Highlands Bankshares (HBSI) 10-Q 2009 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, 2009.

[  ]  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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [   ]  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 [   ]		Smaller reporting company [X]
Accelerated Filer            [   ]	(Do not check if a smaller reporting company)	Non-accelerated filer     [  ]

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 November 12, 2009:  1,336,873 shares of Common Stock, $5 Par Value

HIGHLANDS BANKSHARES, INC.
Quarterly Report on Form 10Q For The Period Ended September 30, 2009
INDEX
		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Statements of Income Nine Months Ended September 30, 2009 and 2008	1
	Unaudited Consolidated Statements of Income Three Months Ended September 30, 2009 and 2008	2
	Unaudited Consolidated Balance Sheet for September 30, 2009 and Audited Consolidated Balance Sheet for December 31, 2008	3
	Unaudited Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2009 and 2008	4
	Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’ Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29
Item 4.	Controls and Procedures	29
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	29
Item 4.	Submission of Matters to a Vote of Security Holders	30
Item 5.	Other Information	30
Item 6.	Exhibits	30
SIGNATURES		30

Page One

PART I.

Item 1. Financial Statements

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)
	Nine Months Ended September 30
	2009			2008
	(unaudited)			(unaudited)
Interest Income
Interest and fees on loans	$	17,513		$	18,774
Interest on federal funds sold		15			231
Interest on deposits in other banks		11			38
Interest and dividends on securities		661			835
Total Interest Income		18,200			19,878
Interest Expense
Interest on deposits		5,566			6,467
Interest on federal funds purchased		0			10
Interest on borrowed money		397			363
Total Interest Expense		5,963			6,840
Net Interest Income		12,237			13,038
Provision for Loan Losses		1,175			636
Net Interest Income After Provision for Loan Losses		11,062			12,402
Non-interest Income
Service charges		1,261			1,286
Investment in insurance contracts		167			208
Gains (losses) on securities		(13	)		109
Gains on sale of fixed assets		1			30
Other non-interest income		411			391
Total Non-interest Income		1,827			2,024
Non-interest Expense
Salaries and employee benefits		4,998			4,740
Equipment and occupancy expense		1,023			1,020
Data processing expense		502			616
Directors fees		310			274
Legal and professional fees		432			413
Other non-interest expense		1,954			1,508
Total Non-interest Expense		9,219			8,571
Income Before Provision For Income Taxes		3,670			5,855
Provision for Income Taxes		1,312			2,096
Net Income	$	2,358		$	3,759
Per Share Data
Net Income	$	1.76		$	2.69
Cash Dividends	$	.87		$	.81
Weighted Average Common Shares Outstanding		1,336,873			1,398,773
The accompanying notes are an integral part of these statements.

Page Two

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands of Dollars, Except Per Share Data)

	Three Months Ended September 30
	2009		2008
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	5,812	$	6,162
Interest on federal funds sold		6		8
Interest on deposits in other banks		5		7
Interest and dividends on securities		217		294
Total Interest Income		6,040		6,471
Interest Expense
Interest on deposits		1,856		1,916
Interest on federal funds purchased		0		10
Interest on borrowed money		128		128
Total Interest Expense		1,984		2,054
Net Interest Income		4,056		4,417
Provision for Loan Losses		354		238
Net Interest Income After Provision for Loan Losses		3,702		4,179
Non-interest Income
Service charges		455		467
Income on insurance contracts		56		89
Gains (losses) on securities		0		0
Gains on sale of fixed assets		0		7
Other non-interest income		169		124
Total Non-interest Income		680		687
Non-interest Expense
Salaries and employee benefits		1,741		1,599
Equipment and occupancy expense		351		341
Data processing expense		163		200
Directors fees		125		76
Legal and professional fees		204		148
Other non-interest expense		659		546
Total Non-interest Expense		3,243		2,910
Income Before Provision For Income Taxes		1,139		1,956
Provision for Income Taxes		404		656
Net Income	$	735	$	1,300
Per Share Data
Net Income	$	.55	$	.97
Cash Dividends	$	.29	$	.27
Weighted Average Common Shares Outstanding		1,336,873		1,337,311

  The accompanying notes are an integral part of these statements.

Page Three

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands of dollars)

	September 30, 2009			December 31, 2008
	(unaudited)			(audited)
ASSETS
Cash and due from banks	$	6,549		$	7,589
Interest bearing deposits in banks		1,091			502
Federal funds sold		12,115			160
Investment securities available for sale		26,807			21,692
Restricted investments		2,185			2,177
Loans		334,491			325,754
Allowance for loan losses		(3,902	)		(3,667	)
Bank premises and equipment, net of depreciation		9,169			8,031
Interest receivable		1,829			2,164
Investment in life insurance contracts		6,683			6,499
Goodwill		1,534			1,534
Other intangible assets		1,069			1,215
Other assets		5,324			4,645
Total Assets	$	404,944		$	378,295
LIABILITIES
Deposits
Non-interest bearing deposits	$	50,825		$	49,604
Interest bearing transaction and savings accounts		72,765			68,610
Time deposits over $100,000		73,229			64,779
All other time deposits		149,799			133,294
Total Deposits		346,618			316,287
Overnight and other short term debt instruments		0			4,800
Long term debt instruments		10,981			11,317
Accrued expenses and other liabilities		6,654			6,492
Total Liabilities		364,253			338,896
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
Treasury stock (100,001 shares, at cost)		(3,372	)		(3,372	)
Retained earnings		36,353			35,157
Other accumulated comprehensive loss		(1,136	)		(1,232	)
Total Stockholders’ Equity		40,691			39,399
Total Liabilities and Stockholders’ Equity	$	404,944		$	378,295
The accompanying notes are an integral part of these statements

Page Four

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In Thousands of Dollars)
	Common Stock		Surplus		Treasury  Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total
Balances at December 31, 2007	$	7,184	$	1,662	$	0		$	32,032		$	(285	)	$	40,593
Cumulative effect adjustment to retained earnings for change in accounting principle									(348	)					(348	)
Other Comprehensive Income:
Net Income									3,759						3,759
Change in other comprehensive income												(54	)		(54	)
Total Comprehensive Income															3,357
Treasury Stock repurchased						(3,372	)								(3,372	)
Dividends Paid									(1,135	)					(1,135	)
Balances September 30, 2008	$	7,184	$	1,662	$	(3,372	)	$	34,308		$	(339	)	$	39,443
	Common Stock		Surplus		Treasury Stock			Retained Earnings			Other Comprehensive Income (Loss)			Total
Balances at December 31, 2008	$	7,184	$	1,662	$	(3,372	)	$	35,157		$	(1,232	)	$	39,399
Other Comprehensive Income:
Net Income									2,358						2,358
Change in other comprehensive income												96			96
Total Comprehensive Income															2,454
Dividends Paid									(1,162	)					(1,162	)
Balances September 30, 2009	$	7,184	$	1,662	$	(3,372	)	$	36,353		$	(1,136	)	$	40,691
The accompanying notes are an integral part of these statements

Page Five

HIGHLANDS BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands of Dollars)

	Nine Months Ended September 30,
	2009			2008
	(unaudited)			(unaudited)
Cash Flows From Operating Activities
Net Income	$	2,358		$	3,759
Adjustments to reconcile net income to net
cash provided by operating activities
Loss (gain) on investment securities		13			(109	)
(Gain) on sale of fixed asset		(1	)		(32	)
Other Loss		0			22
Gain on sale of OREO		(36	)		(0	)
Depreciation		488			512
Change in insurance contracts		(184	)		(209	)
Net amortization of securities		61			3
Provision for loan losses		1,175			636
Deferred income tax benefit		0			(14	)
Writedown on OREO property		40			0
Amortization of intangibles		146			133
Net purchase of intangibles		0			175
Decrease in interest receivable		335			124
(Increase) decrease in other assets		31			(685	)
Increase in accrued expenses and other liabilities		163			189
Net Cash Provided by Operating Activities		4,589			4,504
Cash Flows From Investing Activities
(Increase) decrease in federal funds sold		(11,955	)		13,418
Settlement on insurance contract		0			82
Proceeds from maturities of securities available for sale		5,777			15,282
Purchase of securities available for sale		(10,813	)		(12,537	)
(Increase) in restricted investments		(8	)		(375	)
Proceeds from sale of fixed assets and OREO		669			0
(Increase) decrease  in interest bearing deposits in banks		(589	)		1,361
Purchase of property and equipment		(1,626	)		(461	)
Net increase in Loans		(11,117	)		(5,678	)
Net Cash (Used in) Provided by Investing Activities		(29,662	)		11,092
Cash Flows From Financing Activities
Net change in deposits		30,331			(12,656	)
Federal funds purchased		0			775
Net change in short term borrowings		(4,800	)		0
Additional long term debt		0			1,500
Repayment of long term borrowings		(336	)		(1,869	)
Purchase of treasury stock		0			(3,372	)
Dividends paid in cash		(1,162	)		(1,135	)
Net Cash Provided by (Used in) Financing Activities		24,033			(16,757	)
Net (decrease)  in Cash and Cash Equivalents		(1,040	)		(1,161	)
Cash and Cash Equivalents, Beginning of Period		7,589			7,935
Cash and Cash Equivalents, End of Period	$	6,549		$	6,774

Page Six Supplemental Disclosures	2009 (unaudited)		2008 (unaudited)
Cash paid for income taxes	$	1,111	$	1,997
Cash paid for interest	$	5,793	$	6,746
The accompanying notes are an integral part of these statements.

Page Seven

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE ONE ACCOUNTING 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, 2009 and the results of operations for the three and nine month periods ended September 30, 2009 and 2008.

The results of operations for the three and nine month periods ended September 30, 2009 and 2008 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 2008 annual report on Form 10-K.

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

NOTE TWO     LOANS

A summary of loans outstanding as of September 30, 2009 and December 31, 2008 is shown in the table below (in thousands of dollars):

	September 30,		December 31,
	2009		2008
Loan Type
Commercial	$	95,093	$	97,709
Real Estate construction		28,982		27,210
Real Estate mortgage		168,815		156,877
Consumer installment		41,601		43,958
Total Loans	$	334,491	$	325,754

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, 2009, the total balance of loans in the portfolio secured by real estate was $276,150,000.

NOTE THREE ALLOWANCE FOR LOAN LOSSES

A summary of the transactions in the allowance for loan losses for the nine month periods ended September 30, 2009 and 2008 is shown below (in thousands of dollars):

	2009			2008
Balance, beginning of period	$	3,667		$	3,577
Provisions charged to operations		1,175			636
Loan recoveries		234			102
Loan charge-offs		(1,174	)		(664	)
Balance, end of period	$	3,902		$	3,651

The following summary provides information regarding impaired loans as of September 30, 2009 and December 31, 2008 (in thousands of dollars):

	2009		2008
Period end balance, impaired loans	$	2,782	$	3,841
Allowance for impairments, period end		527		272

Page Eight

NOTE FOUR 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.

NOTE FIVE 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, 2009 and December 31, 2008 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, 2009				December 31, 2008
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value
Available For Sale Securities
U.S. Treasuries and Agencies	$	11,987	$	12,149	$	7,504	$	7,726
Mortgage backed securities		7,010		7,225		10,211		10,342
Obligations of states and municipalities		4,584		4,698		3,596		3,609
Certificates of deposit in other banks Marketable equities		2,705 15		2,711 24		0 28		0 15
Total Available For Sale Securities	$	26,301	$	26,807	$	21,339	$	21,692

Information pertaining to securities with gross unrealized losses at September 30, 2009 and December 31, 2008, 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, 2009
Investment Category
Mortgage backed securities		138		(1	)		138		(1	)		0		(0	)
U.S. Treasuries and Agencies		2,295		(3	)		2,295		(3	)		0		(0	)
Total	$	2,433	$	(4	)	$	2,433	$	(4	)	$	0	$	(0	)
December 31, 2008
Investment Category
Mortgage backed securities		1,225		(17	)		1,156		(16	)		69		(1	)
State and municipals		1,908		(16	)		1,708		(15	)		200		(1	)
Other equity securities		15		(13	)		0		0			15		(13	)
Total	$	3,148	$	(46	)	$	2,864	$	(31	)	$	284	$	(15	)

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

Page Nine

transferability. The Company’s investment in Federal Home Loan Bank (FHLB) stock totaled $2.0 million at September 30, 2009.  FHLB stock is generally viewed as a long term investment and as a restricted investment security, which is carried at cost, because there is no market for the stock other than the FHLBs or member institutions.  Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing temporary declines in value.  Despite the FHLB’s temporary suspension of cash dividend payments and repurchases of excess capital stock in 2009, the Company does not consider this investment to be other than temporarily impaired at September 30, 2009 and no impairment has been recognized.

NOTE SIX EARNINGS PER SHARE

During the second and third quarters of 2008, the Company purchased, at varying intervals, 100,001 shares of outstanding common stock. This purchase by the Company of its outstanding shares reduced the number of weighted average shares outstanding for the three and nine month periods ended September 30, 2009 as compared to the three and nine month periods ended September 30, 2008.

NOTE SEVEN BORROWINGS

The Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB). This debt consists of both borrowings with terms of maturities of six months or greater and also certain debts with maturities of thirty days or less.

The borrowings with long term maturities may have either single payment maturities or amortize. The interest rates on the various long term borrowings at September 30, 2009 range from 3.94% to 5.96%. The weighted average interest rate on the borrowings at September 30, 2009 was 4.61%.

In addition to utilization of the FHLB for borrowings of long term debt, the Company also can utilize the FHLB for overnight and other short term borrowings. At September 30, 2009, the Company had no overnight or other short term borrowings. At December 31, 2008, the Company had balances of $4,800,000 in overnight and other short term borrowings. All of this short term debt was through the FHLB.

NOTE EIGHT ADJUSTMENT TO RETAINED EARNINGS FOR CHANGE IN ACCOUNTING PRINCIPLE

In 2006, the FASB issued pronouncements requiring companies that 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 pronouncements became effective for Highlands Bankshares on January 1, 2008.

These 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 December 31, 2008 and September 30, 2009 balances of retained earnings and is shown as an adjustment to retained earnings in the Consolidated Statement of Changes in Stockholders’ Equity for the period ended September 30, 2008.

Page Ten

NOTE NINE INTANGIBLE ASSETS

The Company’s balance sheet contains several components of intangible assets. At September 30, 2009, 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. The Company performs an impairment test on an annual basis.  No impairment has been recorded to date.

NOTE TEN 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 in 2006, 2007 and 2008 and made a contribution of $589,000 in the third quarter of 2009. The Bank has recognized liabilities of $1,406,000 at September 30, 2009. The following table provides the components of the net periodic benefit cost for the plan for the nine month periods ended September 30, 2009 and 2008 (in thousands of dollars):

	2009			2008
Service cost	$	126		$	127
Interest cost		207			201
Expected return on plan assets		(230	)		(244	)
Amortization of unrecognized prior service costs		0			3
Recognized net actuarial loss		55			40
Net periodic expense	$	158		$	127

NOTE ELEVEN FAIR VALUE MEASUREMENTS

ASC 820, Fair Value Measurements and Disclosures (previously 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:

Page Eleven

The Company, at September 30, 2009, had no liabilities subject to fair value reporting requirements. The table below summarizes assets at September 30, 2009 measured at fair value on a recurring basis (in thousands of dollars):

	Level 1		Level 2		Level 3		Total Fair Value  Measurements
Securities available for sale	$	0	$	26,807	$	0	$	26,807
Total	$	0	$	26,807	$	0	$	26,807

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.

The table below summarizes assets at September 30, 2009 measured at fair value on a non recurring basis (in thousands of dollars):

	Level 1		Level 2		Level 3		Total Fair Value Measurements
Other real estate owned	$	0	$	0	$	2,167	$	2,167
Impaired Loans		0		0		2,255		2,255
Total	$	0	$	0	$	4,422	$	4,422

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. Management believes that the fair value component in its valuation follows the provisions of ASC 820. Management estimates the fair value of real estate acquired through foreclosure at an estimated fair value less costs to sell. At or near the time of foreclosure, the subsidiary banks obtain real estate appraisals on the properties acquired through foreclosure. The real estate is then valued at the lesser of the appraised value or the loan balance, including interest receivable, at the time of foreclosure less an estimate of costs to sell the property. The estimate of costs to sell the property is based on historical transactions at the subsidiary banks of similar holdings.

ASC 820 applies to loans measured for impairment using the practical expedients permitted by Generally Accepted Accounting Pronouncements (“GAAP”), 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. The impairment of loans is measured by the Company based on the estimated value of underlying collateral of the loan. The value of the collateral is typically based on either an appraisal of the collateral or management’s best estimation of the realizable value of the collateral, less estimated costs to sell.

The information above discusses financial instruments carried on the Company’s balance sheet at fair value. Other financial instruments on the Company’s balance sheet, while not carried at fair value, do have market values which may differ from the carrying value. GAAP requires disclosure relating to these market values. The following information shows the carrying values and estimated fair values of financial instruments and discusses the methods and assumptions used in determining these fair values.

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The fair value of the Company's assets and liabilities is influenced heavily by market conditions. Fair value applies to both assets and liabilities, either on or off the balance sheet.  Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

The methods and assumptions detailed below were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are discussed following:

Cash, Due from Banks and Money Market Investments

The carrying amount of cash, due from bank balances, interest bearing deposits and federal funds sold is a reasonable estimate of fair value.

Securities

Fair values of securities are based on quoted market prices or dealer quotes.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Restricted Investments

The carrying amount of restricted investments is a reasonable estimate of fair value.

Loans

The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, taking into consideration the credit risk in various loan categories.

Deposits

The fair value of demand, interest checking, regular savings and money market deposits is the amount payable on demand at the reporting date.  The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Long Term Debt

The fair value of fixed rate loans is estimated using the rates currently offered by the Federal Home Loan Bank for indebtedness with similar maturities.

Short Term Debt

The fair value of short-term variable rate debt is deemed to be equal to the carrying value.

Interest Payable and Receivable

The carrying value of amounts of interest receivable and payable is a reasonable estimate of fair value.

Life Insurance

The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value as of September 30, 2009.  This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Off-Balance-Sheet Items

The carrying amount and estimated fair value of off-balance-sheet items were not material at September 30, 2009 or December 31, 2008.

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The carrying amount and estimated fair values of financial instruments as of September 30, 2009 and December 31, 2008 are shown in the table below (in thousands of dollars):

	September 30, 2009				December 31, 2008
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated  Fair Value
Financial Assets:
Cash and due from banks	$	6,549	$	6,549	$	7,589	$	7,589
Interest bearing deposits		1,091		1,091		502		502
Federal funds sold		12,115		12,115		160		160
Securities available for sale		26,807		26,807		21,692		21,692
Restricted investments		2,185		2,185		2,177		2,177
Loans, net		330,589		325,256		322,087		323,788
Interest receivable		1,829		1,829		2,164		2,164
Life insurance contracts		6,683		6,683		6,499		6,499
Financial Liabilities:
Demand and savings deposits		123,590		123,590		118,214		118,214
Time deposits		223,028		222,903		198,073		200,970
Overnight and other short term debt instruments		0		0		4,800		4,800
Long term debt instruments		10,981		11,576		11,317		11,930
Interest payable		1,039		1,039		848		848

NOTE TWELVE SUBSEQUENT EVENTS

The Company has evaluated events and transactions subsequent to September 30, 2009 through November 13, 2009, the date these consolidated financial statements were issued.  Based on the definitions and requirements of U.S. Generally Accepted Accounting Principles, we have not identified any events that have occurred subsequent to September 30, 2009 and through November 13, 2009, that require recognition or disclosure in the consolidated financial statements.

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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, 2008.  Current performance does not guarantee, and may not be indicative of, similar performance in the future.

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, continued challenges in the current economic environment affecting our financial condition and results of operations, continued deterioration in the financial condition of the U.S. banking system impacting the valuations of investments the Company has made in the securities of other financial institutions, and consumer spending and savings habits, particularly in the current economic environment.  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; (5) the Company is unable to control costs and expenses as anticipated, and (6) any additional assessments imposed by the FDIC. Additionally, consideration should be given to the cautionary language contained elsewhere in this Form 10-Q and in the section “Risk Factors”, Item 1A in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008.  The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

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, 2008. Some of the policies are particularly sensitive, requiring significant judgments, estimates and assumptions by management.

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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) ASC 450, Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, Loans and Debt Securities Acquired with Deteriorated Credit Quality (previously Statement of Financial Accounting Standards 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.

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 GAAP, 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 is evaluated under ASC 450 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.

GAAP does not specify how an institution should identify loans that are to be evaluated for collectability, nor does it specify how an institution should determine that a loan is impaired. Each subsidiary of Highlands 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 that are individually evaluated and found to be impaired, the associated allowance is based 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, are included in a group of loans that are measured under ASC 450 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 ASC 450 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.

Intangible Assets

The Company carries intangible assets related to the purchase of two banks. Amounts paid to purchase these banks were allocated as intangible assets. Generally accepted accounting principles were applied to allocate the intangible components of the purchases. The excess was allocated between identifiable intangibles (core deposit intangibles) and unidentified intangibles (goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value of the goodwill adjusted accordingly, should impairment be found.  As of December 31, 2008, the Company did not identify an impairment of this intangible. In addition to the intangible assets associated with the purchases of banks, the company also carries intangible assets relating to the purchase of naming rights to certain features of a performing arts center in Petersburg, WV. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received.

Post Retirement Benefits and Life Insurance Investments

The Company has invested in and owns life insurance policies on key 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 ASC 715, Compensation –Retirement Benefits.  ASC 715 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

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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.

Recent Accounting Pronouncements

In December 2007, a new accounting pronouncement was issued related to business combinations (ASC 805 Business Combinations). The pronouncement significantly changed the financial accounting and reporting of business combination transactions.  ASC 805 establishes principles for how an acquirer recognizes and measures the identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  The pronouncement is effective for acquisition dates on or after the beginning of an entity’s first year that begins after December 15, 2008.  The Company does not expect the implementation of the pronouncement to have a material impact on its consolidated financial statements, at this time.

In April 2009, a new accounting pronouncement was issued regarding accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies (ASC 805 Business Combinations).  The pronouncement amends and clarifies prior business combination guidance to address application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination.  The pronouncement is effective for assets and liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The Company does not expect the adoption of this pronouncement to have a material impact on its consolidated financial statements.

In April 2009, a new accounting pronouncement was issued regarding determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly (ASC 820 Fair Value Measurements and Disclosures). The pronouncement provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased.  The pronouncement also includes guidance on identifying circumstances that indicate a transaction is not orderly.  The pronouncement is effective for interim and annual periods ending after June 15, 2009, and shall be applied prospectively.  Earlier adoption is permitted for periods ending after March 15, 2009.  The Company does not expect the adoption of the pronouncement to have a material impact on its consolidated financial statements.

In April 2009, a new accounting pronouncement regarding interim disclosures about fair value of financial instruments (ASC 825 Financial Instruments and ASC 270 Interim Reporting) was issued.  The announcement amends prior guidance to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements.  In addition, the pronouncement also amends guidance regarding interim financial reporting to require those disclosures in summarized financial information at interim reporting periods.  The pronouncement is effective for interim periods ending after June 15, 2009, with earlier adoption permitted for periods ending after March 15, 2009.  The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In April 2009, a new accounting pronouncement was issued regarding recognition and presentation of other-than-temporary impairments” (ASC 320 Investments – Debt and Equity Securities).  The pronouncement amends other-than-temporary impairment guidance for debt securities to make guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities.  The pronouncement does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities.  The pronouncement is effective for interim and annual periods ending after June 15, 2009, with earlier adoption permitted for periods ending after

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March 15, 2009.  The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In April 2009, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 111 (SAB 111).  SAB 111 amends and replaces SAB Topic 5.M. in the SAB Series entitled “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities.”  SAB 111 maintains the SEC Staff’s previous views related to equity securities and amends Topic 5.M. to exclude debt securities from its scope.  The Company does not expect the implementation of SAB 111 to have a material impact on its consolidated financial statements.

In May 2009, a new accounting pronouncement was issued dealing with subsequent events (ASC 855 Subsequent Events).  The pronouncement establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The pronouncement is effective for interim and annual periods ending after June 15, 2009. The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In June 2009, a new accounting pronouncement was issued regarding accounting for transfers of financial assets (ASC 860 Transfers and Servicing).  The pronouncement provides guidance to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. The pronouncement is effective for interim and annual periods beginning after November 15, 2009.  The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In June 2009, new accounting pronouncement was issued that amended prior consolidation guidance (ASC 810 Consolidation). The pronouncement improves financial reporting by enterprises involved with variable interest entities.  The pronouncement is effective for interim and annual periods beginning after November 15, 2009.   Early adoption is prohibited. The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In June 2009, a new accounting pronouncement was issued regarding the FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting (ASC 105 Generally Accepted Accounting Principles).  The pronouncement establishes the FASB Accounting Standards Codification which will become the source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities.  The pronouncement is effective immediately. The Company does not expect the adoption to have a material impact on its consolidated financial statements.

In June 2009, a new accounting pronouncement was issued regarding Accounting for own-share lending arrangements in contemplation of convertible debt issuance or other financing (ASC 470 Debt).  The pronouncement clarifies how an entity should account for an own-share lending arrangement that is entered into in contemplation of a convertible debt offering.  The pronouncement is effective for arrangements entered into on or after June 15, 2009. Early adoption is prohibited.  The Company does not expect the adoption of EITF Issue No. 09-1 to have a material impact on its consolidated financial statements.

In June 2009, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 112 (SAB 112). SAB 112 revises or rescinds portions of the interpretative guidance included in the codification of SABs in order to make the interpretive guidance consistent with current U.S. GAAP.  The Company does not expect the adoption of SAB 112 to have a material impact on its consolidated financial statements.

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In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (ASU 2009-05), “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value.” ASU 2009-05 amends Subtopic 820-10, “Fair Value Measurements and Disclosures – Overall,” and provides clarification for the fair value measurement of liabilities. ASU 2009-05 is effective for the first reporting period including interim period beginning after issuance.  The Company does not expect the adoption of ASU 2009-05 to have a material impact on its consolidated financial statements.

In September 2009, the FASB issued Accounting Standards Update No. 2009-12 (ASU 2009-12), “Fair Value Measurements and Disclosures (Topic 820): Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent).” ASU 2009-12 provides guidance on estimating the fair value of alternative investments. ASU 2009-12 is effective for interim and annual periods ending after December 15, 2009. The Company does not expect the adoption of ASU 2009-12 to have a material impact on its consolidated financial statements.

In October 2009, the FASB issued Accounting Standards Update No. 2009-15 (ASU 2009-15), “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.” ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The Company does not expect the adoption of ASU 2009-15 to have a material impact on its consolidated financial statements.

In October 2009, the Securities and Exchange Commission issued Release No. 33-99072, “Internal Control over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers.” Release No. 33-99072 delays the requirement for non-accelerated filers to include an attestation report of their independent auditor on internal control over financial reporting with their annual report until the fiscal year ending on or after June 15, 2010.

Overview of First Nine Months Results

Net income for the first nine months of 2009, as compared to the same period in 2008, decreased by 37.27%.

Total assets increased 7.04% from December 31, 2008 to September 30, 2009 with gross loan balances increasing 2.68% from December 31, 2008. Although average balances of earning assets for the first nine months of 2009 were 3.60% higher than for the same period in 2008, average balances of interest bearing liabilities increased 4.55% for the same comparative time period, which contributed largely to the 6.14% decrease in net interest income.

In response to concerns over the economy and the resulting increase in net loan charge-offs,  the Company’s provision for loan losses was $539,000 more in the first nine months of 2009 as compared to the same period in 2008.

Non-interest income was $l97,000 less in the first nine months of 2009 as compared to 2008. During the first nine months of 2008, the company recorded $109,000 in gains related to securities which were called prior to their scheduled maturities compared to a loss of $13,000 during the same period in 2009.

Non-interest expense increased $648,000 in the first nine months of 2009 as compared to the same period in 2008 primarily due to increases in FDIC premiums applicable to all banks of $400,000.

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Performance Measures

The following table compares selected commonly used measures of bank performance for the nine month periods ended September 30, 2009 and 2008:

	Nine months ended September 30,
	2009			2008
Annualized return on average assets		.80	%		1.33	%
Annualized return on average equity		7.84	%		13.38	%
Net interest margin (1)		4.51	%		4.97	%
Efficiency Ratio (2)		65.55	%		56.91	%
Earnings per share (3)	$	1.76		$	2.69
(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 nine month period ended September 30, 2009 reflect the impact of the share repurchase of 100,001 shares during the second and third quarters of 2008.

Impact of Non-Recurring Items

Non recurring items had an impact on the income for the first nine months of 2009 as compared to the first nine months of 2008. During the year to date 2008, the Company recorded significant non-recurring gains compared to the year to date 2009.  A summary of the impact to income of these non recurring items is found in the table below (in thousands of dollars):

	2009			2008		Change
Net gains (losses) on securities	$	(13	)	$	109	$	(122	)
Net gains on sale of fixed assets		1			30		(29	)
Gain on life insurance settlement		0			30		(30	)
Net gains on other real estate owned and other foreclosed assets		36			8		28
Total		24			177	$	(153	)
Income tax effect of non recurring items		9			66		(57	)
Impact of non recurring items on net income	$	15		$	111	$	(96	)

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 7.16% of total assets and 71.25% of total shareholders’ equity at September 30, 2009.

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.

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

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to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations.   As of September 30, 2009, management determined that all securities with fair values less   than the amortized cost, are related to increases in the current interest rates for similar issues of securities, and that no other than temporary 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, 2009 can be found in Footnote Five 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.

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.

Credit Quality and Allowance for Loan Losses

Non-performing loans increased 50.33% from December 31, 2008 to September 30, 2009 primarily as a result of an increase in restructured loans.  Borrowers of restructured credits are performing in accordance with the revised terms of their contracts.  In addition, based on Management’s analysis, these loans are well secured and no losses are anticipated; therefore, no additional allowance was provided for these restructured credits.    Non-performing loans represented as a percentage of total loans increased to 2.48% during the first nine months of 2009 primarily due to the restructured credits mentioned above.  The allowance for loan losses as a percentage of total loans increased from the December 31, 2008 level of 1.13% to 1.17%.  As noted in Note Three to the unaudited consolidated financial statements, the carrying value of impaired loans declined slightly from $3.6 million at December 31, 2008 to $2.3 million at September 30, 2009.

Each of the Company’s banking subsidiaries determines the adequacy of its allowance for loan losses independently using the same allowance for loan loss methodology.  The allowance is calculated quarterly and 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 elsewhere in the calculation.  Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different historical charge-off rates amongst the functional areas of the banks’ loan portfolios.  Each bank pays particular attention to the individual loan performance, collateral values, borrower financial condition and economic conditions.  A committee, with representatives from both subsidiary banks, meets to discuss the overall economic conditions that impact both subsidiary banks in the same fashion.

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 projected cash flows.  Impaired loans and their resulting valuation allowance are disclosed in Note Three to the Company’s unaudited consolidated financial statements.  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 subjective and actual losses may be greater or less than the current amount of the allowance.  However, Management believes the current level of the allowance for loan losses represents a fair assessment of the losses inherent in the loan portfolio.

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

	September 30, 2009			December 31, 2008
Allowance for loan losses as a percentage of gross loans		1.17	%		1.13	%
Non performing loans as a percentage of gross loans		2.48	%		1.70	%
Ratio of allowance for loan losses to non-performing loans		.47			.66

Non-performing loans include non-accrual loans, loans 90 days or more past due and still accruing interest and restructured loans.  Non-accrual loans are loans on which interest accruals have been suspended.  Loans are typically placed on non-accrual status once they have reached certain delinquency status, 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 returned to accrual status if the obligation is brought current by the borrower, or they are charged off if payment is not made.  Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower.  The following table summarizes the Company’s non-performing loans at September 30, 2009 and December 31, 2008 (in thousands of dollars):

	September 30,		December 31,
	2009		2008
Non-accrual loans	$	3,750	$	1,346
Loans past due 90 days and still accruing interest		2,611		3,472
Restructured loans		1,942		705
Total non-performing loans	$	8,303	$	5,523

The following table summarizes the Company’s net charge-offs by loan type for the nine month periods ended September 30, 2009 and 2008 (in thousands of dollars):

	2009			2008
Charge-offs
Commercial	$	(296	)	$	(170	)
Mortgage and construction		(288	)		(155	)
Consumer		(590	)		(339	)
Total Charge-offs		(1,174	)		(664	)
Recoveries
Commercial		1			19
Mortgage		51			2
Consumer		182			81
Total Recoveries		234			102
Total Net Charge-offs	$	(940	)	$	(562	)

Management believes that the allowance is to be taken as a whole, and the allocation between loan types is an estimation of potential losses within each type given information known at the time.  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, 2009 and December 31, 2008 (in thousands of dollars):

	September 30, 2009					December 31, 2008
			Percent of					Percent of
	Amount		Loans			Amount		Loans
Loan Type
Commercial	$	1,359		28	%	$	1,349		30	%
Mortgage and construction		1,199		60	%		994		57	%
Consumer		1,125		12	%		1,285		13	%
Unallocated		219					39
Totals	$	3,902				$	3,667

Page Twenty-Two

Because of its large impact on the local economy, management continues to monitor 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 addition, multiple manufacturers of household cabinetry are large employers in the Company’s primary trade area. Due to the downturn in the housing market nationally, there have been indications that the demand for cabinetry has decreased, impacting the performance of these manufacturers. Because of the impact on the local economy, management has begun to monitor the performance of this industry as it relates to local employment trends. In recent periods, the Company’s loan portfolio has also begun to reflect a concentration in loans collateralized by heavy equipment, particularly in the trucking, mining and timber industries. Because of the impact of the slowing economic conditions on the housing market, the timber sector has experienced a recent downturn. While the Company has experienced some losses related to the downturn in this industry, no material losses related to foreclosures of loans collateralized by assets typical to the timber harvest industry have occurred.

Net Interest Income

The Company’s net interest income, on a fully taxable equivalent basis, decreased 6.03% from the first nine months of 2008 as compared to the same period in 2009 as average balances of earning assets increased 3.60% as compared to a 4.55% increase in the average balances of interest bearing liabilities.

Decreases during recent years in the target rate for federal funds sold have caused overall rates on both interest bearing liabilities and earning assets to decrease. Although these decreases didn’t all occur in the first nine months of 2009, the effects are still being seen in the Company’s net interest income as variable loans reprice and older balances of other earning assets and interest bearing liabilities mature and are replaced with new assets and liabilities at lower rates. In addition, increased competition for loans has impacted loan yields as the average rate earned on loans in the first nine months of 2009 fell 91 basis points

as compared to the same period in 2008. Although rates paid on interest bearing liabilities decreased also, the decrease was not as large as experienced with loans.

In addition to increased competition for loan balances, the Company has been required, in order to increase deposit balances to fund loan growth, to match or better local competitive rates paid on deposits, which also contributes to the decline in net interest margins. During previous years, the Company has chosen to fund loan growth through reduction in balances of comparatively lower earning assets such as securities and federal funds sold. In the recent quarters, the Company has begun to fund this loan growth through either new borrowings, typically short term or overnight borrowings, or through increases in balances of time deposits.

Also, the Company has recently placed larger balances of loans into non-accrual status than have been placed there historically. This, combined with increases in balances of Other Real Estate Owned due to foreclosures, has had a negative impact on interest income.

Changes for the third quarter 2009 compared to the third quarter 2008 are similar to those described above for the nine month periods.

Page Twenty-Three

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 2008 to 2009 and changes in average rates on interest bearing liabilities and earning assets from 2008 to 2009 (in thousands of dollars):

EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
Increase (Decrease) Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
	Due to change in:
	Average Volume			Average Rate			Total Change
Interest Income
Loans	$	881		$	(2,142	)	$	(1,261
Federal funds sold		(3	)		(213	)		(216	)
Interest bearing deposits		(20	)		(7	)		(27	)
Taxable investment securities		(35	)		(159	)		(194	)
Nontaxable investment securities		32			(1	)		24
Total Interest Income		855			(2,522	)		(1,667	)
Interest Expense
Demand deposits		(2	)		(38	)		(40	)
Savings deposits		(2	)		(190	)		(192	)
Time deposits		346			(1,015	)		(669	)
Borrowings		45			(21	)		24
Total Interest Expense		387			(1,264	)		(877	)
Net Interest Income	$	468		$	(1,258	)	$	(790	)

Page Twenty-Four

The table below sets forth an analysis of net interest income for the nine month periods ended September 30, 2009 and 2008 (Average balances and interest/expense shown in thousands of dollars):

	2009								2008
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	329,987		$	17,513		7.08	%	$	313,392		$	18,774		7.99	%
Federal funds sold		9,887			15		.20	%		12,157			231		2.53	%
Interest bearing deposits		622			11		2.26	%		1,747			38		2.90	%
Taxable investment securities		19,467			548		3.76	%		20,717			742		4.78	%
Nontaxable investment securities3		3,946			179		6.05	%		3,239			148		6.09	%
Total Earning Assets		363,909			18,266		6.69	%		351,252			19,933		7.57	%
Cash and cash equivalents		6,934								7,339
Allowance for loan losses		(3,711	)							(3,605	)
Insurance contracts		6,652								6,368
Non-earning assets		20,340								16,337
Total Assets	$	394,026							$	377,692
Interest Expense
Interest bearing demand deposits	$	22,308		$	33		.20	%	$	23,700		$	73		.41	%
Savings and money markets		49,362			147		.40	%		50,144			339		.90	%
Time deposits		209,817			5,386		3.42	%		196,328			6,055		4.11	%
Borrowings		13,222			397		4.01	%		11,217			363		4.31	%
Short-term borrowings		0			0		0.00	%		496			10		2.69	%
Total Interest Bearing Liabilities		294,709			5,963		2.70	%		281,885			6,840		3.24	%
Demand deposits		49,925								50,020
Other liabilities		9,290								5,499
Stockholders’ equity		40,102								40,288
Total liabilities and stockholders’ equity	$	394,026							$	377,692
Net Interest Income				$	12,303							$	13,093
Net Yield on Earning Assets3							4.51	%							4.97	%
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-Five

The table below sets forth an analysis of net interest income for the three month periods ended September 30, 2009 and 2008 (Average balances and interest/expense shown in thousands of dollars):

	2009								2008
	Average			Income/					Average			Income/
	Balance			Expense		Rate			Balance			Expense		Rate
Interest Income
Loans1,2	$	330,801		$	5,812		7.03	%	$	316,627		$	6,162		7.78	%
Federal funds sold		12,798			6		.19	%		1,383			8		2.31	%
Interest bearing deposits		845			5		2.10	%		773			7		3.63	%
Taxable investment securities		21,467			176		3.29	%		21,669			257		4.74	%
Nontaxable investment securities3		4,516			64		5.67	%		3,535			57		6.45	%
Total Earning Assets		370,427			6,063		6.65	%		343,987			6,491		7.55	%
Cash and cash equivalents		6,450								7,260
Allowance for loan losses		(3,795	)							(3,698	)
Insurance contracts		6,652								6,423
Non-earning assets		21,978								16,749
Total Assets	$	401,712							$	370,721
Interest Expense
Interest bearing demand deposits	$	22,037		$	9		.16	%	$	22,878		$	20		.33	%
Savings and money markets		51,134			47		.37	%		49,300			88		.71	%
Time deposits		219,523			1,800		3.28	%		191,463			1,809		3.78	%
Borrowings		11,040			128		4.65	%		11,283			128		4.54	%
Short term borrowings		0			0		0.00	%		1,478			10		2.71	%
Total Interest Bearing Liabilities		303,734			1,984		2.61	%		276,402			2,054		2.97	%
Demand deposits		50,859								49,832
Other liabilities		6,696								5,410
Stockholders’ equity		40,423								39,077
Total liabilities and stockholders’ equity	$	401,712							$	370,721
Net Interest Income				$	4,079							$	4,437
Net Yield on Earning Assets3							4.40	%							5.16	%
1Balances of loans include loans in non accrual status
2Interest income on loans includes fees
3Yields are on a fully taxable equivalent basis

Non-interest Income

Non interest income decreased $197,000, or 9.73%, during the first nine months of 2009 compared to the same period in 2008.  The year over year change in non-interest income was significantly impacted by non-recurring items.  Further discussion relating to non-recurring items can be found earlier on page seventeen.

Service charges on deposit accounts decreased 1.94%. The largest portion of these charges is non-sufficient funds fees on non-interest bearing transaction accounts. In prior periods, these charges increased as the subsidiary banks implemented programs commonly referred to as “courtesy overdraft” programs. Both subsidiaries have now had these courtesy overdraft programs in place in excess of twelve months and the volumes of fees from these programs appear to have stabilized.

During the periods 2004 through the present, the Company’s volume of new installment loans decreased. These loans are the primary market for credit life and accident and health insurance. As a result, earnings on

Page Twenty-Six

the sales of these insurance policies decreased over this same period as old policies matured but were not replaced by new policies at the same rate of maturity of the older credit related policies. This has contributed to a decline in insurance earnings.

The quarter-to-quarter comparisons are primarily due to the same items as described above.

Non-interest Expense

Non-interest expense increased 7.56% for the first nine months of 2009 as compared to 2008.

Changes in salary and benefits expense

The following table compares the components of salary and benefits expense for the nine month periods ended September 30, 2009 and 2008 (in thousands of dollars):

Salary and Benefits Expense
	2009		2008		Increase (Decrease)
Employee salaries	$	3,326	$	3,159	$	167
Employee benefit insurance		712		683		29
Payroll taxes		277		232		45
Post retirement plans		683		666		17
Total	$	4,998	$	4,740	$	258

The table below illustrates the change in salary expense for the first nine months of 2009 as compared to the same period in 2008 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	$	261
Changes due to increase in the average full time equivalent employees for the periods		(94	)
Total increase in salary expense	$	167

The quarter to quarter comparison is comparable to the changes described above with an 8.88% increase in salary and benefits expense for third quarter 2009 compared to third quarter 2008.

Changes in data processing expense

Data processing expense decreased 18.51%. During the later parts of 2008 and early into 2009, the Company completed a process for selection of a new service to complete its core data processing activities. Conversion to a new service is expected to occur in the fourth quarter of 2009. After this conversion, the costs associated with this system are expected to be approximately equivalent to the recent costs of the current system. However, during negotiations, the vendor of the new system provided incentives related to credits for the Company’s current contractual arrangements. This contributed significantly to the decline in data processing costs. Although recurring costs post-conversion are expected to be approximately equivalent to recent data processing costs, allowing for customer increases due to operational growth, the Company may experience certain other additional costs in the remaining quarters of 2009 relating to this implementation.

Quarter-to-quarter comparisons are similar to the change described above for the first nine months of 2009 compared to the first nine months of 2008.  Data processing expense decreased 18.50% in the third quarter 2009 compared to the third quarter 2008.

Page Twenty-Seven

Changes in occupancy and equipment expense

The following table illustrates the components of occupancy and equipment expense for the nine month periods ended September 30, 2009 and 2008 (in thousands of dollars):

	2009		2008		Increase (Decrease)
Depreciation of buildings and equipment	$	488	$	512	$	(24	)
Maintenance expense on buildings and equipment		307		316		(9	)
Utilities expense		92		67		25
Real estate and personal property tax		69		62		7
Other expense related to occupancy and equipment		67		63		4
Total occupancy and equipment expense	$	1,023	$	1,020	$	3

On a quarter-to-quarter basis, equipment and occupancy expense increased by 2.93% primarily due to an increase in utilities and real estate and personal property tax expense as see in the year-to-date numbers shown above.

Changes in miscellaneous non-interest expense

As discussed in Part I, Item 1 of the Company’s Annual Report on Form 10-K for the period ended December 31, 2008, under the heading Regulation and Supervision, the Company’s FDIC assessments increased by $400,000 for the first nine months of 2009 due to a special assessment and an overall increase in premiums.  Most other components of other non-interest expense remained fairly consistent for 2009 as compared to 2008. 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. Additional increases during the remainder of 2009 could further increase non interest expenses.

The table below illustrates components of other non interest expense for the nine month periods ended September 30, 2009 and 2008 (in thousands of dollars). All significant individual components of other non interest expense are itemized.

	2009		2008		Increase (Decrease)
Office supplies and postage & freight expense	$	346	$	382	$	(36	)
FDIC Premiums		442		42		400
ATM expense		162		146		16
Amortization of intangible assets		146		134		12
Advertising and marketing expense		119		134		(15	)
State franchise tax		85		79		6
Miscellaneous components of other non interest expense		654		591		63
Total	$	1,954	$	1,508	$	446

On a quarter-to-quarter basis, miscellaneous non-interest expense increased 20.70% primarily due to the increased FDIC premiums as noted above.

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, 2009 and throughout the nine month periods ended September 30, 2008 and 2009 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.

Page Twenty-Eight

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 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, 2009, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $4,543,000 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, 2009, 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, 2009 and December 31, 2008:

	September 30, 2009						December 31, 2008
	Actual			Regulatory			Actual			Regulatory
	Ratio			Minimum			Ratio			Minimum
Total Risk Based Capital Ratio
Highlands Bankshares		14.22	%		8.00	%		14.20	%		8.00	%
Capon Valley Bank		12.89	%		8.00	%		12.77	%		8.00	%
The Grant County Bank		14.06	%		8.00	%		13.99	%		8.00	%
Tier 1 Leverage Ratio
Highlands Bankshares		9.83	%		4.00	%		10.18	%		4.00	%
Capon Valley Bank		8.53	%		4.00	%		9.11	%		4.00	%
The Grant County Bank		9.92	%		4.00	%		10.00	%		4.00	%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares		12.97	%		4.00	%		12.98	%		4.00	%
Capon Valley Bank		11.64	%		4.00	%		11.52	%		4.00	%
The Grant County Bank		12.83	%		4.00	%		12.79	%		4.00	%

Page Twenty-Nine

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, 2008.

Item 4.      Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Interim Principal Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of September 30, 2009. Based on this evaluation, the Company’s Chief Executive Officer and Interim Principal Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of September 30, 2009. 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, 2008.

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

None

Item 3.      Defaults Upon Senior Securities

None

Page Thirty

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 Principal 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 Principal 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/ Alan Brill
	Alan Brill
	Interim Principal Financial Officer
November 13, 2009