon Valley Bank		13.10	%		8.00	%		14.78	%		8.00	%
The Grant County Bank		13.98	%		8.00	%		13.23	%		8.00	%
Tier 1 Leverage Ratio
Highlands Bankshares		10.05	%		4.00	%		9.95	%		4.00	%
Capon Valley Bank		9.07	%		4.00	%		10.00	%		4.00	%
The Grant County Bank		9.85	%		4.00	%		9.09	%		4.00	%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares		13.00	%		4.00	%		13.28	%		4.00	%
Capon Valley Bank		11.85	%		4.00	%		13.53	%		4.00	%
The Grant County Bank		12.75	%		4.00	%		12.09	%		4.00	%

In April of 2008, Highlands Bankshares announced that its Board of Directors had authorized the Company’s management to repurchase up to 100,000 shares of the Company’s outstanding common stock and in early July of 2008 announced that the repurchase of 100,000 shares had been completed.  This repurchase of the Company’s common stock outstanding has had the effect of lowering capital. Management and the board of directors feels that the Company and both subsidiary banks’ current levels of capitalization as compared to regulatory minimums are such that the effects on capital of this repurchase program have not reduced capital to an extent that any type of regulatory action will occur as a result of lowered capital levels.

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Subsequent to September 30, 2008, U.S. Treasury announced a Troubled Asset Relief Program (“TARP”) which includes provisions whereby the US Treasury could infuse capital into qualifying banks via a capital purchase program. The amount of capital available under TARP is limited to a minimum of 1% of risk weighted assets and a maximum of 3% of risk weighted assets and would be available to qualifying banks via sale of senior preferred stock, in combination with warrants on common stock, to the United States Treasury.  After careful consideration of the potential outcomes relating to participating in this capital purchase program versus not participating, Management and the Board of Directors of Highlands Bankshares have decided not to participate in the capital purchase program.

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, 2007.

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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, 2008. 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, 2008. 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.

PART II OTHER 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.

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, 2007.

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

(a)  None

(b) None

(c)  On April 8, 2008 the Company announced a share repurchase plan whereby Management was authorized by the Board of Directors to repurchase up to 100,000 shares of the Company’s Common Stock, $5 par value, through open market transactions. On July 8, 2008 the Company announced that it had successfully completed the share repurchase plan at a total cost of $3,372,000 to repurchase 100,001 shares of the Company’s shares of common stock outstanding. The table below summarizes the shares purchased from the announcement date through September 30, 2008.

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan		Maximum Number of Shares that May Yet Be Purchased Under the Plan
April 9, 2008—April 30, 2008		3,100	$	29.07		3,100		96,900
May 1, 2008—May 31, 2008		4,631	$	31.21		4,631		92,269
June 1, 2008—June 30, 2008		68,710	$	33.70		68,710		23,559
July 1, 2008—July 31, 2008		23,560	$	34.88		23,560		0
Total		100,001	$	33.72		100,001		0

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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

EXHIBIT INDEX
Exhibit Number	Description
3(i)	Articles of Incorporation of Highlands Bankshares, Inc., as restated, are hereby incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s Form 10-Q filed November 13, 2007 .
3(ii)	Amended Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed January 9, 2008.
31.1	Certification of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley  Act  of 2002 Chapter 63, Title 18 USC 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 USC 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.

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
	Principal Financial Officer
November 12, 2008